The Open Economy — End of Chapter Problem You read on a financial website that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that international capital flows equalize the real interest rates in the two countries and that purchasing-power parity holds. Use this information along with the Fisher equation (introduced in an earlier chapter) to answer the questions. a. What can you infer about expected inflation rates in Canada compared with the United States? Expected inflation is 4 percent in both countries, due to the nominal exchange rate. is 4 percent higher in Canada than in the United States. is 4 percent higher in the United States than in Canada. is 4 percent in both countries, due to the real exchange rate. b. What can you infer about the expected change in the exchange rate between the Canadian dollar and the U. S. dollar? The nominal exchange rate will depend upon the difference in the real exchange rate between the two countries. will equal the difference between the expected rates of inflation between the two countries. is dependent upon the net value of purchasing-power parity. will remain unchanged, due to purchasing-power parity between the two countries.

provided in the explanation segment

Explanation:

We can follow the explanation above to arrive at the answer.

a.

From Fisher Equation, we can state that;

Real interest rate(r) should be equal to the nominal interest rate(i) minus the expected inflation(e) in the economy.

equation given thus;

(1+ Nominal rate of interest) = (1+ Real rate of Interest) * (1 + Expected Inflation) .

Broken down as:

Nominal rate of interest = Real rate of Interest + Expected Inflation

i.e. i = r + e

Using the above formula:

For Canada:

i Canada= r Canada + e Canada

For US:

i US = r US  + e US

Since the real interest rate is equalized in both countries, we get

i Canada - i US = e Canada -  e US

e Canada -  e US = 12% - 8%

= 4%

Therefore, e Canada -  e US = 4%

Expected inflation in Canada is higher by 4% than the expected inflation US.

b.

The expected change in the currency is defined by the interest rate parity equation which states that:

Domestic interest rates equal to foreign interest rates minus the expected appreciation in domestic currency.

i Canada =   i US - change in exchange rate of Canadian dollar

Change in exchange rate of Canadian dollar = 8% - 12% = -4%

The negative sign denotes that the Canadian currency depreciating by 4% compared with the US dollar.

c. The get rick quich scheme to make a arbitrage (risk free) profit of 4% is wrong. This is because the difference of 4% is calculated on the nominal interest rates.

The arbitrage occurs only when the is a difference in the real interest rate of the economy.

Real interest rate signifies the real potential of the economy excluding the inflation rate.

Thus, the arbitrage profit should be calculated by the real interest rates and not the nominal interest rate.

Suppose, a person takes a loan at 8% from US bank for an year's time.

Cost of funds = 8%

Now, he converts the US dollars into Canadian dollars at the existing exchange value.

Later he invests the money in Canadian Bank at 12% for an year's time.

Rate of return = 12%

After 1 Year:

He gets a 12% return from Canadian Bank and withdraws the Canadian dollar.

Now, he has to convert it into US dollar.

While converting, he will lose 4% of the value as the Canadian currency is depreciating by 4% compared to US dollar in a year i.e. since the Canadian dollar has depreciated, the person will get less US dollars.

This decreases by return by 4%.

Return = 12% - 4% = 8%

Since, loan is taken at 8%, the net return will b 0%.

Therefore, there is no get rich quick scheme as the change in exchange rate is not taken into accoutn while calculating the return.

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