Suppose that the United States and the United Kingdom both use the gold standard. Their prices of gold are $35 = 1 ounce and £7 = 1 ounce, which yields an implied exchange rate of $5 = £1. Now suppose that the exchange rate temporarily rises to $5.50 = £1. What will happen to the U.S. and U.K. money supplies as a result of arbitrage?

Question

Quizplus · Accepted Answer

If the exchange rate rises from $5 = £1 to $5.50 = £1, then it is cheaper to buy an ounce of gold in the U.S. for $35 and sell it in the U.K. for £7 x $5.50 = $38.50. This creates an arbitrage opportunity, as investors can profit by buying gold for $35 in the U.S. and selling it for $38.50 in the U.K. This will increase demand for U.S. dollars and decrease demand for British pounds, causing the U.S. money supply to fall and the U.K. money supply to rise. This is because investors will use their U.S. dollars to buy gold and then use the British pounds they earn from selling the gold to buy more U.S. dollars. The U.S. money supply falls because investors are converting their dollars to gold, while the U.K. money supply rises because investors are converting their pounds to dollars.

Suppose That the United States and the United Kingdom Both