Question

The Argentine peso was fixed through a currency board at Ps1.00​/$ throughout the 1990s. In January 2002 the Argentine peso was floated. On January​ 29, 2003 it was trading at Ps3.24​/$. During that one year period​ Argentina's inflation rate was 21​% on an annualized basis. Inflation in the United States during that same period was 2.3​% annualized.

a. What should have been the exchange rate in January 2003 if PPP​ held? (Round to five decimal​ places.)

b. By what percentage was the Argentine peso undervalued on an annualized​ basis? (Round to five decimal​ places.)

c. What were the probable causes of​ undervaluation?

Answer 1

a). PPP Exchange Rate = Beginning Spot Rate x [(1 + Inflation_Peso) / (1 + Inflation_USD)]

= Ps1.00/$ x [1.21 / 1.023] = Ps1.00/$ x 1.18280 = Ps1.18280/$

b). Percentage overvaluation (positive) or undervaluation (negative)

= [PPP Exchange Rate - Actual Exchange Rate] / Actual Exchange Rate

= [Ps1.18280/$ - Ps3.24/$] / Ps3.24/$ = -Ps2.0572/$ / Ps3.24/$ = -63.49396

c). The rapid decline in the value of the Argentine peso was a result of not only inflation, but also a severe crisis in the balance of payments.