Question

Please verify the my solutions below. These are practice examples and I am unsure if I answered them correctly.

Please explain any discrepancies in detail and please explain any calculations or formulas. For parts C&D, please add detail, if my answers are not sufficient.

Practice # 17. Considering Purchasing Power Parity and the Law of One Price:

part a: Assume that the current price of a Big Mac in the United States today is $2.75. Assume also that the current price of a Big Mac in Malaysia is 6.5000 ringgits and that the current USDMYR exchange rate is 3.0250 ringgits per $. What is the implied PPP of the USD?

Answer:

• 6.50000/2.75000 = 2.3636
• 2.3636 ringgits per USD

part b: Using the assumptions above, what is the under (-) / over (+) valuation of Malaysian ringgits versus the U.S. dollar in percentage terms?

Answer:

• (2.3636-3.025)/3.025 = -0.2186
• 21.86% under-valued

part c: What are the long-term implications associated with your answer to part b.?

Answer:

• Over the long term, the exchange rates should normalize and the currency should no longer be overvalued.
• Over the long term, demand for ringgits will increase and the exchange rate should move toward the implied PPP rate.

d. Describe the short-falls, if any, of PPP as a predictor of currency exchange rates?

Answer:

• Commodities such as big macs cannot be traded between countries
  • Prices are influenced by several factors in each country, including real estate, rental rates, and taxes
• The PPP does not take into account any transaction costs of the exchange.
• Unless you are dealing with a universal currency, there will always been transaction costs.

Answer 1

a) Implied PPP rate of USD = Cost in ringgits / Cost in USD = 6.5 / 2.75 = 2.36 ringgits/USD

b) Actually, 1$ = 3.025 ringgits

PPP rate , 1$ = 2.36 ringgits

so, undervaluation of ringgits = [(2.36 - 3.025)/3.025]* 100 = -21.85%

c) Over the long term, demand for ringgits will increase and the exchange rate should move toward the implied PPP rate. The purchasing power will become the same in both countries and no currency will remain undervalued.

d) Commodities such as big macs cannot be traded between countries. Prices are influenced by several factors in each country, including real estate, rental rates, and taxes. The PPP does not take into account any transaction costs of the exchange. Unless you are dealing with a universal currency, there will always been transaction costs.