2. From base price levels of 100 in 2000, Japanese and U.S. price levels in 2003

Question

2. From base price levels of 100 in 2000, Japanese and U.S. price levels in 2003 stood at 102 and 106, respectively a. If the 2000 S exchange rate was 130/S, what should the exchange rate be in 2003 according to Purchasing Power Parity? b. In fact, the exchange rate in 2003 was Y115/S. Was yen overvalued or undervalued in the foreign exchange market of 2003? By how much? (Please show your calculations) c. In fact, the exchange rate in 2003 was 115/S. Was dollar overvalued or undervalued in the foreign exchange market of 2003? By how much? (Please show your calculations)

Explanation / Answer

1. Let the dollar value of Yen in 2003 be ‘x’. Thus x/(1/130) = 106/102

Or x = $0.007994.

Thus exchange rate in 2003 = 1/0.007994 = Yen 125/$

2. Exchange rate on 2003 was Yen 115/$ or 1/115 = $0.008696

Thus yen was clearly overvalued and the quantum by which it was overvalued was ($0.008696 - 0.007994)/ 0.007994 = 8.78%

3. Now 1$ should have been Yen 125 in 2003 but in fact it is Yen 115. Thus dollar is undervalued and the quantum by which it is undervalued = (125-115)/125 = 8.00%

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