Assume that the United States and the United Kingdom produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and £1.35 in the United Kingdom.
a) According to the Law of One Price, what should the nominal spot exchange rate ($/£) be?
b) Assume the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from the United Kingdom. What is the nominal spot exchange rate ($/£) that ensures no arbitrage?
Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and £1.35 in the United Kingdom.
c) What should the one-year forward exchange rate ($/£) be? If the one-year forward exchange rate is $/£ 3, is there any arbitrage opportunity?
d) What is the change in the nominal exchange rate implied by these prices (approximately)?