Assuming the law of one price, explain what the exchange rate between U.S. dollars and yen has to be if the price of steel in Japan is 15,000 yen per ton and the price in the U.S. is $125 per ton (assume no transaction costs).
What will be an ideal response?
Given the price for steel in each country, the exchange rate has to be 120 yen per U.S. dollar. This makes the prices of steel equal in each country. If this weren't the exchange rate, steel buyers would have an incentive to buy in the country where steel was cheaper, and steel producers would have the incentive to sell in the country where the steel price was higher. The increased demand and decreased supply in the relatively cheaper country would increase the price there. The increased supply and decreased demand in the relatively higher priced country would decrease the price there. This process would continue until prices in both countries were the same.
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What will be an ideal response?