Suppose in 1992, the average price level in Pacifica was 100, and that in Atlantica it was also 100. In the foreign exchange market 1 Pacifica pound was exchanged for 1 Atlantica mark. In 2012, the price level in Pacifica had risen to 280 and the price level in Atlantica had risen to 360.a. According to the relative purchasing power parity (PPP) theory, what should the pound-mark exchange rate be in 2012?b. If the actual pound per mark exchange rate is 0.5 pound/mark in 2012, is the mark overvalued or undervalued relative to its PPP value?
What will be an ideal response?
POSSIBLE RESPONSE:
a. According to the relative PPP theory, 1 pound should equal to 1.2857 mark (360/280=1.2857) or 1 mark should equal to 0.778 pounds (280/360 = 0.778).
b. The mark is undervalued relative to its PPP value.
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