The consumption basket for the small Pacific island of Tropicalia consists of one coconut (price: TT1), one tatami mat (TT0.5), and one bottle of suntan lotion (TT2). Coralland, an island in the Caribbean, has a basket containing the same items in the same quantities, but with different prices: CC8 per coconut, CC4 per mat, and CC16 per bottle of lotion. [“TT” and “CC” are, respectively, the currency symbols for the Tropicalian tropic and the Corallandish coral.]

a) Assume that there is a vibrant, competive global trade and air freight shipments are free so that the law of one price holds for each commodity. What does this imply about the price of corals in terms of tropics, E1TT/CC?

b) Let each country’s consumer price level be equal to the simple average of the prices of the items in the home consumption basket. Given the tropic/coral exchange rate from (a), does absolute PPP hold?

c) If a greedy Tropicalian coconut producer tries to raise the tropic price of coconuts relative to their Coralland price as measured in tropics, will she be able to?

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a Ass ume that there is a vibrant compet ive global trade and air freight shipments are free so that the law of one price holds for each commodity Wha... View the full answer