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 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?
The friend's get-rich-quick scheme appears to be profitable at first glance. By borrowing money at 8% in the United States and depositing it in a Canadian bank that offers a 12% interest rate, it seems possible to make a 4% profit. However, there are a few key factors to consider.
First, we need to understand the concept of real interest rates. Real interest rates are nominal interest rates adjusted for inflation. Inflation erodes the purchasing power of money over time, so it is crucial to consider it when making investment decisions.
In this scenario, if the real interest rates are equalized between the two countries, it means that the inflation rates in both countries are similar. For the sake of simplicity, let's assume that the inflation rates are both 2%.
Now, let's break down the scheme step by step:
1. Borrowing at 8% in the US: When you borrow money at an 8% nominal interest rate, you are essentially paying an 8% cost on the borrowed amount. However, you need to consider the inflation rate in the US. If the inflation rate is 2%, your real cost of borrowing would be 8% - 2% = 6%.
2. Depositing at 12% in Canada: When you deposit the borrowed money in a Canadian bank at a 12% nominal interest rate, you would earn a 12% return on the deposited amount. However, you also need to consider the inflation rate in Canada, which we assumed to be 2%. So, the real return on your deposit would be 12% - 2% = 10%.
Now, let's calculate the real profit in this scheme:
Real profit = Real return on deposit - Real cost of borrowing
= 10% - 6%
= 4%
As you can see, the real profit in this scheme is zero, not 4%. Even though the nominal interest rates seem favorable, when adjusted for inflation, the real interest rates are equalized. Therefore, you would not make a real profit by implementing this strategy.
In addition to the equalization of real interest rates, it is important to remember the concept of purchasing-power parity. Purchasing-power parity suggests that, in the long run, the exchange rate between two currencies should adjust to account for differences in inflation rates. If the inflation rate is higher in Canada than in the United States, the Canadian currency should depreciate relative to the US currency, reducing any potential gains from the scheme.
In conclusion, this get-rich-quick scheme fails to consider the equalization of real interest rates and the impact of purchasing-power parity, making it an ineffective strategy for making a profit.