Suppose a basket of goods that costs $400 in the United States costs only £200 in Britain and the current exchange rate is $1/pound.According to the purchasing power parity theory, the equilibrium exchange rate should be higher than $1/pound.Why?

Question

Quizplus · Accepted Answer

According to the purchasing power parity theory, the exchange rate should adjust such that the basket of goods costs the same amount in both countries when converted to a common currency. Since the basket costs $400 in the United States and £200 in Britain, the exchange rate should be $2/pound ($400 divided by £200). However, the current exchange rate is only $1/pound, which means that the pound is undervalued relative to the dollar. This presents an opportunity for arbitrage, where an individual could purchase the basket in Britain for £200, convert the pounds to dollars at the current exchange rate ($1/pound), and then sell the basket in the United States for $400. The individual could then take the $400 and exchange it back into pounds at the current exchange rate, receiving £400. Since the initial cost of the basket was only £200, the individual would make a profit of £200 ($400 - £200 = £200), demonstrating that the exchange rate should be higher than $1/pound. Choice A is the only option that correctly explains this concept.

Suppose a Basket of Goods That Costs $400 in the United