Question

A meal at a McDonald's restaurant in New York costs \(8 .\) The identical meal at a McDonald's restaurant in London costs \(£ 4 .\) According to the purchasing-power-parity theory of exchange rates, the exchange rate between U.S. dollars and British pounds should tend to move toward: LO39.3 a. \(\$ 2=£ 1\) b. \(\$ 1=£ 2\) c. \(\$ 4=£ 1\) d. \(\$ 1=£ 4\)

Short answer

The exchange rate should move toward $2 = £1, so the answer is (a).

Step-by-step solution

Understanding the Concept

The purchasing-power-parity (PPP) theory suggests that in an efficient market, identical goods should have the same price in different countries when prices are expressed in the same currency.

Defining the Cost of a Meal in New York

The price of a McDonald's meal in New York is given as 8 US dollars ( $8").

Defining the Cost of a Meal in London

The price of a McDonald's meal in London is given as 4 British pounds (£4").

Setting Up the PPP Equation

According to PPP, the cost of the meal in New York should equal the cost of the meal in London when converted to the same currency. Therefore, we set up the equation: $8 = E imes £4$, where E is the exchange rate in terms of $/£.

Solving for the Exchange Rate

To find E, solve the equation: $8 = E imes £4$. Divide both sides by 4 to isolate E: $8/4 = E$. Therefore, E = 2.

Conclusion and Choosing the Right Answer

Since E = 2, the exchange rate should be $2 = £1. This corresponds to answer choice (a).

Key concepts

Exchange Rates

Exchange rates represent the value of one currency in terms of another currency. In our exercise, we look at the exchange between the U.S. dollar (USD) and the British pound (GBP). Exchange rates fluctuate based on various factors, including economic conditions, interest rates, inflation, and market psychology.

• An exchange rate is vital for international trade and investments because it affects how much goods cost when traded between countries.
• It determines how much foreign currency you receive when you exchange your money.

In the context of purchasing power parity (PPP), exchange rates are used to compare the cost of similar goods in different countries. Ideally, the exchange rate should make prices of goods equal when expressed in a common currency. According to PPP, if a hamburger costs $8 in New York and £4 in London, the exchange rate should be $2 for every £1 to ensure equal purchasing power. Therefore, PPP makes a strong case that the exchange rate should adjust until price equalities are achieved.

Currency Conversion

Currency conversion involves using exchange rates to convert the value of one currency into another. It's a practical task that anyone traveling abroad or engaging in international trade needs to understand. In our example, converting the cost of a meal from British pounds to U.S. dollars helps determine the applicable exchange rate.

• Currency conversion is essential for comparing costs, determining profits, and managing risks associated with foreign exchange.
• It allows businesses and consumers to understand the real value of money across borders.

The method of currency conversion depends heavily on the current exchange rate. If $1 equals £2, then converting £4 would result in a requirement of $8, as seen in our exercise. Properly understanding this concept helps in making informed financial decisions when dealing with foreign currencies. It's not only about exchange rates—it's about what the conversion delivers in terms of purchasing power and equivalency, reinforcing the concept of purchasing power parity.

International Economics

International economics deals with the flow of goods, services, and finances across national boundaries. It encompasses trade policies, international finance, and economic integration.

In our exercise, international economics is illustrated through the concept of purchasing power parity. PPP is a foundational theory in international economics that posits that in equilibrium, identical goods should have the same price globally. This principle helps economists understand how prices and exchange rates interact in the global market.

• By analyzing PPP, economists gauge whether a currency is undervalued or overvalued.
• It helps in identifying opportunities for arbitrage, trade imbalances, and the impact of inflation.

Understanding international economics is crucial for policymakers and businesses to navigate the complexities of the global market. It ensures that countries can develop strategies to stabilize their economies, promote efficient trade, and support economic growth. The exchange rate that aligns with PPP in our exercise is a small but clear example of the broader mechanisms at work in international economics.