Question

Angela Smith travels between New York City and Paris on a regular basis. She is interested in purchasing a nice designer-made business suit and would like to use purchasing power parity to determine if she is paying the same price regardless of where she makes her purchase.

(a) If the price of a designer-made business suit in NYC is USD750 and the price of the same suit in Paris is EUR720, using purchasing power parity, is the price of the business suit truly equal if the spot rate is USD1.12/EUR? What is the real exchange rate?

(b) If the price of the business suit remains the same in New York one year from now, determine the price of the suit in Paris in one year’s time if PPP holds true. The U.S. inflation rate is 1.5% and the inflation rate in France is 3%.

Answer 1

(a)

If the spot rate is USD 1.12 / EUR, then the price of the suit in Paris should be 750 / 1.12 = 669.64 EUR.

However, the price in Paris is 720 EUR.

The price is the suit is not truly equal

Real exchange rate = price in USD / price in EUR

Real exchange rate = 750 / 720

Real exchange rate = USD 1.0417 / EUR

(b)

Price in EUR = price in USD / (current exchange rate * (1 + EUR inflation rate) / (1 + USD inflation rate))

Price in EUR = 750 / (1.12 * (1 + 1.5%) / (1 + 3%))

Price in EUR = EUR 659.89