ECON 1102 TUTORIAL 9

Open Economy Exchange Rates, Net Exports and International Capital Flows
Textbook Reference: Chapter 14 & 15
Question 7*
(All students must submit a written answer to this question at the beginning of this tutorial)
The Economist magazine uses prices of McDonalds Big Mac hamburger to calculate the PPP values
for currencies. The following data are taken the January 2012 Big Max Index.
Big Mac Price in Local Currency
US US$ 4.20
Australia $A 4.80
New Zealand $NZ 5.10
(i)Calculate the implied PPP values for the Australian dollar against the US dollar and for the
Australian dollar against the New Zealand dollar.
Implied PPP Value for USD/AUD
= 4.20/4.80
=0.875

Implied PPP Value for NZF/AUD
=5.10/4.80
=1.0625

(ii)Using the daily exchange rate data from the RBA website at
http://www.rba.gov.au/statistics/tables/index.html#exchange_rates what are the values of the
$A/$US and $A/$NZ exchange rates for the 31 January 2012?
USD/AUD value = 1.0637
NZD/AUD value = 1.2909

(iii)Compared to its PPP value, is the Australian dollar overvalued or undervalued in terms of the
US dollar? Explain.
The Australian dollar is overvalued in terms of the US dollar when compared to the PPP value as
according to the law of one price, the prices should be uniform in all the locations and if the
exchange rate was correctly valued, the cost of a Big Mac in the US would be $5.11 but it is only
$4.20, suggesting the AUD is overvalued.

(iv)Compared to its PPP value, is the Australian dollar overvalued or undervalued in terms of the
NZ dollar? Explain.
Similarly, the Australian dollar is also overvalued in terms of the New Zealand Dollar when compared
to the PPP value, with the cost of a Big Mac being $5.10 and thus lower than the $6.20 required to
be equivalent in value to the Australian Big Mac, suggesting that the Australian dollar is overvalued.

(v)Taking the Australian price as given and ignoring transportation costs, according to the law of
one price what should have been the price of a Big Mac in New Zealand on 31 January 2012?
Explain whether or not you would expect the law of one price to hold for a Big Mac.
Assuming there are no transportation costs and the law of one price holds, the price of a Big Mac
should be $6.20. The law of one price would only hold when transport costs, input costs that are not
traded such as labour, costs of premises and services are ignored as it is largely a uniform product.
However, factors such as the competition within the fast food industry may also cause variations in
prices for the Big Mac.