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If Inflation in the US is running about 4% and in Mexico it's running about 12%...

If Inflation in the US is running about 4% and in Mexico it's running about 12% over a one year period, and interest rates in the US are 6%, what should interest rates be for the same maturing debt in Mexico and why?

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Answer #1

This question needs to be calculated on the basis of theory that real interest rates in all countries should be equal, with differences in nominal rates reflectingdifferences in expected inflation. This effect is also caaled as common real interest rates and is a part of International Fischer Relation.

Hence, according to this theory,

Nominal rate (US) - Inflation (US) = Nominal rate (Mexico) - Inflation (Mexico)

6% - 4% = Nominal rate (Mexico) - 12%

Nominal Rate (Mexico) = 14%

If real interest rates are not equal, it will provide an arbitrage opportunity for US investors, where they could invest money in Mexican debt and earn higher rate of return.

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