Suppose a basket of goods costs $400 in the United States and £200 in Britain.If the exchange rate is $1/pound, what will happen in the foreign exchange market, according to the purchasing power parity theory?

Question

Quizplus · Accepted Answer

According to the purchasing power parity theory, 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 costs $400 in the United States and £200 in Britain, so the exchange rate should be $1/pound. However, the current exchange rate is $1/pound, which means that the pound is undervalued relative to the dollar. This will lead to an increase in demand for pounds, which will drive up the price of pounds.

Suppose a Basket of Goods Costs $400 in the United