You read in a newspaper that the nominal interest rate is 12 percent per year in

Question

You read in a newspaper that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that the real interest rates are equalized in the two countries and that purchasing-power parity holds. a) Using the Fisher equation, what can you infer about expected inflation in Canada and in the United States? b) What can you infer about 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 US bank at 8%, deposit the money in a Canadian bank at 12%, and make a 4% profit. What is wrong with this scheme?

Explanation / Answer

a. Inflation will be higher in Canada.
b. The US dollar will increase in value relative to the looney or whatever the Canadians use.
3. When the Looney drops in value relative to the dollar, and you have to pay back the loan in US dollars, you'd be lucky to break even. In fact, you could expect to lose whatever you pay the bank in interest on the loan.

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