EC3343 Tutorial 4

Q1.
Explain the Law of One Price. Give an example of how it can be attained.

Q2.
Discuss the differences between Absolute PPP and Relative PPP.

Q3.
Suppose Zimbabwe's inflation rate is 13.58% per month, but the inflation rate in the
United States is only 0.13% per month. According to relative PPP, what should happen
over the month to the US dollar exchange rate against the Zimbabwean dollar?

Q4.
Consider the following events. What are the predictions for the long-run equilibrium
exchange rate using the Monetary Approach with PPP (flexible prices)?
a. A permanent decrease in domestic money supply level.
b. A decrease in domestic output.
c. An increase in the growth rate of domestic money supply from 𝝅 to 𝝅 + ∆𝝅 after 𝒕𝟎 ,
where 𝝅 and ∆𝝅 are constants (using relative PPP).

Q5* (More challenging question.)

Consider two countries, say US and Japan. Both produce tradables and nontradables.
Assume markets are perfect competitive, with free entry of new firms and free mobility
of labour across two sectors in both countries.
Suppose the linear production technology in the United States is described by:

𝑸𝑼𝑺 𝑼𝑺 𝑼𝑺 𝑼𝑺
𝑻 = 𝒂𝑻 𝑳𝑻 where 𝒂𝑻 = 0.4,

and

𝑸𝑼𝑺 𝑼𝑺 𝑼𝑺 𝑼𝑺
𝑵 = 𝒂𝑵 𝑳𝑵 where 𝒂𝑵 = 0.1;

similarly, the linear production technology in Japan is:

𝑱𝑷 𝑱𝑷 𝑱𝑷 𝑱𝑷
𝑸𝑻 = 𝒂𝑻 𝑳𝑻 where 𝒂𝑻 = 0.2,

and
𝑱𝑷 𝑱𝑷 𝑱𝑷 𝑱𝑷
𝑸𝑵 = 𝒂𝑵 𝑳𝑵 where 𝒂𝑵 = 0.2,

where
𝑸𝒄𝑻 and 𝑸𝒄𝑵 , respectively, denote the output of tradable sector and non-tradable sector;
𝒂𝒄𝑻 and 𝒂𝒄𝑵 denote labour productivity, i.e. output per worker; and
𝑳𝒄𝑻 and 𝑳𝒄𝑵 denote the amount of employed labour in tradable and non-tradable sector,
in the respective countries: c=US or c=Japan.

1
Suppose that the price index in the United States is given by: 𝑷𝑼𝑺 = √𝑷𝑼𝑺 𝑼𝑺
𝑻 𝑷𝑵 , and

𝑱𝑷 𝑱𝑷 𝑱𝑷
that the price index in Japan is given by: 𝑷 = √𝑷𝑻 𝑷𝑵 .
Note that prices in US are expressed in dollar, and prices in Japan are expressed in
Yen.
𝑱𝑷
The law of one price holds only for the tradable sector, 𝑷𝑼𝑺
𝑻 = 𝑬$/¥ 𝑷𝑻 , where 𝑬$/¥ ,
defined as units of US dollar per unit of Japanese yen.
𝑱𝑷
𝑬$/¥ 𝑷
a. Calculate the real dollar-Yen exchange rate, 𝒒$/¥ = .
𝑷𝑼𝑺
b. Suppose for the US, 𝒂𝑼𝑺 𝑼𝑺
𝑻 is growing by 3% per year while 𝒂𝑵 is growing by 1% per
𝑱𝑷 𝑱𝑷
year. For Japan, 𝒂𝑻 is growing by 1% per year while 𝒂𝑵 is growing by 3% per
year. Determine what will happen to 𝒒$/¥ , and whether there will be a real
depreciation or a real appreciation for the US dollar relative to Japanese yen.
Explain the economic idea behind it.