Suppose a basket of internationally traded goods that sells for $10,000 in the United States sells for €8,000 in the euro zone. According to purchasing power parity theory, the equilibrium exchange rate should be

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The equilibrium exchange rate should be $2.50 per euro because the purchasing power parity theory states that the exchange rate between two currencies should be equal to the ratio of the prices of a basket of goods in the two countries. In this case, the basket of goods sells for $10,000 in the United States and €8,000 in the euro zone, so the equilibrium exchange rate should be $10,000 / €8,000 = $2.50 per euro.

Suppose a Basket of Internationally Traded Goods That Sells for $10,000