Question

Law of one price and Purchasing-power-parity theory

We employ a theory called the Purchasing Power Parity to explain the movement of nominal exchange rate. The PPP theory is built on the Law of One Price, which states that a currency must have the same purchasing power in all countries. Based one this assumption, PPP theory establishes the functional relationship between Nominal exchange rate, domestic price level, and foreign price level. Suppose you are provided with the following information: 1) P is the price of a basket of goods in US (measured in dollars); 2) P* is the price of a basket of goods in Mexico (measured in Peso); 3) e is the nominal exchange rate between USD and Peso; 4) you have $1 in hands.

1) Suppose there are two markets selling the same good located in Seattle and Dallas, respectively. Initially, the price is $5 in Seattle, and $4 in Dallas. Assuming perfect information and sufficient low cost of transporting. How does the price of good in these two markets adjust in the long run? (6pts) and why? (4pts) Show your analysis using graph or words in details.

An international version of law of one price states that one USD should have the same purchasing power in the U.S. and in any other countries. Based on the principle of law of one price,

2) What is the purchasing power of $1 in U.S and Mexico, respectively? (5pts) Express nominal exchange rate e as a function of P and P* , show your work with details (5pts)

3) Suppose that money supply growth continues to be higher in U.S than it is in Mexico. What does purchasing-power parity imply will happen to the real and to the nominal exchange rate between Peso and U.D. dollar? (10pts)

Minimum-Wage Law and Unemployment

Using labor supply and demand graph, explain

1) how are the equilibrium quantity of labor and the equilibrium wage rate determined? (6pts)

2) why might minimum-wage law lead to unemployment? (In other words, under what conditions does the minimum wage law lead to unemployment?) (9pts)

Answer 1

Purchase Power Parity :-

Answer to question no 1:-

In long run purchase power parity , the importer and exporters cannot respond quickly to the deviations in the cost of market baskets between two countries.

Instead of immediate response to price difference they engage in arbitrage , buying at low prices and selling at high . Thus they respond slowly to these price signals .

Answer to question no 2:-

S=P1/P2

Where S = Exchange rate of country 1 to country 2 .

P1 = Price of good at country 1

P2 = Price of good at country 2

Here 1$= 18.96 peso

Therefore

E= 1 /18.96

=0.0527

Answer to question no 3 :-

If the money supply accelerates in the market , this means the real price of US dollar will fall . So to buy 1 dollar , less amount of peso will be required.

However more dollar will be required to buy peso

​Thus from the following graph we can see that due to increase in supply of dollar the domestic (US) exchange rate falls from E1 to E2.

Labour and wage Determination :-

Answer to question no 1 :-

Perfectly Competition:-

In such markets the wage is determined by demand and supply equilibrium.

1) There is a direct relationship between demand and wages . Higher the demand , higher the wage and lower the demand , lower the wage

2) There is an inverse relationship between supply and wage . This means lower supply , higher wage and higher supply , lower wage

Monopolistic competition :-

Because monopolistic faces a downward sloping demand curve , increased hiring of labour and resulting large output forcing the firm to lower it's price .

Because it must lower it's price it's MR is less than price

The firm MRP curve lies below VMP curve

Thus firm hires Qm rather than Qc

Answer to question no 2:-

Minimum wages can actually rise unemployment by :-

1) Giving employers less incentive to hire and more incentive to automate .

2) It also forces business to raise prices to maintain desired profits .Higher prices means less revenue than in turns lead to less money to pay as wages which leads to less employment.