Practice Quiz 6 — Exchange Rates & PPP

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The exchange rate is S = $/£ = 1.25, meaning it costs $1.25 to buy one British Pound. A Starbucks latte costs $5.50 in Los Angeles and £3.80 in London. US inflation is 3% and UK inflation is 4%.

(a) Using absolute PPP applied to lattes, what is the PPP-implied exchange rate S = $/£? At market rates, is the pound overvalued or undervalued relative to the dollar?

(b) Using the log-linear approximation to relative PPP, what is the predicted percentage change in S = $/£ over the next year? Will the pound strengthen or weaken against the dollar?

(c) In one sentence, explain the economic intuition for why the higher-inflation country’s currency should depreciate under relative PPP.