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    Question

    If the Law of One Price holds then              

                                                      I.   Changes in national saving do not affect the real exchange rate II.  Changes in investment spending do affect the real exchange rate III. When the real exchange rate is fixed, then any change in the nominal exchange rate must be due to changes in the price levels in either of the two countries Which of the above statements is true?
    A Statements I, II and III are true. Correct Answer Incorrect Answer
    B Statements I and II are true. Correct Answer Incorrect Answer
    C Statements I and III are true. Correct Answer Incorrect Answer
    D Statement I is true. Correct Answer Incorrect Answer

    Solution

    The Law Of One Price (referred to as LOOP) is an economic theory which states that the price of identical goods in various markets  must be the same after taking into consideration the currency exchange, i.e. when the prices are expressed in the same currency. The law applies mainly to securities traded on financial markets. LOOP forms the basis  of the purchasing power parity  principle. The assertion, in some cases, would cost exactly the same number. In the standard open-economy model, changes in national savings affect the real exchange rate in the short to medium term. However, if the LOP and absolute PPP hold perfectly, the real exchange rate is fixed by definition (at 1), so it is not affected by changes in domestic real variables like national saving.

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