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Chapter 30: Problem 9

In December \(2016,\) you needed 83 percent more pesos to buy one U.S. dollar than you had needed in December 2004\. Over the same time period, the consumer price index in Mexico increased 57.8 percent, and the consumer price index in the United States increased 26.7 percent. Are these data consistent with the theory of purchasing power parity? Briefly explain.

Short Answer

Expert verified
No, these data are not consistent with the theory of Purchasing Power Parity. The exchange rate increased by more than the change in relative price levels of the two countries, which contradicts with the theory of PPP.

Step by step solution

01

Find the increase in the exchange rate

We first find the increase in the exchange rate. The exercise tells us that we need 83 percent more pesos to buy one U.S. dollar. In other words, the exchange rate has increased by 83 percent.
02

Calculate Change in Relative Prices

Next, we need to calculate how much the price level has changed in Mexico relative to the United States. The change in relative price levels can be calculated by subtracting the percent change in the CPI in the United States from the percent change in the CPI in Mexico. Therefore, we subtract 26.7 percent from 57.8 percent to get 31.1 percent.
03

Compare the increase in the exchange rate with the change in relative prices

Lastly, we compare the increase in the exchange rate with the change in relative prices. We found that the exchange rate increased by 83 percent and relative prices increased by 31.1 percent. Since the exchange rate increased by more than the relative price levels, these data are not consistent with the theory of Purchasing Power Parity. According to PPP, the exchange rate should adjust to compensate for the changes in relative buying power of the two countries, meaning that the increase in the exchange rate should be similar to the change in relative prices.

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Most popular questions from this chapter

In January \(2007,\) before the financial crisis, the exchange rate was \(\$ 1.30\) per euro. In July 2008 , during the financial crisis, the exchange rate was \(\$ 1.58\) per euro. Was this change in the dollar-euro exchange rate good news or bad news for U.S. firms exporting goods and services to Europe? Was it good news or bad news for European consumers buying goods and services imported from the United States? Briefly explain.

According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain.

How were exchange rates determined under the gold standard? How did the Bretton Woods system differ from the gold standard?

(Related to the Apply the Concept on page 1071 ) An article on usatoday.com included the following two observations: First, "Chinese companies and individuals have begun to invest more heavily outside the country." Second, "The yuan has dropped nearly 7 percent against the dollar so far this year. The Chinese government has responded by draining its foreign exchange reserves to buy yuan, hoping to slow the currency's fall." a. Is there a connection between Chinese companies and individuals investing more heavily outside the country and the drop in the yuan? Briefly explain. b. Why might the Chinese government want to slow the fall in the yuan? c. Why would the Chinese government have to drain its foreign exchange reserves to slow the fall in the yuan?

What does it mean when one currency is "pegged" against another currency? Why do countries peg their currencies? What problems can result from pegging?
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