Question

Around 1900, a small town on the U.S.-Mexican border was experiencing a strange currency exchange situation. On the Mexican side of the border, a U.S. dollar was only worth ninety Mexican peso (1 USD = 0.90 MXN), while on the U.S. side, a Mexican peso was only worth ninety U.S. cents (1 MXN=0.90 USD). In other words, the citizens of both countries discounted the other country's currency by ten percent.

In this particular town, the international border ran right down the center of the main street, and there were bars on both sides catering to workers from the surrounding area. One Saturday, an American worker rolled into town with little money (only U.S. $1.00) but lots of financial cunning. He stopped at the first bar he found on the U.S. side of the street, ordered himself a ten-cent beer, paid with his U.S. dollar, and asked for a Mexican peso in change (worth only U.S. $.90, remember). After finishing his beer, he walked across the street to a Mexican bar, ordered another ten-cent beer, paid with the Mexican Peso, and asked for a U.S. dollar in change (there, worth only Mexican Peso $.90). Back he went to the American side for another beer, then back across to the Mexican side -- and so on all afternoon and evening, finally staggering back to his camp after a final drink from a Mexican bar and a U.S. one-dollar bill in change -- just as he had started out with.

Use the exchange rate theory to explain why this worker had free beer.

Share your thoughts.

Answer 1

On the Mexican side, 1USD = 0.90 peso. Thus with 1USD one can buy 0.90 peso worth of goods.

While on the U.S side, 1 peso = 0.90 USD. Ideally it should have been 1 peso = 1.11 dollars as the value of the peso is greater on the Mexican side where by just giving 0.90 peso, one gets 1USD.

Whereas the value of the dollar is higher on the U.S side, where by just giving 0.90 USD one gets 1 peso.

American side	1 USD	10 cent	0.90 USD	1 peso
Mexican side	1 peso	10 cent	0.90 peso	1 USD

Thus he had 1 USD, spent 0.10 on beer, exchanged the rest for a peso. In a similar way he did it on the Mexican side.

The worker had free beer because there is no equilibrium exchange rate. There is no purchasing power parity. According to this theory the price of beer should be equal if one measures in common currency. Price of US side is 10 cents, then as per the exchange rate of 1 USD = 0.90 peso, price of beer in Mexico should be 0.09 peso. But it is 0.10 peso.

As the purchasing power of the currencies was different in either of the markets, it led to the person enjoying free beers.