P rob l e m 3 3 . 1 . Sup p o s e q u o t e s f o r t h e d o ll a r -e ur o e x

Question

Problem 3

3.1.   Suppose quotes for the dollar-euro exchange rate E$=e   are as follows: in New York

$1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates.   Explain how this process will affect the dollar price of the euro in New York and Tokyo.

3.2. What is covered interest rate parity?

3.3. What is uncovered interest rate parity?

3.4. Consider some good g that sells in the U.S. and Europe. What is the relative price of this good?

3.5. What is the law of one price, and if it holds, what should be true about the relative price of good g in (3.4)?

3.6. Consider a basket of goods in the U.S. and Europe. Given these baskets, determine the real exchange rate.

3.7. What is purchasing power parity, and if it holds, what would be true about the real exchange rate in (3.6)?

Explanation / Answer

3.1) Investors will buy euros in New York at a price of $1.50 each because this is relatively cheaper than the price in Tokyo. They will then sell these euros in Tokyo at a price of $1.55, earning a $0.05 profit on each euro. With the influx of buyers in New York, the price of euros in New York will increase. With the influx of traders selling euros in Tokyo, the price of euros in Tokyo will decrease. This price adjustment continues until the exchange rates are equal in both markets.

3.2)

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