Question: Consider two economies A and B. Let's call their currencies also A and B. In country A, US$100 can buy 20 cheeseburgers; in country

Consider two economies A and B. Let's call their currencies also A

Consider two economies A and B. Let's call their currencies also A and B. In country A, US$100 can buy 20 cheeseburgers; in country B, US$100 can buy 25 identical cheeseburgers. Assumes 1USD=1.25A and 1USD=1.20 B. The exchange rate between A and B can be determined by the cross-rates as there is no transaction costs/arbitrage, namely: A/B=A/USD*USD/B. (a) (4 points) Does the law of one price hold for cheeseburgers in these two economies? (b) (4 points) What is the market exchange rate between A and B (expressed in terms of units of A per unit of B)? (c) (4 points) What should be the PPP exchange rate implied by the price of cheeseburgers expressed in terms of units of A per unit of B)? (d) (4 points) Is the market exchange rate between A and B overvalued or undervalued relative to PPP exchange rates? (e) (4 points) Now assume that the market rate adjusts to the PP rates. Assume that the A/USD market exchange rate does not change, what should be the B/USD market exchange rate? Assumes that the price of cheeseburger stays the same, how many cheeseburgers can you buy in buy in both economies?

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aNo the law of one price does not hold for cheeseburgers in these two economies This is because the exchange rate between A and B indicates that US100 can buy more cheeseburgers in country B 25 than i... View full answer

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