The NEWS magazine uses the price of a Mercedes Benz A-class to determine whether a currency is undervalued or overvalued. In July 2019, the price of Mercedes Benz was $55 thousand in New York, 390 thousand yuan in Beijing, and 66.5 thousand Swiss francs in Geneva. The exchanges rates were 6.79 yuan per U.S. dollar and 0.96 Swiss francs per U.S. dollar.

a. Does the purchasing power parity hold? Was yuan undervalued or overvalued relative US

dollar? Explain your answer and show the calculation.

 

b. Do you think the price of a representativeness car, Mercedes Benz in different countries

provides a valid test of purchasing power parity?

A) Purchasing power parity does not hold. Yuan is overvalued by 1.43%.

B) No

Step-by-step explanation

A) Actual exchange rate: US $1 = 6.79 yuan or 1 yuan = $0.14727 

Actual exchange rate = $0.14727 to 1 yuan 

Price of Mercedes Benz A-class: 

In New York = $55,000 

In Beijing = 390,000 yuan 

Implied purchasing power parity = $55,000 / 390,000 yuan = $0.14102 to 1 yuan 

Since the implied and actual exchange rates are different, purchasing power parity does not hold.

The exchange rate from implied purchasing power parity is lower than the actual exchange rate. This implies that yuan is overvalued to dollar by 1.43% ((0.14727 - 0.14102) / 0.14102).  

B) No, the price of a representativeness car, Mercedes Benz in different countries will not provide a valid test of purchasing power parity. This is because the countries not only differ in terms of prices but there are other factors as well. In some countries, it is a luxury good while in some it is not considered as luxurious. Other than that, not complete car can be manufactured in a single country. There are transportation costs included which affect the prices. Also, the car is not available in many countries. So, we cannot compare exchange rate for those countries. The features of cars also differ in countries which makes the price variable. Thus, all these factors account for the variability in price.