A Starbucks Grande Latte costs $3.75 in the U.S.and 28 yuan in China.The nominal exchange rate is 6.75 yuan per dollar.The real exchange rate is
A)1.106.If purchasing-power parity held the nominal exchange rate would be higher.
B)1.106.If purchasing-power parity held the nominal exchange rate would be lower.
C).904.If purchasing power parity held the nominal exchange rate would be higher.
D).904.If purchasing-power parity held the nominal exchange rate would be lower.

Question

Quizplus · Accepted Answer

To calculate the real exchange rate, we need to divide the price of a Starbucks Grande Latte in the U.S. by the price in China and multiply it by the exchange rate:

Real exchange rate = (U.S. price/China price) x nominal exchange rate
Real exchange rate = ($3.75/28 yuan) x 6.75 yuan/dollar
Real exchange rate = 0.536 x 6.75
Real exchange rate = 3.623 yuan/dollar

This means that it costs 3.623 yuan to buy one U.S. dollar's worth of goods in China. Since the nominal exchange rate is 6.75 yuan/dollar, this suggests that the yuan is undervalued relative to the dollar, i.e. it takes fewer yuan to buy the same amount of goods as in the U.S. Thus, if purchasing power parity held, the nominal exchange rate would be higher (i.e. it would take more yuan to buy one U.S. dollar). Therefore, the answer is C - .904, and not 1.106.

A Starbucks Grande Latte Costs $3