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 seems attractive at first, but there are a couple of key factors that make it not profitable in reality. Let's break down why this scheme doesn't work:
1. Nominal interest rates vs. real interest rates: The nominal interest rates mentioned (12% in Canada and 8% in the United States) are the rates published by the central banks. However, it's important to consider the real interest rates, which take inflation into account. If the real interest rates are equalized and purchasing-power parity holds, it means that after adjusting for inflation, the real interest rates will be similar across the two countries.
2. Exchange rate risk: The scheme assumes that the exchange rate between the Canadian dollar (CAD) and the U.S. dollar (USD) will remain constant or work in favor of the investor. However, exchange rates fluctuate based on many factors such as economic indicators, market sentiment, and geopolitical events. If the CAD depreciates against the USD during the investment period, the gains earned from the interest rate differentials may be offset or even turn into losses when converted back to USD.
3. Transaction costs: When exchanging currencies or making international transactions, there are often fees and costs associated with these activities. These transaction costs can eat into any potential gains, making the scheme less profitable.
4. Jurisdictional and banking regulations: Moving money across borders may involve compliance with legal and regulatory frameworks, which can add complexity and expenses to the process. It's important to consider the legal and administrative aspects of executing such transactions.
Overall, while the scheme may seem appealing on the surface, it ignores the important factors of real interest rates, exchange rate risk, transaction costs, and jurisdictional considerations. It's essential to analyze the bigger picture and consider these factors to make informed investment decisions.