Problem Set # 4

International Finance Miguel D. Ramirez

1. Suppose a Big Mac at the McDonald’s in New York costs $2.50 and FFr 15 in Paris.

a. What spot exchange rate establishes the Law of One Price for these two commodities?

b. If the current spot rate is Ffr 5/$, what is the real exchange rate? What are the units of the calculation?

c. According to your calculation, is the dollar overvalued or undervalued? How about the French Franc?

2. Suppose the current spot rate is $1.55/£ on the first of January. By year-end, the U.S. CPI is expected to climb from 144 to 150 and the U.K. CPI from 120 to 130. According to PPP, what is the expected spot rate on December 31?

3. Suppose the expected annual inflation rate is the U.K. is 5.5 percent and that in the U.S. 4 percent. According to PPP, will the dollar depreciate or appreciate in value? By what percentage?

4. Define and contrast absolute and relative purchasing power parity. Provide an example of each. What is the most appropriate method and why?