The Big Mac Index is a numerical tool for assessing disparities in
consumer purchasing power between countries. Suppose that the Big Mac costs 7.50 Canadian dollars in Canada and 5.50 US dollars in the US. Suppose that the nominal exchange rate is 1.2 Canadian dollars to 1 US dollar.
(i) Calculate the real exchange rate.
(ii) Is the Canadian dollar undervalued or overvalued against the US dollar? Explain
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To calculate the real exchange rate, we need to first convert the prices of the Big Mac in each country to the same currency. In this case, we will convert the Canadian dollar price to US dollars.
(i) Calculate the real exchange rate:
The Canadian price of the Big Mac is 7.50 CAD. Using the nominal exchange rate of 1.2 CAD to 1 USD, we can convert the Canadian price to US dollars:
7.50 CAD / (1.2 CAD/USD) = 6.25 USD
Now that both prices are in US dollars, we can calculate the real exchange rate by dividing the US price of the Big Mac in Canada by the US price of the Big Mac in the US:
Real exchange rate = (US price of Big Mac in Canada) / (US price of Big Mac in US)
= 6.25 USD / 5.50 USD
= 1.136
The real exchange rate is approximately 1.136.
(ii) Determine whether the Canadian dollar is undervalued or overvalued against the US dollar:
To determine if the Canadian dollar is undervalued or overvalued, we compare the real exchange rate to the nominal exchange rate. If the real exchange rate is higher than the nominal exchange rate, the currency is considered overvalued, meaning it is more expensive in relation to the other currency. If the real exchange rate is lower than the nominal exchange rate, the currency is considered undervalued, meaning it is cheaper in relation to the other currency.
In our case, the real exchange rate (1.136) is lower than the nominal exchange rate (1.2). This means that the Canadian dollar is undervalued against the US dollar. In other words, the Canadian dollar is cheaper in relation to the US dollar, which suggests that it may have lower purchasing power compared to the US dollar.