Question

The important implication of purchasing power parity theory (for our purposes) is in regard to nominal exchange rates (and changes in these rates). If purchasing power parity theory is true, we can use price differences (or price level differences more broadly) in two countries to make a prediction of what the nominal exchange rate “should be”. If a Big Mac costs 300 yen in Japan and $3.25 in the U.S., what should be the nominal exchange rate of yen per U.S. dollar?

Answer 1

Purchasing power parity helps us to calculate exchange rate such that a same currency can buy equal amount of good in any country. For example , in our case If Purchasing power parity holds then $1 can buy same amount of good in US as it can buy in Japan after we convert it into Yen.

Hence Mathematically,

Nominal Exchange rate(Yen/$) = Price in Japan/ Price in US

= Price of Big Mac in Japan/ Price of Big mac in US

= 300/3.25

= 92.31

Hence, the nominal exchange rate of yen per U.S. dollar = 92.31