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An economics book has the following example:

In the USA, a Big Mac sells for 1 USD, while in Germany it sells for 3 EUR.

The "fair" FX relation would therefore be 1 USD = 3 EUR. At the FX market, however, the FX relation is 1 USD = 2 EUR.

The author now concludes that the EUR is undervalued. But I think that's wrong, the EUR is overvalued here, isn't it?

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  • $\begingroup$ Why do you think the EUR is overvalued relative to the USD? $\endgroup$ – luchonacho Apr 15 '17 at 8:51
  • $\begingroup$ @luchonacho Let's suppose I'm a tourist to the US who wants to have a Big Mac at the German airport before taking off. I then decide otherwise and have the Big Mac at the US airport. Swapping my 3 EUR I get back 1.5 USD and can practically now have 1.5 Big Macs - hence the EUR is overvalued against the USD. $\endgroup$ – Thorsten Apr 15 '17 at 9:23
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Your conclusion is correct here. Since at the current FX rate you can buy the burger cheaply at an equivalent rate of 2 EUR in the US. So basically, if you live in Germany and want to buy a Big Mac, you are better of buying the Big Mac from the US since via the FX rate you will still have 1 EUR left(if you started with 3 EUR) and hence this will increase the demand of the USD in the foreign exchange market and hence

USD should appreciate in the future => USD in undervalued => EUR is overvalued.

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You are right. The EUR is overvalued. Or, to put it differently, a change in the exchange rate from 1/3 to 1/2 means that the EUR appreciated (or increased its value) with respect to the USD. Equivalently, the USD depreciated with respect to the EUR. You need more USD to buy a Big Mac in Germany.

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