Question

1. Suppose the dollar-euro exchange rate, Esle, are as follows: in New York, $1.2 per euro; and in Paris, $1.3 per euro. (10 pts) a. Describe how investors use arbitrage to take advantage of the difference in exchange rates. (5 pts) b. Will this make euros appreciate or depreciate (against dollars) in Paris? Will this make euros appreciate or depreciate (against dollars) in New York? Under what conditions will the equilibrium be restored? Explain. (5 pts)

Answer 1

Answer:

a)

Arbitraguaers will buy euro from New York at $1.2 each and will sell it in Paris at $1.3 each. Hence, earning $0.1 per Euro. Or will buy dollars in Paris and will sell dollars in New York.

b)

When supply of euro will increase in Paris due to action of arbitraguaers the value of euro will depreciate(against dollar).

On the other hand, When demand of euro will increase inNew York due to action of arbitraguaers the value of euro will appreciate(against dollar).

Equilibrium will be restored when dollar-euro exchange rate will be same in both cities and there will be no opportunity to arbitrage.