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?

a b c

To answer these questions, we need to use the Fisher equation, which relates the nominal interest rate, the real interest rate, and the expected inflation rate. The Fisher equation is:

Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate

a) Using the Fisher equation, we can infer about expected inflation in Canada and the United States. Since the real interest rates are equalized, we can set them as equal:

12% (Canada's nominal interest rate) = 8% (United States' nominal interest rate) + Expected Inflation Rate

Simplifying the equation, we find:

Expected Inflation Rate = 12% - 8% = 4%

Therefore, the expected inflation rate in both Canada and the United States is 4%.

b) To infer about the expected change in the exchange rate between the Canadian dollar and the U.S. dollar, we need to consider the concept of purchasing-power parity (PPP). PPP suggests that the exchange rate between two currencies adjusts to reflect the price levels in each country.

Since the real interest rates are equalized and purchasing-power parity holds, we can infer that the expected change in the exchange rate between the Canadian dollar and the U.S. dollar will be equal to the expected inflation rate difference between the two countries. In this case, as both countries have an expected inflation rate of 4%, we can conclude that there is no expected change in the exchange rate.

c) The proposed get-rich-quick scheme of borrowing from a US bank at 8%, depositing the money in a Canadian bank at 12%, and making a 4% profit may appear profitable at first. However, there are a few problems with this scheme:

1. Exchange rate risk: The scheme assumes that the exchange rate between the Canadian dollar and the U.S. dollar will remain constant. In reality, exchange rates can fluctuate, which can impact the profitability of the scheme.

2. Transaction costs: Converting currencies and transferring funds between banks may involve fees and charges that can eat into the potential profit.

3. Time frame: The scheme assumes that the borrowing and deposit periods align perfectly. In practice, there may be a time gap between borrowing and depositing, during which exchange rates might change.

4. Legal restrictions: Some countries may have capital controls or regulations that limit or prohibit such transactions.

Overall, while the scheme may sound appealing, it involves various risks and uncertainties that can undermine the anticipated profit. It's essential to carefully consider these factors before engaging in any financial activity.