| | | | | | liquidity, degree of business risk, and legal system characterizing the United States. The implicit degree of riskiness associated with, say, Canadian bonds, may be greater than with U.S. bonds (because of uncertainty caused by the possibility of Quebec separation or by the large size of the Canadian national debt), implying that the real rate in Canada must incorporate a risk premium and therefore be higher than in the United States to compensate for the difference in risk. | | | | | | | | | A major dimension of the risk factor is the possibility of changes in currency values, and for this reason the risk premium is sometimes called a currency premium. A U.S. investor buying Canadian bonds, for example, will be paid Canadian dollars when the bond matures, so the investor is running the risk that the value of the Canadian dollar may be lower at maturity than it was when he or she bought the bonds. Offsetting this danger is the possibility that the value of the Canadian dollar may be higher, but the point is that there is a risk. An investor will accept this risk only if a higher real rate of return is offered. An investor can purchase insurance to protect against this type of risk (this is called hedging), but at a cost that is of course higher, the higher is the risk. To cover this cost, the real interest rate on the Canadian bond must be higher to make it comparable to U.S. bonds in the eyes of U.S. investors. | | | | | | | | | 18.3
Why Not Nominal Interest Rates? | | | | | | | | | The best way to explain why nominal interest rate differences are not relevant, except insofar as they reflect differences in real interest rates, is to look at a specific example. | | | | | | | | | Suppose that the United States and Canada are in equilibrium with a flexible exchange rate, that both countries have a real growth rate of 2 percent per year, that their money supplies are both growing at 7 percent per year, and that their real rates of interest are 3 percent and 4 percent, respectively, implying a risk premium of one percentage point in favor of the United States. | | | | | | | | | What are the inflation rates in the United States and Canada? Using our rule of thumb from chapter 9, the rate of inflation in both countries should be 5 percent, calculated in each case as 7 percent - 2 percent. | | | | | | | | | What are the nominal interest rates in the United States and Canada? Using the relationship between the real and nominal interest rates, the nominal interest rate in the United States should be 3 percent + 5 percent = 8 percent, and in Canada it should be 4 percent + 5 percent = 9 percent. | | | | | | | | | What is happening to the exchange rate? Because the rates of inflation in these two economies are the same, the purchasing power parity theorem implies that the exchange rate is constant. | | | | | | | | | Will there be capital flows? Since the one-percentage-point higher real interest rate in Canada just compensates U.S. lenders for the higher risk of investing in Canadian bonds, there should be no capital flows. | | | | |
