tourist traveling to Mexico will find that many products seem cheaper than in the United States, after converting at the spot exchange rate. Of course, it also implies that goods and services are relatively cheaper in Mexico.Ī simple guide to judge whether a currency is overvalued is to consider it from the perspective of a tourist. dollar to be overvalued with respect to the peso means that goods and services are relatively more expensive in the United States than in Mexico. Since LS > RS, goods and services cost more on average in the United States than in Mexico at the current exchange rate. The right side (RS) is the cost of the basket in Mexico also evaluated in pesos. market basket converted to pesos at the current spot exchange rate. The left side (LS) of this expression represents the cost of a U.S. Therefore, the following will hold: E p/$ C B $ > C B p. This will also mean the exchange rate exceeds the ratio of market basket costs: E p/$ > C B p C B $ dollar is overvalued with respect to the Mexican peso, then the spot exchange rate exceeds the PPP exchange rate: E p/$ > E p/$ PPP. Which represents the PPP value of the U.S. dollar would be written as E p/$ PPP = C B p C B $ , The PPP exchange rate between the Mexican peso and the U.S. The PPP exchange rate is defined as the rate that equalizes the cost of a market basket of goods between two countries. Over- and Undervaluation with Respect to PPPįirst let’s consider over- and undervaluation with respect to PPP. Of more interest is what it means when it happens. Thus overvaluation or undervaluation of an exchange rate, for either reason (PPP or current account balance) should be thought of simply as something that happens. Also, there is no reason to think that current account balance represents some equilibrium or goal for an economy: countries can run trade deficits or surpluses for an extended period and suffer no ill effects. As was previously discussed, PPP is unlikely to hold, even over very long periods, for a variety of very good reasons. However, one should refrain from accepting this implication. The mere use of these terms suggests immediately that there is some “proper” value for the exchange rate. The person may mean the exchange rate is overvalued with respect to purchasing power parity (PPP), or he may mean the exchange rate is overvalued relative to the rate presumed Needed to balance the current account (CA). The first question one should ask when someone claims the exchange rate is overvalued is “overvalued with respect to what?” There are two common reference exchange rates often considered. It is quite common to hear people claim that a country’s exchange rate is overvalued or undervalued. Recognize how the terms overvalued and undervalued exchange rates are defined, applied, and interpreted.