If the actual exchange rate for the euro value of the British pound is less than the exchange rate that would satisfy absolute PPP, which of the currencies is overvalued and which is undervalued? Why?
What will be an ideal response?
The terminology of "overvalued" and "undervalued" refers to the relationship of the exchange rate to the PPP theory. If the actual exchange rate of euros per pound is less than the PPP prediction, the euro is overvalued and the pound is undervalued. We know this is the correct answer because if the actual exchange rate were to move to the PPP prediction, the euro would have to weaken, and the pound would correspondingly have to strengthen, on the foreign exchange market. The weakening of the euro would correct its overvaluation, and the strengthening of the pound would correct its undervaluation.
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