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Economic Indexing

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The Big Mac Price Index computed by the Economist has consistently found the U.S. dollar to be undervalued against some other major currencies, which seems to call for a rejection of the purchasing power parity theory. Explain why the index may not be a valid test of the theory.

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First some background on the purchasing power parity theory: the theory states that a dollar should buy the same amount in all countries. Thus, in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each ...

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