Question

Suppose Big Mac costs 120 pesos in Mexico City and 6 pounds in London. If the current exchange rate is 25 pesos per pound, then according to law of one price, pound is ______ and should _______ in the long run.

undervalued; appreciate

overvalued; depreciate

overvalued; appreciate

undervalued; depreciate

Answer 1

According to Law of one price,

Exchange Rate = Cost of Big Mac in Mexico / Cost in London

= 120/6 = 20 pesos per pound

now you are actually getting more pesos according to the current exchange rate then the the law of One price exchange rate as a result of which you can understand that Mexican peso is undervalued or pound is overvalued.

because pound is overvalued it will depreciate against the Mexican peso in the long run and settle at the price determined by law of one price

Therefore (b) overvalued, depriciate is the answer to this question

Because you are getting more pesos, pound is overvalued and not undervalued in order to return to equilibrium it has to depreciate and not appreciate

That's why (a,c,d) are wrong