The Law of One Price. Suppose that two countries, Italy and Palestine, produce olive oil. The...

The Law of One Price. 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?

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 olive oil in both countries?

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

a.} Price of Olive Oil in Italy = 6 Euro per Litre

1 Euro is equal to 5NIS

Hence, olive oil price in Palestine will be 6*5 = 30 NIS.

b.)As per part a.) based on law of one price, price of olive oil in PAlestine should be 30 NIS but it is 24 NIS. Therefore, relative price of olive oil in Palestine Verses Italy is 24: 30 or 4: 5.

c.) Bilateral exchange rate of NIS/EUR is undervalued. Price of olive oil in Palestine is 24 NIS, instead of 30 NIS. This shows that 1 EUR should be equal to 4 NIS instead of 5 NIS. Hence, NIS is undervalue by 1 unit in comparision to EUR. Hence NIS is expected to appreciate in future in comparision to Euros.

d.) As per "Law of One Price", price of commodity should be equal in two markets and there should be no arbitrage opportunity. However in this case, there is arbitrage opportunity. Based on exchange rate of 5 NIS = 1 Eur at 24 NIS, in Palestine Market, Olive oil is selling at 4.8 Euros. Hence, trader can buy olive oil from Palestine for 4.8 Euros and then sell it in Italy market at 6 Euros and will make profit of 1.2 Euros per litre. Hence, Law of One Price is not held in this case. Based on assumptions of Law of One Price, we are not considering transportation cost in estimating profit.

Thanks

Rahul Sunny answered 1 year ago

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