Question

Currently, you get the price of a Canadian dollar is 19 Dirham (the official currency of Maroc). In Canada, you can buy a Big Mac for C$6. If the price of a Big Mac is 125 Dirham in Maroc, which of the following is true according to the theory of Purchasing Power Parity?

Ans: Relative to the Canadian dollar, the Dirham is currently overvalued. We expect the Dirham to depreciate.

In the Chegg tutor's solution, I don't understand the bold parts:

C$ = 125/6 = 20.83

Whereas, Current Exchange Rate of Dirham/C$ = 19

One Canadian Dollar is available for Less Dirham, then it should be, then the Canadian Dollar is Undervalued. Therefore, Dirham is overvalued

As Dirham is overvalued, it will be sold. Therefore, Depreciate.

Therefore, Option (2) Dirham is currently Overvalued and we expect Dirham to Depreciate.

I'm confused why we compare 19 and 20.83 because 20.83 is bigger than 19 because we used $6 CAD so of course 20.83 >19. 19 was calculated with $1 CAD. Maybe I am thinking of it wrong and so I'm confusing myself.

Please clarify the bold, thanks.

Answer 1

Answer

Here in this case you need to understand the concept of purchasing power parity ( PPP) which is bused to compare the economic productivity and the living standards of two countries we are considering like Canada and Maroc in our case This theory uses basket of goods approach and its formula is b

S = P1 / P2

where S is the exchange rate of currency 1 to 2

P1 is the cost of good X in currency 1

P2 is the cost of good x in currency 2

so

S = 125/ 6 = 20.8333

Therefore the exchnage rate of currency 1 to 2 is 20.8333

and the answer  Relative to the Canadian dollar, the Dirham is currently is correct because we can see that one Canadian dollar the dirham deprecfiates by the exchange rate of 20.8333

HAVE A GOOD DAY !