Question

1. Write the equation for national saving for a small open economy. If national saving is held constant, what happens to domestic investment if NCO decreases? Why?
2. Suppose the nominal exchange rate is 100 yen per dollar. Further, suppose the price of a baseball glove in Canada is $50 and the price of a baseball glove in Japan is 7500 yen. What is the real exchange rate between Japan and Canada in terms of baseball gloves?
3. Is there a profit opportunity that could be exploited with arbitrage due to different price of gloves in Japan and Canada? Where would people buy and where would they sell gloves? (linked to ii above)
4. List three goods for which the law of one price is likely to hold. Justify your choices.
5. List three goods for which the law of one price is not likely to hold. Justify your choices.

Answer 1

The law of one price states that the long-run prices of all commodities will be similar in all economies when quoted in the same currency. In other words, it means that in the long-run, there would be no gain from arbitrage. The economic law holds for goods having similar attributes and low shipping costs incurred in transportation to different markets.

Explanation:

i) In an open economy, national saving, savings by private and public sectors, is used either by the domestic firms (that is domestic investment) or by the foreign firms (that is net capital outflow). So, the national saving can be expressed as:

S = I + NCO,

Where:

S is national saving, I is domestic investment by firms, and NCO is the net capital invested abroad in the form of foreign investments and lending.

So, a decrease in the value of NCO without any change in national saving would mean that the decrease in NCO is matched by the increase in domestic investment. Put it differently, a lower NCO would boost domestic investment by the same amount so that national saving remains constant.

ii) The real exchange rate(Re) between Japan and Canada is calculated by the following formula:

Re = Price of a basketball glove in Canada* Nominal exchange rate / Price of a basketball glove in Japan, putting the given values:

Re = 50* 100 yen / 7500 yen,

Re = 5000 / 7500,

Re = 2/3,

Re = 0.67 /1

Therefore, the real exchange rate in terms of basketball glove should be 1 basketball glove produced in Canada equals to 0.67 basketball glove produced in Japan. In other words, it means that amount required to purchase a glove in Canada can buy only 0.67 unit of glove in Japan.

iii)

Yes, there are profits prospects that could be earned by involving in arbitrage opportunity.It is because the prices are not alike in both markets when defined in the same currency.

The basketball gloves are relative cheaper in Canada, so people will buy gloves from Canada at a cheaper price and then sell it at a higher price in Japan to enjoy arbitrage profits.

iv) The three goods for which the law of one price will work are:

a) Agricultural goods such as wheat and potatoes which are homogeneous in nature across all economies.

b) Technology products like computer software like Microsoft excel which can be sold in different markets at a very negligible transaction costs.

c) Clothes as they can be shipped in different economies at a low transaction costs.