Question

[Real Exchange Rate via Big Mac Index: The real cost of living] You are planning to...

[Real Exchange Rate via Big Mac Index: The real cost of living]

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.

[Hint: the real exchange rate is calculated by: US Big Mac price in USD / Foreign Big Mac price in USD]

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Answer #1

(1)

Price of Big Mac in United States = $4.20

Price of Big Mac in Australia = 5.75 AUD

Converting the price of Big Mac in Australia in US dollars -

Price of Big Mac in Australia (in US dollars) = 5.75 * 0.76 = $4.37

Calculate the real exchange rate -

Real exchange rate = US Big Mac price in USD/Australia Big Mac price in USD

Real exchange rate = $4.20/$4.37 = 0.96

The real exchange rate is 0.96

(2)

The real exchange rate indicates that 1 unit of Australian good is equal to 0.96 units of US goods.

Thus,

Cost of living in Australia is cheaper.

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