Refer to Figure 2-1. Point A is A) technically efficient. B) ...

[rl]

Refer to Figure 2-1. Point A is
 
  A) technically efficient.
  B) unattainable with current resources.
  C) inefficient in that not all resources are being used.
  D) the equilibrium output combination.

Question 2

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 Mexico, the average price of a Big Mac at that time was 49 pesos. If the exchange rate between the dollar and the peso was 13.60 pesos per dollar, how would purchasing power parity predict the exchange rate will change in the long run? Support your answer graphically.

[pami445]

Answer to Question 1

C

Answer to Question 2

The dollar in this example is overvalued while the peso is undervalued. The relative price ratio of 49 pesos per Big Mac to 4.79 per Big Mac (10.23 pesos per dollar) is less than the current exchange rate of 13.60 pesos per dollar. In other words, the dollar cost of a Big Mac in Mexico is only 3.60 (49/13.60). This implies that the supply of dollars will rise as more Americans trade their dollars in for pesos to buy Big Macs in Mexico. This increase in the supply of dollars (as shown below) will reduce the exchange rate (lower the value of the dollar), as shown below. (Similarly, the demand for the peso is rising, indicating an increase in the value of the peso.) Adjustments will continue until the exchange rate is equal to 10.23 pesos per dollar.

[rl]

Excellent

[upturnedfurball]

TYSM