PRINCIPLES OF MACROECONOMICS(LOOSELEAF)
7th Edition
ISBN: 9781260110920
Author: Frank
Publisher: MCG
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Chapter 17, Problem 7RQ
To determine
Describe the speculative attack on overvalued exchange rate sing a demand and supply diagram.
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Suppose a currency is temporarily undervalued by a fixed exchange rate system, such as the international gold standard. Let that currency be the US dollar, and expressed in terms of British pounds. First show this disequilibrium using a supply and demand graph and then Clearly explain how one could profit by arbitraging in dollars using a bill of exchange.
Suppose that on January 1, the dollar exchange rate with the yen is 1/120 $/Y.
Over the year, the Japanese inflation rate is 5%, and the US inflation rate is 10%.
If the exchange rate at the end of the year is 1$=130Y, does the yen appear to be
overvalued, undervalued, or at the PPP level? Explain. What if Japanese inflation
were 10% and the US inflation rate were 5% over the year, instead? Explain why
your answer changes.
The Big Mac index was introduced by The Economist magazine in 1986, as a playful example to introduce the concept of purchase power parity (PPP) and under/overvaluation of currencies. The PPP rates are usually compiled based on consumer baskets of comparable quality. The problem is that goods in different economies are hardly comparable. The customer basket contains only one good which is made everywhere in exactly the same way – McDonald’s Big Mac. You might think that is an oversimplification, but in fact the Big Mac Index has been widely used for comparing currencies ever since it was first published.
Explore the concept behind the Big Mac index and critically assess the importance of comparability of goods in various economies.
Chapter 17 Solutions
PRINCIPLES OF MACROECONOMICS(LOOSELEAF)
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