Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:Single choice
A
A. correctly valued.
B
B. overvalued.
C
C. undervalued.
D
D. There is not enough information to answer this question.

Question

Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:Single choice

A

A. correctly valued.

B

B. overvalued.

C

C. undervalued.

D

D. There is not enough information to answer this question.

BlackTom AI · Accepted Answer

We start by identifying the key comparison: the implied PPP exchange rate is 8.50 Mexican pesos per 1 U.S. dollar, while the current market rate is 10.80 pesos per 1 dollar. This difference tells us how the peso is trading relative to PPP.
Option A: 'A. correctly valued.' If the market rate differed from PPP, the currency would not be correctly valued by PPP standards. Since 10.80 > 8.50, the market rate implies a deviation from PPP, so this option is not accurate.
Option B: 'B. overvalued.' An overvalued currency would be one that buys more of the foreign currency than PPP suggests. Here, one U.S. dollar costs more pesos in the market (10.80) than PPP would imply (8.50). This means the peso is actually cheaper to buy dollars for (more pesos per dollar) than PPP would justify, which corresponds to the peso being undervalued, not overvalued. Therefore this option is incorrect.
Option C: 'C. undervalued.' With the market rate higher than the PPP rate (10.80 > 8.50), the peso buys fewer dollars than PPP would predict, indicating the peso is undervalued relative to PPP. This aligns with the typical interpretation of a higher domestic price of dollars under PPP.
Option D: 'D. There is not enough information to answer this question.' The question provides both the implied PPP rate and the current exchange rate, which are sufficient to assess valuation relative to PPP, so this option is incorrect.
In summary, the comparison shows a discrepancy where the actual market rate (10.80) exceeds the PPP rate (8.50), which points to the peso being undervalued according to PPP and the Law of One Price.