Question

The British pound is currently trading at $1.26. Currently the price of a Big Mac in Great Britain Is £3.19 and the price of a Big Mac in the United States is $3.99. Calculate the real exchange rate for Big Macs between the two countries. Briefly explain what economic theory would predict would occur to prices in both countries and the nominal exchange rate if the exchange rate given your answer?

Answer 1

Ans)- we have the formula for calculating real exchange rate

Real Exchange rate(Between 2 countries) = Nominal exchange rate(Between 2 countries) × Ratio of prices of both countrries)

Here, Nominal exchange rate = $1.26/£ i.e. $1.26 dollars per pound(£)

Price of Big macs in Great Britain = £3.19

price of Big Macs in USA = $3.99

So, Real exchange rate = Nominal Exchange rate × Price of Macs in Britain/Price of Macs on USA

= 1.26 × £3.19/ $3.99

= $1.00736/£

Real Exchange rate is $1.00736 per pound(£).

The Theory of purchasing power parity explains or predicts this.

i.e. According to Purchasing power parity theory of exchange rate, the real exchange rate between two countries is defined as the product of the nominal exchange rate and the ratio of the countries price indices.