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Explain the intuition behind the law of one price

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Reference no: EM132655697

Consider a world with two economies, Domestic and Foreign, with the following data

Domestic GDP deflator at 31/12/2019: 100

Foreign GDP deflator at 31/12/2019 : 100

Domestic GDP deflator at 31/12/2020: 105

Foreign GDP deflator at 31/12/2020: 110

Nominal Exchange Rate Domestic: 1

a) Explain the intuition behind the law of one price. Use this law to predict the nominal exchange rate for December 31 2020. Show your derivations.

In the remaining of the problem assume your prediction is correct.

b) On January 1st 2019 one-year bonds issued by the domestic economy command a nominal interest rate of 8% while those issued by the foreign economy pay a nominal rate of return of 10%. Both economies have zero default risk. If you had 100 units of domestic currency on January 1 2020 where would you invest them. Provide an explanation for your answer.

c) Calculate the real interest rate for both economies (for 2020). Show your derivations.

Reference no: EM132655697

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