Question

Using the absolute purchasing power parity, what must be the Can/ exchange rate if the cost of your favorite running shoes in the U.S. is $105 and the exact same shoes in Canada cost Can122.90?

Answer 1

To estimate the Can/USD exchange rate for absolute purchasing power parity, divide the Canadian price of the shoes by the U.S. price, resulting in 1 Canadian dollar equaling 1.17 U.S. dollars, an outcome that aligns with the avoidance of arbitrage opportunities.

Step-by-step explanation:

The concept called absolute purchasing power parity posits that in the absence of transportation and other transaction costs, identical goods should have the same price when expressed in a common currency. To calculate the Can/USD exchange rate necessary for absolute purchasing power parity, we need to equalize the cost of the favorite running shoes in both the U.S. and Canada.

To find out what the Canadian dollar should be worth in U.S. dollars (Can/USD exchange rate), we would divide the Canadian price by the U.S. price. Using the numbers given, the calculation would be: Can122.90 / $105 = 1.17. Therefore, the equivalent Can/USD exchange rate for absolute purchasing power parity would be 1 Canadian dollar is equal to 1.17 U.S. dollars.

This also illustrates the concept of arbitrage, where discrepancies in prices can lead to buying in one market and selling in another for profit, thus eventually equalizing the prices in both the markets when corrected for the exchange rate.