Question

You are planning to visit Sydney, Australia for the summer session and want to know about the cost of living there relative to the US. Assume that the price of Big Mac is US is $4.20 (that is, 4.20 USD), while the price of Big Mac in Australia is 5.75 AUD. If today’s exchange rate between the two countries is 1AUD = 0.76 USD, then (1) calculate the real exchange rate and (2) determine which country’s cost of living is cheaper.

Answer 1

Real exchange rate (USD/AUD) = Nominal exchange rate (USD/AUD) x PAUD/PUSD

= 0.76 x 5.75 / 4.20

= 1.0405

Since 1 AUD has a nominal value of 0.76 USD but a real value of 1.0405, USD is more valuable so it is cheaper to live in US. This can be understood as:

price of Big Mac is US is $4.20 so we spent 4.20 USD and get a Big Mac in US. The same USD in Australia gives 4.2/0.76 = 5.52 AUD from which we cannot buy a Big Mac as it is priced at 5.75 AUD. Hence Australia is expensive to live.