The last time The Economist checked, a Big Mac costs $5.30 in the US while it co

Question

The last time The Economist checked, a Big Mac costs $5.30 in the US while it costs 16.9 Israeli Shekel (NSI) in Israel. If the actual exchange rate is 3.54 NSI/USD, then the Israeli Shekel is _____ relative to the (Big Mac) PPP. The Israeli Shekel should change by _______ percent so that we reach the Law of One Price (Purchasing Power Parity) for the Big Mac.

A. a. Undervalued; -9.9%

B. b. Undervalued; -11%

C. c. Overvalued; +9.9%

D. d. Overvalued; +11%

Westerlands and Crownlands are two countries that trade with each other and no other countries. Assume that Westerlands’ currency is pegged to Crownlands’ currency. Meanwhile, due to inflationary pressures, the central bank of Westerlands wishes to decrease the money supply. Which statement is correct – assume that initially (before conducting the monetary policy), Westerlands central bank does not have to intervene in Foreign Exchange Market:

A. To achieve this, Westerlands’ central bank can decrease money supply and sell its foreign reserves in foreign exchange markets.

B. Since the exchange rate is fixed, Westerlands’ central bank cannot perform this monetary policy.

C. Crownlands’ central bank can decrease its money supply in order to decrease demand for Westerlands’ currency.

D. None of the above.

Assume that Argentina keeps a fixed exchange rate with respect to the Brazilian currency and that the Brazilian central bank decides to lower the money supply in Brazil. Following the monetary contraction in Brazil and to maintain its exchange rate, the Argentinean central bank should ______________ Argentinean currency in the foreign exchange market, which leads to a _________ in the money supply in Argentina.

A. buy; increase.

B. buy; decrease.

C. sell; increase.

D. sell; decrease.

Explanation / Answer

1. A. Undervalued, -9.9%

Calculation:

According to the PPP, 16.9 NSI is worth 5.30 USD. So, 1 NSI = 5.30/16.9 = 0.3136

According to the actual exchange rate, the value of 1 NSI = 1/3.54 = 0.2824

Therefore, the Israeli Shekel is undervalued relative to the Big Mac PPP.

The NSI needs to change from 3.54 NSI/USD to 3.188 NSI/USD (Note: 16.9/5.3 = 3.54)

So, the % change required is = (3.54 - 3.188)/3.54 * 100 = 0.352/3.54 * 100 = 0.0994 * 100 = 9.94% = 9.9%

Also, the sign should be negative ad it is a negative change.

So, right answer is A, undervalued, -9.9%

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