Suppose that Northern Ireland and Southern Ireland each have 1,000 hours of labor per day. Southern workers are paid €1 per day and Northern workers are paid £1 per day. What is the exchange rate associated with an international price of one keg of beer = 1 bottle of whiskey?

Question

Quizplus · Accepted Answer

Let's assume that producing one keg of beer in Southern Ireland requires 1 hour of labor and producing one bottle of whiskey in Northern Ireland requires 2 hours of labor.
Thus, in Southern Ireland, the cost of producing one keg of beer is €1 and in Northern Ireland, the cost of producing one bottle of whiskey is £2. Therefore, the international price per keg of beer in terms of bottles of whiskey would be:

1 keg of beer = (cost of 1 keg of beer in Southern Ireland) / (cost of 1 bottle of whiskey in Northern Ireland)
1 keg of beer = €1 / (£2 × exchange rate)

On the other hand, we know that the international price per keg of beer in terms of bottles of whiskey is 1 keg of beer = 1 bottle of whiskey. Therefore, equating the two expressions for 1 keg of beer, we get:

€1 / (£2 × exchange rate) = 1
exchange rate = £2 / €1 = €1.25 = £1

Suppose That Northern Ireland and Southern Ireland Each Have 1,000