Question

Some people read tea leaves to predict the future, The Economist magazine prefers hamburgers. The magazine started the Big Mac Index in 1986 as a light-hearted guide to test whether currencies are at their “correct” exchange rate based on the Law of One Price. Under the Law of One Price, the price of the Big Mac should be the same if its local price is converted into dollars at the current exchange rates. Currently, the average price of a Big Mac is €5.0 in France, and $5.2 in the U.S. And the current spot exchange rate is $1.15/€.

Based on the information above, please answer the following questions:

1. Where can you buy cheaper hamburgers: France or U.S.? Please explain.

2. Calculate the “fair” (i.e., PPP implied) exchange rate based on the law of one price.

3. Based on the PPP, is the euro overvalued or undervalued? And by how much?

Answer 1

Here current spot exchange rate

= 1 euro = 1.15 $

Thus 5 euro = ?

= 5 x 1.15

=5.75 $

Thus one can buy cheaper hamburgers in US as it cost $5.2 in US where as it cost $5.75 in france

Fair exchange rate based on the law of one price = Cost of hamburger in US/ Cost of hamburger in france

= $5.2 / Euro 5

= 1.04 $

Thus Fair exchange rate = 1 euro = 1.04$

As per PPP, exchane rate should be 1 euro = 1.04$ however it is 1 euro = 1.15 $ , thus we can say that euro is overvalued by 1.15-1.04 = 0.11$