Suppose that the British pound is pegged to gold at £6 per ounce, whereas one ounce of gold is worth €12. Under the gold standard, any misalignment of the exchange rate will be automatically corrected by cross border flows of gold. Calculate the possible gains for buying €1,000, if the British pound becomes undervalued and trades for €1.80. (Assume zero shipping costs). (Hint: Gold is first purchased using the devalued British pound from the Bank of England, then shipped to France and sold for €1,000 to the Bank of France).

Question

Quizplus · Accepted Answer

To calculate the gains, first determine how much gold can be bought with the devalued British pound. If £1 = €1.80, then €1,000 = £555.56. With £555.56, you can buy 92.59 ounces of gold (£555.56 / £6 per ounce). Selling this gold in France at €12 per ounce gives €1,111.11 (92.59 ounces * €12). The gain is €1,111.11 - €1,000 = €111.11. Converting this back to pounds at the rate of £1 = €1.80 gives £61.73. The closest answer is £55.56.

Suppose That the British Pound Is Pegged to Gold at £6