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 correct option is option a: $2= 1 pound

Step-by-step solution

Purchasing power parity and exchange rates

The economic theory of purchasing power parity (PPP) helps understand why different currencies have different purchasing power and enables setting the exchange rate.

The exchange rate between one currency and another is in equilibrium when their domestic purchasing power at that exchange rate is equivalent.

Determining the exchange rate

A McDonald’s meal in New York City is $8 while the same meal costs 4 pounds in London. This implies that the relative price of the meal is higher in New York City than in London.

Thus, the pound to the dollar exchange rate is $2 that is 1pound equals $2, which means it costs $2 to purchase 1 pound.

The correct option is option a.