Suppose that a Toyota Camry costs $25,000 in the U.S. and €20,000 in Europe, while the nominal dollar-euro exchange rate is 0.9€/$.
A. Describe how an arbitrageur could profit from this situation (What would they buy? What would they sell?)
B. Based on the Law of One Price, what is the equilibrium nominal exchange rate between the U.S. dollar and the euro? What is the equilibrium rate between the U.S. and Europe?
C. Suppose the price of everything in the U.S. (including a Toyota Camry) increased by 5%. All else equal, how would that affect the equilibrium euro price of the U.S. dollar (i.e. – e*(€/$)) in the long run (up or down, and by how much)? Explain.
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