Question

Assume that Big Mac costs $6.50 in the U.S. and £5 in the U.K. Find the implied absolute PPP exchange rate. If the actual exchange rate $/E=1.4505, then according to absolute PPP, which of the following statements is correct? A) It costs the same in dollars to buy Big Mac in the U.K. B) Absolute PPP holds between the US. and the UK. C)It casts more in pounds to buy Hie Mac in the U.5 D)The pound is undervalued relative to the dollar. E) The pound is overvalued relative to the doilar.

Answer 1

The correct statement is: E) The pound is overvalued relative to the dollar.

Step-by-step explanation:

The implied absolute PPP exchange rate can be found by dividing the price of the Big Mac in the U.S. by the price of the Big Mac in the U.K. In this case, the implied absolute PPP exchange rate is $6.50/£5.00 = $1.30/£1.00.

The actual exchange rate $/E is given as 1.4505. According to absolute PPP, the value of the implied absolute PPP exchange rate should be equal to the actual exchange rate. In this case, since the implied absolute PPP exchange rate is $1.30/£1.00 and the actual exchange rate is $1.4505/£1.00, we can conclude that the pound is overvalued relative to the dollar.