Suppose that 091 swiss francs trade for 1 in the us a big...

Suppose that 0.91 Swiss francs trade for $1, in the U.S. a Big Mac costs $4.37, and in Switzerland price a Big Mac costs 6.5 francs. (a) What is the value of the real exchange rate between the Swiss and the U.S. Big Mac? (b) Explain what the theory of purchasing-power parity implies. (c) If PPP held, what should be the nominal exchange rate between the Swiss franc and the US dollar? (d) Why is PPP not entirely true in the real world? Please use a specific example to explain why PPP does not hold true even for a fairly standard product like a Big Mac.

Transcript

00:01 So what do we know? we know that 0 .19 francs, i have no idea what the symbol for the swiss franc is.

00:10 I'm just going to call it sf.

00:12 Swiss francs is equal to $1.

00:15 Right? this is what we know.

00:17 Probably there is some symbol for swiss francs.

00:19 I don't know.

00:19 We know that the price of the big mac is equal to $437 in dollars.

00:28 And the price of the big mac is, mac is equal to 6 .5 swiss francs.

00:37 What is the value of the real exchange rate? well, what the heck is the real exchange rate, right? the real exchange rate is talking about how many, say, us goods for how many swiss goods, right? the nominal exchange rate is in terms of dollars, but the real exchange rate is in terms of goods.

01:07 So we need to set up a formula for the real exchange rate, which we tend to call epsilon.

01:12 First of all, let's start with the nominal exchange rate.

01:18 So we know the nominal exchange rate is, say, one u .s .d per 0 .91 swiss francs.

01:26 This is the nominal exchange rate literally.

01:29 We also know something about what we want to get.

01:32 I want to cancel off the currencies, right? i want to get a measurement that's free of currencies and only involves goods.

01:38 So i'm going to put usd on the bottom.

01:40 Now, i'm going to think about, i know that i can get, it is 437, 437 usd per us big mac.

01:54 Right? to get a big mac in the united states, it's 437.

01:56 And it's 6 .5 swiss francs to get a swiss big mac.

02:02 You see how usd cancels and swiss francs cancel? so my measurement is only in terms of us big macs for swiss big macs, right? i just need to punch this into my calculator.

02:15 6 .5 divided by 0 .91 divided by 4 .37 is equal to 1 .6 .3 is equal to 1 .6 .3...

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