Suppose a basket of goods that costs $400 in Canada 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

Purchasing power parity (PPP) suggests that in the absence of transaction costs and barriers to trade, the same basket of goods should have the same price across different countries when prices are expressed in a common currency. If a basket costs $400 in Canada but only £200 in Britain, and the exchange rate is $1/£, it implies that the same goods are cheaper in Britain. Therefore, one could buy the goods in Britain for £200, sell them in Canada for $400, and then exchange the $400 for £400 (assuming the current exchange rate), making a profit of £200. This arbitrage opportunity indicates that the real value of the pound is undervalued at $1/£, suggesting that the equilibrium exchange rate should be higher to eliminate such profit opportunities.

Suppose a Basket of Goods That Costs $400 in Canada