Suppose a Starbucks tall latte cost $4.00 in the United States, 5.00 euros in the euro area and $2.50 Australian dollars in Australia. Nominal exchange rates are .80 euros per dollar and 1.4 Australian dollars per U.S. dollar. Where does purchasing-power parity hold?
A) both the euro area and Australia
B) the euro area but not Australia
C) Australia but not the euro area
D) neither the euro area or Australia

Question

Quizplus · Accepted Answer

To test for purchasing-power parity, we need to compare the prices of the same good in different countries after adjusting for exchange rates. We can use the U.S. price as the base because the U.S. dollar is the world's dominant currency.

Using the nominal exchange rates given, we convert the euro and Australian prices to U.S. dollars:

- 5.00 euros / 0.80 euros per dollar = $6.25 
- $2.50 Australian dollars / 1.4 Australian dollars per dollar = $1.79

Now we can compare the prices:

- U.S. price = $4.00 
- Euro price (PPP) = $6.25 
- Australian price (PPP) = $1.79

The euro price is higher than the U.S. price, indicating that the euro is overvalued relative to the dollar. The Australian price is lower than the U.S. price, indicating that the Australian dollar is undervalued relative to the dollar.

Therefore, purchasing-power parity holds in Australia but not in the euro area. Choice B is the correct answer.

Suppose a Starbucks Tall Latte Cost $4