Assume that American rise sells for $100 per bushel, Japanese rice sells for 16,000 yen per bushel, and the nominal exchange rate is 80 yen per dollar.

Question

Explain how you could make a profit from this situation. What would be your profit per bushel of rice? If other people exploit the same opportunity, what would happen to the price of the rice in Japan and the price of rice in the United States?

Suppose that rice is only commodity in the world what would happen to the real exchange rate between the United States and Japan?

Answer 1

In this situation, you could make a profit by exploiting the difference in rice prices between the United States and Japan, known as arbitrage. Here's how:

1. Buy American rice for $100 per bushel.
2. Exchange dollars to yen at the nominal exchange rate of 80 yen per dollar (100 USD * 80 yen/USD = 8000 yen).
3. Use the 8000 yen to buy 0.5 bushel of Japanese rice (8000 yen / 16,000 yen/bushel).
4. Sell the 0.5 bushel of Japanese rice equivalent to 1 bushel of American rice for $100 in the United States.

Your profit per bushel of rice would be $100 - $100 * (8000 yen / 16,000 yen) = $100 - $50 = $50.

If other people exploit the same opportunity, the demand for American rice would increase, and the demand for Japanese rice would decrease. This would lead to an increase in the price of American rice and a decrease in the price of Japanese rice until the arbitrage opportunity disappeared.

If rice were the only commodity in the world, the real exchange rate between the United States and Japan would adjust to equalize the prices of rice in the two countries. The real exchange rate is the rate at which goods in one country can be exchanged for goods in another country, taking into account both the nominal exchange rate and the prices of goods in both countries.

In this case, the real exchange rate would be: (Price of American rice / Price of Japanese rice) * Nominal Exchange Rate = (100 USD / 16,000 yen) * 80 yen/USD = 0.5. That means, 1 bushel of American rice would be equivalent to 0.5 bushel of Japanese rice.