Suppose a Germanmade automobile is priced at 20000 An identi

Suppose a German-made automobile is priced at €20,000. An identical U.S.-made car costs $26,000.

a) What does Purchasing Power Parity tell us about the likely exchange rate between the U.S. dollar and the euro?

b) Suppose one euro trades for $1.50 in the foreign currency exchange markets. Based on your answer to part (a), is the dollar overvalued or undervalued? Briefly explain how you know.

Solution

A) Exchange rate=Price in US/Price in Euro=26000/20000=1.3

Thus according to purchasing power 1Euro should be $1.3

B) Exchange rate in market is 1Euro=$1.5

Since Euro is getting more dollar in exchange market compared to Purchasing power rule which makes Euro to be overvalued and dollar to be undervalued.