A Big Mac in Japan costs 400 yen while it costs $4.50 in the U.S..The nominal exchange rate is 100 yen per dollar.Which of the following would both make the real exchange rate move towards purchasing-power parity?
A)the price of Big Macs in the U.S.falls,the nominal exchange rate falls
B)the price of Big Macs in the U.S.falls,the nominal exchange rate rises
C)the price of Big Macs in the U.S.rises,the nominal exchange rate falls
D)the price of Big Macs in the U.S.rises,the nominal exchange rate rises

Question

Quizplus · Accepted Answer

According to the theory of purchasing-power parity, the real exchange rate is determined by the relative prices of similar goods in different countries. Here, the price of a Big Mac in Japan is lower than in the U.S., which means that the yen is undervalued relative to the dollar. To move towards purchasing-power parity, the real exchange rate needs to adjust so that the yen appreciates relative to the dollar. One way this can happen is if the price of Big Macs in the U.S. falls, which makes the U.S. dollar relatively weaker. If the nominal exchange rate also falls, it would reinforce the adjustment in the real exchange rate. Therefore, option A is the correct answer. Option B would lead to the opposite effect, where the real exchange rate diverges from purchasing-power parity. Option C or D might also lead to exchange rate adjustments, but they would depend on other factors affecting the exchange rate besides Big Mac prices.

A Big Mac in Japan Costs 400 Yen While It