Suppose (imaginary) countries of Ambrosia and Bolumbia produces wheat. Assume Ambrosian wheat sells for Ambrosian$ (AMD) 100 per tonne, Bolumbian wheat sells for Bolumbian$ (BMD) 550 per tonne. The nominal exchange rate is 5 BMD per AMD.

a) Explain how you could make a profit from this situation. (3 marks)

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b) What would be your profit per tonne of wheat? (1 mark)

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c) If other people exploit the same opportunity, what would happen to the price of wheat in Bolumbia and price of wheat in Ambrosia. (2 marks)

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d) Suppose wheat is the only commodity in this world and law of one price and Purchasing Power Parity (PPP) theory hold. What would happen to real exchange rate between Ambrosia and Bolumbia.(2 marks)

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e) What would prevent the exchange rate from adjusting? (Hint: think about the limitations of PPP theory).(2 marks)

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