Post by: mrsjacobs44 on Mar 16, 2019
The "Big Mac Theory of Exchange Rates" tests the accuracy of purchasing power parity theory. In July 2015, The Economist reported that the average price of a Big Mac in the United States was $4.79. In Switzerland, the average price of a Big Mac at that time was 6.50 Swiss francs. If the exchange rate between the dollar and the Swiss franc was 0.93 Swiss francs per dollar, how would purchasing power parity predict the exchange rate will change in the long run? Support your answer graphically.
Post by: mmpiza on Mar 16, 2019
The dollar in this example is "undervalued" while the Swiss franc is "overvalued." The relative price ratio of 6.50 Swiss francs per Big Mac to $4.79 per Big Mac (1.36 Swiss francs per dollar) is greater than the current exchange rate of 0.93 Swiss francs per dollar. In other words, the dollar cost of a Big Mac in Switzerland is $6.99 (6.50/0.93). This implies that the supply of dollars will fall as fewer Americans trade their dollars in for Swiss francs to buy Big Macs in Switzerland. This decrease in the supply of dollars (as shown below) will increase the exchange rate (raise the value of the dollar), as shown below. (Similarly, the demand for the Swiss franc is falling, indicating a decrease in the value of the Swiss franc.) Adjustments will continue until the exchange rate is equal to 1.36 Swiss francs per dollar.
Post by: Kevin Rice on Jul 25, 2020