Discussion: exchange rate and free beer

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.

Discussion Topic:

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

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