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Unit VIII Case Study : The Big Mac Index

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Business

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Homework

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1. Big Mac
The purchasing power parity theory may not be a valid test of the dollar overvalued against
some currencies of the world and undervalued against some currencies of the world because
price levels in two counties are not the same. Though the PP theory says that prices in two
countries should converge towards equality through a process of arbitrage. This in reality never
happens because of the system of protectionism followed in some countries which cause
sustained differences in prices. This is not due to exchange rate fluctuations but other
macroeconomic factors. Exchange rate fluctuations are solely dependent on currency
movements and monetary policies of countries and hence the valuation of currencies depends
solely upon economic indicators and the monetary policy of a country as opposed to other trade
features and one price equilibrium. .Hence the PP theory cannot be a valid test of currency
valuation. The price levels between china and USA are not the same . The theory of arbitrage
cannot work between the two countries because of many factors which have contributed to
currency fluctuations the PP theory has no role to play here.
2. China :
China keeps its Yuan undervalued largely by buying US dollars in the open market. Since China
has a huge trade surplus it can buy dollars in the open market and keep the demand for US
dollars very high and push the price of dollars upwards relative to the Yuan and hence the Yuan
remains undervalued. The Chinese growth is spurred by their exports the lower the value of
Yuan the more advantageous it is for Chinese exporters so in order to bring in that advantage to
Chinese exporters the Yuan has been kept undervalued . Thus it has been able to help Chinese

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exporters to be cost competitive.China has made a deliberate attempt to keep the Yuan
undervalued in order to capture world markets through mass production and low cost products
.This has been possible in the wake of the low value of the currency. But undervalued currencies
cannot stay for long in the same position

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