Explanation The exchange rate is the rate at which a currency is exchanged with another. It is calculated by equating the demand for and supply of the currencies in the exchange rate market. According to the purchasing power parity theory, the exchange rate should be adjusted in such a way that the same commodity should be available at the same rate in all countries. Thus, if one good is available for $1 in the US, it should be available in the UK at the cost which is equal to $1 in the £ value. Thus, the exchange rate should be calculated by dividing the foreign price with the domestic price as follows: Exchaneg rate = Foreign price domestic price (1) In the example, the cost of the item in the US is $8 and in London is £4. Thus, the exchange rate which holds the purchase power parity can be calculated by substituting the given values in equation (1) as follows: Exchaneg rate = Price in London Price in US = 4 8 = 1 2 Thus, the exchange rate which keeps the price of the item in two countries the same is $2 = £1. Option (a): The given example says that the foreign price is £4 and the domestic price is $8 for the same product. The purchase power parity theory explains that the same commodity should cost the same in both markets to the purchase power parity to hold. If it is so, the price that the consumer has to pay in London can be calculated by multiplying the exchange rate with the price in the US as follows: Price in London = Exchnage rate × Price in US = 0.5 × 8 = 4 Since the calculated price is equal to the given price, 2 dollars are required to purchase 1 pound which will keep the price of the item the same in the two regions. Thus, option ‘a’ is correct. Option (b): The calculated exchange rate which holds the purchasing power parity theory true is $2 = £1. Thus, 2 dollars are required to purchase 1 pound which will keep the price of the item the same in the two regions

The exchange rate between dollar and pound.

MACROECONOMICS (LL)

21st Edition

ISBN: 9781260186949

Author: McConnell

Publisher: MCG

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The exchange rate between dollar and pound.

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The exchange rate between dollar and pound.

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The exchange rate between dollar and pound.

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