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) The purchasing power parity does not hold. The yuan is overvalued as compared to dollar.

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 

As per actual exchange rate, if 1 US $ is equal to 6.79 yuan, then the price of $55,000 Mercedes Benz A-class should be equal to 373,450 yuan (55,000 * 6.79). But the actual price is 390,000. So, the purchasing power parity does not hold.

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

B) The price of a representative car cannot serve as a good test for measuring purchasing power parity due to the following reasons:

a) There are differences in the standard of living in all countries. The car may be a luxury good in a poor country and in a developed country, it may not be as much luxurious.

b) All the parts of a car cannot be manufactured in the respective countries. There are transportation costs involved which affect the price of the car.

c) The car may not be available in some countries and may need to be imported which will further increase the price of the car.

d) The features of a car differ according to the countries, so the prices may vary according to that.

Keeping in mind all these factors, we can say that using the car as a measure of purchasing power parity is not a good idea.