Question

The nominal exchange rate is 1.25 £ / $, the price of a basket of goods in London is £150 and the price of the same basket of goods is $100. a. (5 points) Find the real exchange rate. What is the units of the exchange rate? b. (5 points) Does the law of one price hold? Explain why or why not.

Answer 1

Answer - Real exchange rate = 150/100

= 1.5 £ / $

This means that 1.5 £ will be exchanged for 1 $ as per the real exchange rate.

No , the law of one price does not hold. This is because there is the difference between the nominal and real exchange rate. As per the nominal exchange rate given , the price of basket in London should have been £ 125 if it costed $ 100 in US as per the rate of 1.25 £ / $. But it is actually costing £ 150 which is different. Hence law of one price does not hold here.