A can of soda costs .25 in the United States and 25 pesos in...

A can of soda costs \$1.25 in the United States and 25 pesos in Mexico. What is the peso$-$dollar exchange rate (measured in pesos per dollar) if purchasing power parity holds? If a monetary expansion caused all prices in Mexico to double, so that soda rose to 50 pesos, what would happen to the peso$-$dollar exchange rate?

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Key Concepts

Exchange Rate Determination

Exchange rate determination involves figuring out how much of one currency is needed to purchase a unit of another currency. Under PPP, the exchange rate adjusts in response to relative price levels ensuring that similar goods cost the same in different countries when prices are converted using the exchange rate.

Purchasing Power Parity (PPP)

PPP is an economic principle which states that in the absence of transportation and transaction costs, identical goods should have the same price when expressed in a common currency. It provides a method to determine the equilibrium exchange rate by equating the cost of a basket of goods in one country with the cost of the same basket in another country.

Monetary Expansion and Inflation

Monetary expansion refers to an increase in a country's money supply, which can lead to inflation—a rise in the general price level of goods and services. In the context of PPP, if a monetary expansion causes domestic prices to rise, the exchange rate must adjust accordingly; in this case, a doubling of domestic prices implies a proportional depreciation of the currency in terms of the foreign currency.

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