Question: (a) What is the difference between Law of One Price (LOP) and Purchasing Power Parity (PPP)? (b) Consider a world that only comprises 3 goods

(a) What is the difference between Law of One Price (LOP) and Purchasing Power Parity (PPP)?

(b) Consider a world that only comprises 3 goods (Good 1, Good 2, Good 3) and 2 countries (France and Japan). Assume that consumption weights of these goods for both countries be (0.50, 0.25, 0.25).

The price of the goods at time t are listed below:

France (EUR) Japan (JPY)

Good 1 40 20

Good 2 80 55

Good 3 60 150

Note: EUR stands for Euros and JPY stands for Japanese yen

(i) For each good, what exchange rate, S(EUR/JPY), is consistent with the law of one price?

(ii) Let the spot exchange rate at time t be equal to 0.50 EUR/JPY. Does absolute purchasing power parity (PPP) hold between the France and Japan?

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