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

Expected inflation is higher in Canada than in the U.S., as inferred from higher nominal interest rates with equal real interest rates. The Canadian dollar is expected to depreciate against the U.S. dollar. The proposed investment scheme fails to account for the effects of inflation and exchange rate fluctuations.

Step-by-step explanation:

When analyzing the nominal interest rates and the implications for real interest rates and exchange rates between Canada and the United States, several economic principles apply, including the Fisher equation, purchasing-power parity, and international capital flows.

a. Expected Inflation Rates in Canada vs. the United States

The Fisher equation relates nominal interest rates, real interest rates, and expected inflation. Given the higher nominal interest rate in Canada (12%) as compared to the United States (8%), and assuming that real interest rates are equalized due to international capital flows, we can infer that expected inflation must be higher in Canada than in the United States.

b. Expected Change in the Exchange Rate

If purchasing-power parity holds true, the currency of the country with higher inflation is expected to depreciate. Therefore, we can infer that the Canadian dollar is expected to depreciate relative to the U.S. dollar.

c. Flaws in the Get-Rich-Quick Scheme

The proposed scheme ignores the effects of inflation and potential changes in exchange rates. It assumes that the nominal interest rate differential will directly translate into profit, which is not the case when considering real interest rates and the impact on the exchange rate due to varying inflation rates between the two countries.

Answer 2

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.)