Question

If Canada always had 10% of inflation, and the US always had 0% inflation, explain what would happen to the nominal and real exchange rates over time, and the difference between Canadian and US nominal interest rates, and real interest rates.

Answer 1

If Canada always has 10% of inflation and US had 0% inflation then there will be trade deficit in Canada due to which Canadian dollar demand will decrease and US dollar demand will increase. To maintains stability in the market or according to purchasing power parity condition, U.S. Dollar will appreciate by 10% every year and thus net real interest rate from both Canadian and US dollar will be same. But Canadian dolllar returns are from increase in Canada nominal interest rate whereas US real interest rate is due to appreciation of dollar