Economics in Global Environment
Homework Ch06 16.10.2020
FX in Long Run
1. Suppose that two countries, Vietnam and Côte d’Ivoire, produce coffee. The currency
unit used in Vietnam is the dong (VND). Côte d’Ivoire is a member of Communaute
Financiere Africaine (CFA), a currency union of West African countries that use the CFA franc
(XOF). In Vietnam, coffee sells for 5,000 dong (VND) per pound of coffee. The exchange
rate is 30 VND per 1 CFA franc, E VND/XOF =30.
a. If the law of one price holds, what is the price of coffee in Côte d’Ivoire, measured in CFA
francs?
30 VND = 1 CFA
5.000 VND = 166.66 CFA
So, the coffee price per pound of coffee is 166.66 CFA
b. Assume the price of coffee in Côte d’Ivoire is actually 160 CFA francs per pound of coffee.
Calculate the relative price of coffee in Côte d’Ivoire versus Vietnam. Where will coffee
traders buy coffee? Where will they sell coffee? How will these transactions affect the price
of coffee in Vietnam? In Côte d’Ivoire?
160 CFA per pound coffee/ 166.66 CFA per pound coffee = 0.96
2. Consider each of the following goods and services. For each, identify whether the law of
one price will hold, and state whether the relative price, , is greater than, less than,
or equal to 1. Explain your answer in terms of the assumptions we make when using the law of
one price.
a. Wheat traded freely in the United States and Canada.
All requirements of law of one price are meet. The good is homogenous, no trade barriers, low
transportation cost, free trade agreement between countries:
RP = 1
POOP holds
b. Sugar traded in the United States and Mexico; the U.S. government imposes a quota on sugar
imports into the United States.
Law of one price means there is only one price for the same good in two countries. However,
if government policies interfere to artificially higher the price (here with import quotas on
sugar), the price is higher. So, the law of one price does not hold.
The price in US is higher than in Mexica >> relative price is greater than 1.
Economics in Global Environment
Homework Ch06 16.10.2020
FX in Long Run
c. The McDonald’s Big Mac sold in the United States and Japan.
The good is very homogenous, as it is the same fast-food chain. For the product no negative
governmental interference is expected. Even though both countries are far apart, the price
should be almost the same. Because the production of the product is happening local. Therefore,
RP = 1; LOOP holds
d. Haircuts in the United States and the United Kingdom.
Haircuts cannot be traded internationally, therefore no arbitrage opportunities. The law of one
price should hold. Relative price =1
However, haircuts are services and depend on the wage rate of the country. So, if the average
wage of hairdressers differs in the countries, the haircut can be two different prices.
3. You are given the following information. The current dollar−pound exchange rate is $2 per
British pound. A U.S. basket that costs $100 would cost $120 in the United Kingdom. For the
