Richland and Poorland each have two industries: traded food and nontraded house

Question

Richland and Poorland each have two industries: traded food and nontraded house maintenance. It takes 1 day for a worker in each country to maintain a house.lt takes 2 days for a Richland worker to produce a unit of food and 4 days for a Poorland worker to produce a unit of food. The wage rate in Richland is $100 per day, and the wage rate in Poorland is Ps800 per day. What is the equilibrium exchange rate (measured as pesos per dollar)? What is the dollar price of house maintenance in Richland? In Poorland? Suppose that productivity in Poorland's food industry improves, so that it now takes only 3 days of labor to produce a unit of food. If the government of Poorland wishes to keep the peso per dollar exchange rate fixed at the level you calculated for part (a), what must the new peso wage be in Poorland? Assume there are no changes in Richland's economy. Continuing with part (c), use the new peso wage to calculate the new peso prices of food and house maintenance in Poorland and compare these with the original peso prices. Has Poorland experienced inflation or deflation?

Explanation / Answer

(a)

In answering this question, we assume Law of One Price (LOOP) holds true, that says the (exchange-rate adjusted) price of a good will be identical in all countries.

Price of 1 unit of food, Richland = 2 days x $100/day = $200

Price of 1 unit of food, Poorland = 4 days x PS800/day = PS3200

For LOOP to hold,

$200 = PS3200

So, exchange rate = PS3200 / $200 = PS16 per dollar ($1 = 16 Pesos)

(b)

Dollar price of house maintenance, Richland = 1 day x $100 = $100

Dollar price of house maintenance, Poorland = 1 day x PS800 / PS16 per $ = $50

(c)

Exchange rate = PS16 per dollar

Let Peso wage rate be PS Z per day.

Price of 1 unit of food, Poorland = 3 days x PS Z /day = PS 3Z

Price of 1 unit of food, Richland = 2 days x $100/day = $200

So,

$200 x PS 16/$ = PS 3Z

Z = 200 x 16 / 3 = PS 1066.67 per day

(d)

Peso price of house maintenance, Richland = 1 day x $100 x PS16 / $ = PS 1600

Peso price of house maintenance, Poorland = 1 day x PS1066.67 = PS 1066.67

Earlier,

Peso price of house maintenance, Poorland = 1 day x PS800 = PS 800

Therefore, house maintenance has become costlier (inflation).

For food,

Price of 1 unit of food, Poorland = 3 days x PS1066.67/day = PS3200

Earlier,

Price of 1 unit of food, Poorland = 4 days x PS800/day = PS3200

So, food prices are unchanged.

Since house maintenance prices have increased, Poorland experienced inflation.

Related Questions

Navigate

• Browse (All)
• Browse R
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.