Question

The world is back on the gold standard. The US central bank will convert US dollars into gold at a rate of $6/oz. The European Central Bank will convert gold at €5/oz.

1. What is the theoretical direct (US dollars per Euro) cross-exchange rate between the US and the Euro zone?

The market cross exchange rate is currently €0.67/$.

2. Which currency is undervalued relative to the other currency?

You have $1,000, but you need to switch to euros in order to import European goods.

3. What is the simple (fastest) way to get euros (i.e. go to the banks and get gold, or go to the market and do a direct exchange). If you go the “fastest” route, how many euros do you end up with?

4. Now, go the “longer” route. How many euros do you end up with?

Answer 1

(1) Under the hypothetical gold standard, US Exchange Rate is $ 6/oz and European Exchange Rate is €5/oz.

Therefore, $ 6 = €5

€ = (6/5) = $ 1.2

Theoretical Exchange Rate = $ 1.2 / €

(2) The simpler way of getting euros is to go to the market and exchange the available $ 1000 for euros. However, the same would be executed at the market cross exchange rate of € 0.67 / $ or ~ $ 1.5 / €

Euros Received if fastest route is followed = (1000 x 0.67) = € 670

Euros Received if the longer route is followed = (1000 / 1,2) = € 833,33