Question

Suppose that you travel to Cali (Colombia), where the exchange rate is$1USDto2,900$Colombian pesos. As you enter a McDonald’s restaurant, you realize you need $17,400$Colombian pesos to buy a Big Mac. Assuming a Big Mac sells for $\$5$in the United States, would you say that the Colombian peso is over- or undervalued in terms of PPP?

Short answer

The rate should be$3,480pesosfor\$1$and because the actual rate of exchange is $2,900pesosfor\$1$, it shows the lesser pesos in $\$1$. So, the Colombian peso is overvalued in terms of PPP.

Step-by-step solution

Concept Introduction 

Purchasing power parity (PPP) refers to the speculation that indicates the rate of exchange of the $2$currencies from various countries is adequate the ratio between their purchasing power.

Explanation of Solution 

Colombian pesos to be purchased from $\$1are2,900$pesos.

Rate of $1$Big Mac in pesos is $17,400pesoswhileinU.Sdollaris\$5$.

The formula to calculate the rate as per PPP is:

Exchange rate as per PPP $\text{Exchange rate as per PPP}=\frac{\text{Purchasing power of Country}1}{\text{Purchasing power of Country}2}$

$Putting17,400forpurcha\sin gpowerofcountry1and5$for purchasing power of country $2$within the above formula,

Exchange rate as per PPP $=\frac{17,400}{5}$

$=3,480\text{Pesos}$

As per PPP, the rate should be $3,480pesosfor\$1$and because the actual rate of exchange is $2,900pesosfor\$1$, it shows the lesser pesos in $\$1$. So, the Colombian peso is overvalued in terms of PPP.

Thus, the Colombian pesos are overvalued in terms of PPP.