Suppose the Canadian and U.S. economies, on a flexible exchange rate, have real

Question

Suppose the Canadian and U.S. economies, on a flexible exchange rate, have real growth rates of 2% and a risk premium of 1% (Canada is riskier). The Canadian money growth rate is 10%, the U.S. money growth rate is 7% and the U.S. real interest rate is 3% 1)The Canadian nominal interest rate is: a) 10% or less b) 11% c) 12% d) more than 12% 2)The value of the Canadian dollar is falling each year by: a) less than 2% b) 2% c) 3% d) more than 3% please explain how you got the answer. the answer for both the parts is c)

Explanation / Answer

Let i(foreign) be the nominal interest rate for US in this case and i(domestic) represents the nominal interest rate for Canada and r(foreign) be the real interest rate in US and r(domestic) be the real interest rate for Canada.

Based on the International Fisher Effect,we get:-

{1+i(domestic)}/{1+i(foreign))}={1+r(domestic)}/{1+r(foreign)}

Notice here that the Canadian economy has a real growth rate of 2% and the risk premium of 1% and the difference between the real growth rate of Canadian economy and the Canadian risk premium is 3% which represents the depreciation rate of Canadian dollar relative to US dollar.

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