How do you know if a currency is overvalued or undervalued I have 2 questions with...

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Finance

How do you know if a currency is overvalued or undervalued
I have 2 questions with answers that don't seem to bematching:
If real exchange rate qUS/qforeign is more than 1, then UScurrency is said to be undervalued correct?
Question 1: You are given the following information. The currentdollar-pound exchange rate is $2 per pound. A U.S basket that costs$100 would cost $120 in the United Kingdom. For the next year, theFed is predicted to keep U.S. inflation at 2% and the Bank ofEngland is predicted to keep U.K inflation at 3%. The speed ofconvergence to absolute PPP is 15% per year.
Answer: The dollar is overvalued because real exchange rate is1.29 (=$120/$100). shouldn't it be undervalued since it is morethan 1?
Question 2:
Suppose a new car costs 210,000 Mexican pesos in Mexico, whilethe same car costs $19,500 in the United States. The nominalexchange rat is currently at E$/Peso = $.10/Peso. If we assume PPPto hold, is the dollar under or overvalued? If so, by how much?
qUS/qPESO= (210,000)*(.1)/(19,500)=1.0769. The answer is thatthe US is overvalued as well.
Why is it that qUS/qForeign are both more than one but UScurrency is overvalued in one of them but undervalued by another.Is the answer wrong or am i missing something?

Answer & Explanation Solved by verified expert

4.2 Ratings (601 Votes)

The way you have determined that US currency is overvalued than the Mexican Peso in Question 2 is correct based on the nominal sport rate In question 1 however the current nominal spot exchange See Answer

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How do you know if a currency is overvalued or undervaluedI have 2 questions with answers that don't seem to bematching:If real exchange rate qUS/qforeign is more than 1, then UScurrency is said to be undervalued correct?Question 1: You are given the following information. The currentdollar-pound exchange rate is $2 per pound. A U.S basket that costs$100 would cost $120 in the United Kingdom. For the next year, theFed is predicted to keep U.S. inflation at 2% and the Bank ofEngland is predicted to keep U.K inflation at 3%. The speed ofconvergence to absolute PPP is 15% per year.Answer: The dollar is overvalued because real exchange rate is1.29 (=$120/$100). shouldn't it be undervalued since it is morethan 1?Question 2:Suppose a new car costs 210,000 Mexican pesos in Mexico, whilethe same car costs $19,500 in the United States. The nominalexchange rat is currently at E$/Peso = $.10/Peso. If we assume PPPto hold, is the dollar under or overvalued? If so, by how much?qUS/qPESO= (210,000)*(.1)/(19,500)=1.0769. The answer is thatthe US is overvalued as well.Why is it that qUS/qForeign are both more than one but UScurrency is overvalued in one of them but undervalued by another.Is the answer wrong or am i missing something?