Question

In: Economics

Suppose that two countries, Italy and Palestine, produce olive oil. The currency used in Italy is...

Suppose that two countries, Italy and Palestine, produce olive oil. The currency used in Italy is the euro (EUR), while Palestine uses the New Israeli Shekel (NIS). In Italy, olive oil sells 6€ per litre. The exchange rate is 5 NIS per 1 EUR.

a. If the law of one price holds, what is the price of olive oil in Palestine, measured in NIS? (5 points)

b. Assume the average market price of olive oil in Palestine is actually 24 NIS per litre. Compute the relative price of olive oil in Palestine versus Italy. Where will traders buy and where they will sell it? How will these transmissions affect the price of coffee in both countries? (5 points)

c. Is the bilateral exchange rate (NIS/EUR) undervalued or overvalued with respect to the LoOP relative to olive oil? How should the exchange rate be under the LoOP in this case? (5 points)

d. Is the law of one price holding in this case? Provide arguments to explain your answer. (5 points)

Solutions

Expert Solution

1. If the law of one price holds, price of olive oil would be equal to (5*6) 30 NIS in Israel.

2. If price of oil in Israel is 24 NIS and the exchange rate is 1EUR = 5 NIS then relative price of oil in Italy is (24/5) 4.8 EUR, however price of oil in Italy is 6 EUR. Therefore traders will buy oil from Israel and sell in Italy thereby making a profit of (6 - 4.8) 1.2 EUR. This trade will help increase in value of NIS and exchange rate will move down.

Price of coffee will be affected as per the relative price of coffee between Italy and Israel. As there is no information given about price of coffee it will not be possible to ascertain the effect.

3. If price of oil in Israel is 24 NIS, then the exchange rate of 1EUR = 5 NIS is overvalued. It should drop down to (24/6) 4 NIS.

4. Law of one price is not holding in this case. As per law of one price, oil should be sold in Israel at 30 NIS, not 24 NIS. Therefore it violates the law of one price.

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Rahul Sunny answered 1 month ago
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