Question

Suppose that in the last year the variation in the real exchange rate was −5% and that all this variation was due to the imposition of a tariff by the US to the imports of Chinese manufacturing goods. Assume that, absent the tariff, the law of one price held for both goods:_______

Answer 1

Answer:

Country with fallen exchange rate (fall - 5%) , will face domestic Inflation.

Explanation:

Law of One price suggests that goods cost same in two countries, when their prices are converted into common currency based on exchange rate.

International Price of a good = Domestic Price x Exchange Rate

So maintaining 'Law of one price' : Fall in exchange rate is accompanied by Increase in domestic prices (Inflation). And, Increase in exchange rate is accompanied by Decrease in domestic prices (Deflation).

Given : Fall in real exchange rate by 5%. So, corresponding domestic currency prices will inflate.