Question

You read on a financial website that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that international capital flows equalize the real interest rates in the two countries and that purchasing-power parity holds. Use this information along with the Fisher equation to answer the questions.
a. What can you infer about expected inflation rates in Canada compared with the United States?
b. What can you infer about the expected change in the exchange rate between the Canadian dollar and the U.S. dollar?
c. A friend proposes a get-rich-quick scheme: borrow from a U.S. bank at 8 percent, deposit the money in a Canadian bank at 12 percent, and make a 4 percent profit. What's wrong with this scheme?

Answer 1

Answer and Explanation:

a. The conclude of expected inflation rates in Canada compared with the United States is stated below:-

Using Fisher's equation,

Nominal interest rate ~ real interest rate + inflation.

Real interest rate = nominal interest rate - inflation

So, As the real interest rate in US and Canada are equal,

The Nominal rate of Canada - Inflation of Canada = Nominal Rate of US - Inflation of US

12% - inflation of Canada = 8% - Inflation of US

Inflation of Canada = 4% + Inflation of US

Therefore, inflation in Canada will be 4% greater than in the US.

b. Inflation is higher in Canada, its value will again depreciate the US dollar. I.e. the US dollar becomes better and the Canadian dollar becomes weaker. The value will change by 4 per cent.

c. Assume 1 USD = 1 CAD and the amount loaned be $1 in the US for a particular year.

The Amount which is payable in US after 1 year is

= $1 × (1 + 8%)

= $1.08

     Now,

Amount converted to CAD = CAD 1

The Amount in CAD after 1 year is

= CAD 1 × (1 + 12%)

= CAD 1.12

Hence,

New Exchange rate after 1 year is

= 1 × (1 + 4%)

= 1.04

that is 1 USD = 1.04 CAD (i.e USD costs higher in CAD)

So,

The Amount in USD converted from CAD is

= 1.12 ÷ 1.04 = 1.0769 ~ 1.077 USD

This plan thus actually loses money because the value of the loan to be repaid is USD 1.08 which is higher than USD 1.077 gained from CAD interest rates. (Even without mentioning transaction fees at the exchange rate etc.)