Suppose the dollar–euro exchange rate, E$/€, are as follows: in New York, $1.2 per euro; and in Paris, $1.3 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. 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.
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Exchange rate in New York = $1.2 per euro
Exchange rate in Paris = $1.3 per euro
A person can buy $1.3 dollar by giving one euro in Paris. As exchange rate in New York is $1.2 per euro, $1.3 in New York implies 1.083 euro. That person can sell $1.3 dollar in New York by accepting 1.083 euro in exchange of it. Thus, a person can easily make 0.083 euro by investing one euro in Paris through arbitrage.
As arbitrager will buy dollar from Paris, it will raise demand of dollar in Paris which will reduce exchange rate or we can say euro to depreciate against dollar. She sells dollar in New York which will raise supply of dollar in New York and raise exchange rate there or we can say euro to appreciate against dollar. Exchange rate in New York will increase and exchange rate in Paris will decrease till the time are equal and arbitrager profit is zero.
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