Question

Assume the reference commodity costs 200 US dollars in New York, 360 Australian dollars in Sydney, 120 pounds sterling in London, 800 yuan in Shanghai and 22,000 yen in Tokyo.

a.         What exchange rates are predicted by the PPP model? List the price of the Australian dollar, British Pound, Chinese Yuan and Japanese Yen, as measured in US dollars.

b.         Assume the following current spot exchange rates:

•           us$0.60 per Australian dollar

•           us$1.70 per British pound

•           us$0.20 per Chinese yuan

•           us$0.01 per Japanese yen

How do these spot rates compare with the PPP predictions? Which currencies are “overvalued” and which are “undervalued”, based on PPP theory?

c.         Calculate the real exchange rate for each of the above currencies (measured in US dollars).

Answer 1

Part a)

The exchange rates predicted by the purchasing power parity model are:

US Dollar – Australian Dollar

US Dollar – Pound sterling

US Dollar – Yuan

US Dollar – Yen

Australian Dollar – Pound sterling

Australian Dollar – Yuan

Australian Dollar – Yen

Pound sterling – Yuan

Pound sterling – Yen

Yuan – Yen

The prices as measured in US Dollars are:

US dollars – 1$

Australian dollars – 0.556$

Pounds sterling – 1.67$

Yuan – 0.25$

Yen – 0.0091$

Part b)

The spot rates are very close to the calculated values by the PPP model.

Currencies that are overvalued –

Australian dollar by 0.044$

British pound by 0.03$

Japanese Yen by 0.0009$

Currency that is undervalued –

Chinese yuan by 0.05$

Part c)

Same as part 1)