DD5.txt - Under the assumption that multiple countries define their currency in terms of the quantity of gold lets consider a two country example

DD5.txt - Under the assumption that multiple countries...

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Under the assumption that multiple countries define their currency in terms of the quantity of gold, let s consider a two country example. Suppose that the U.S. defines the dollar as 1/20 of an ounce of gold and the U.K. defines the pound as 1/4 of an ounce of gold. It follows that the price of one ounce of gold is $20 in the U.S. and 4. Note that this implies that $20 should buy 4. Thus, the exchange rate should be $5 per pound. We can use this to discuss important results. Suppose that the current exchange rate is equal to the official exchange rate. Suppose that I borrow 1 pound at an interest rate i_{UK} for one period and then exchange those pounds for dollars and invest those dollars in some financial instrument in the U.S. that pays me a guaranteed rate of i_{US} for one period. The cost of my borrowing when we reach the next period is (1 + i_{UK})\pounds 1. But remember, I exchanged pounds for dollars in the first period and 1 pound purchased 5 dollars and invested these dollars. So my payoff is (1+i_{US})\$5. I
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  • Fall '15
  • DR. Aimal

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