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: a. \(\$ 2=£ 1\) b. \(\$ 1=£ 2\) c. \(\$ 4=£ 1\) d. \(\$ 1=£ 4\)

Short answer

The exchange rate is $2=£1, which is option (a).

Step-by-step solution

Understanding the Problem

We are given the cost of a meal in two different currencies: $8 in the U.S. and £4 in the UK. The problem asks us to determine the exchange rate according to the purchasing-power-parity (PPP) theory, which suggests that in the long run, exchange rates should adjust to equalize the price of identical goods in different currencies.

Identifying Price Ratios

According to the PPP, the exchange rate should equal the ratio of prices in the two countries. Here, the price in the U.S. is $8, and in the UK, it is £4. Thus, the price ratio in this case is 8/4 (price in dollars over price in pounds).

Calculating the Exchange Rate

To find the exchange rate using the price ratio, divide the price of the meal in the U.S. by the price in the UK: \ \(\frac{8}{4} = 2\). This suggests an exchange rate where $2 equals £1.

Matching with Given Options

Compare the calculated exchange rate with the provided options: a. $2=£1, b. $1=£2, c. $4=£1, d. $1=£4. The calculated rate of $2=£1 matches option (a).

Key concepts

Exchange Rates

Exchange rates are pivotal in understanding how currencies translate between each other on the global stage. Imagine you are traveling from the U.S. to the U.K. with a pocketful of dollars. You need pounds to spend when you're there. An exchange rate helps you figure out how many pounds you can get for your dollars. For instance, if the exchange rate is $2 to £1, every two dollars you exchange will get you one British pound.
This conversion rate isn't fixed and can change due to factors such as economic conditions, interest rates, inflation, and more. For students studying international economics, getting familiar with exchange rates is crucial. They are not just numbers, but reflections of relative economic strengths and global market conditions.

Price Ratio

When it comes to purchasing power parity (PPP), the concept of price ratio is incredibly important. It refers to the relation between prices of similar items in different countries expressed through their respective currencies. In our example, a meal costs $8 in the U.S. and £4 in the U.K. The price ratio can be found by dividing the U.S. price by the U.K. price, which gives us 8/4 = 2.
This ratio tells us that, according to PPP, the currency exchange should be such that $2 equals £1. If you understand the price ratio, you can grasp how much more or less expensive the same item is in different countries, accounting for their currency value.

International Economics

International economics offers a view into how countries interact financially on a broad scale. It explores how goods, services, and capital move across borders and how such exchanges impact global economies. A key element is understanding how currency values and exchange rates affect trade and purchasing power.

• Trade Balances: How much a country exports versus how much it imports.
• Capital Flow: Movement of money for investment, trade, or business production.
• Impact of Exchange Rates: They can make exports cheaper or more expensive, affecting competitiveness.

By appreciating these concepts, students can get a better grasp of why purchasing power parity and exchange rates are so significant in international trade. They demonstrate how interconnected our world has become and how delicate the balance of economic power can be.

Currency Comparison

Currency comparison, especially using PPP, involves checking how much of one currency is needed to buy the same item in another currency. This is essential for understanding the real value of money in global terms. For example, if $8 buys a meal in the U.S. and £4 buys the same meal in the U.K., we are essentially comparing the value of these two currencies.
With purchasing power parity, we look beyond the surface value of the numbers. Instead, we try to equalize what those numbers can actually buy in a real-world context. This helps in determining whether a currency is overvalued or undervalued relative to another, providing insight into market dynamics and economic policies. Understanding currency comparisons is crucial for anyone engaged in international finance or business.