A. If a cup of coffee costs 2 euros in Paris and $6 in New York and purchasing-power parity holds ...

Expert Answer

A. Exchange Rate Calculation (Purchasing-Power Parity)

The concept of purchasing-power parity (PPP) is fundamental in international economics. PPP theory suggests that, in the absence of transportation costs and trade barriers, identical goods should sell for the same price when expressed in a common currency. If a cup of coffee costs 2 euros in Paris and 6 dollars in New York, PPP would imply that the exchange rate should adjust so that the prices of goods are equivalent across countries when expressed in the same currency. This provides a simple way to determine the exchange rate between two currencies based on the prices of similar goods in those countries.

To compute the exchange rate under PPP, we use the formula:

Price of coffee in New York (in USD) Price of coffee in Paris (in EUR) =Exchange rate in USD/EUR\frac{\text{Price of coffee in New York (in USD)}}{\text{Price of coffee in Paris (in EUR)}} = \text{Exchange rate in USD/EUR}Price of coffee in Paris (in EUR)Price of coffee in New York (in USD)?=Exchange rate in USD/EUR

Using the provided prices:

• Price of coffee in New York = 6 USD
• Price of coffee in Paris = 2 EUR

The exchange rate (in dollars per euro) is:

6 USD2 EUR=3 USD/EUR\frac{6 \text{ USD}}{2 \text{ EUR}} = 3 \text{ USD/EUR}2 EUR6 USD?=3 USD/EUR

This means that 1 euro is worth 3 dollars in nominal terms. However, the question asks for the exchange rate in euros per dollar. To convert this, we simply take the reciprocal:

13 EUR/USD\frac{1}{3} \text{ EUR/USD}31? EUR/USD

Thus, the exchange rate is 1/3 euro per dollar. This is because 1 dollar would buy 1/3 of a euro in the exchange market.

In summary, the correct answer is:

b. 1/3 euro per dollar

This calculation assumes that PPP holds, meaning that exchange rates are determined by the relative prices of identical goods between countries. In reality,