Purchasing-power parity holds between the nations of Ectenia and Wiknam, where the only commodity is Spam. a. In \(2020,\) a can of Spam costs 4 dollars in Ectenia and 24 pesos in Wiknam. What is the exchange rate between Ectenian dollars and Wiknamian pesos? b. Over the next 20 years, inflation is expected to be 3.5 percent per year in Ectenia and 7 percent per year in Wiknam. If this inflation comes to pass, what will the price of Spam and the exchange rate be in \(2040 ?\) (Hint: Recall the rule of 70 from Chapter 27 .) c. Which of these two nations will likely have a higher nominal interest rate? Why? d. A friend of yours suggests a get-rich-quick scheme: Borrow from the nation with the lower nominal interest rate, invest in the nation with the higher nominal interest rate, and profit from the interest-rate differential. Do you see any potential problems with this idea? Explain.

Understanding exchange rates is fundamental to grasping purchasing-power parity (PPP). An exchange rate is the value of one currency in terms of another. For instance, in our example, the initial exchange rate was determined using the price of a can of Spam: 24 Wiknamian pesos for 4 Ectenian dollars, which equates to 6 pesos per dollar.

The calculation is simple: you divide the cost of an item in one currency by its cost in another. So, if you're ever given the price of an object in two different currencies, just divide those prices to get the exchange rate. This will give you a direct understanding of the purchasing power between two economies - crucial for businesses, travelers, and investors alike.

To assess the future price of an item, taking into account inflation, you can use the compound interest formula. Inflation measures how much the price levels of goods and services increase over time. To calculate future price, the formula is:

The term ‘nominal interest rate’ refers to the percentage yield that you earn or pay on a loan or investment, without taking inflation into account. This is different from the real interest rate, which is adjusted for inflation and reflects the true cost of borrowing. In our exercise, the country with higher inflation, Wiknam, is likely to offer a higher nominal interest rate to investors. This compensates for the diminishing purchasing power of its currency due to inflation.

As an investor or a borrower, it's important to recognize that while high nominal rates might appear attractive, they could be indicative of high inflation in the country, which may erode the real value of returns over time.

Currency risk arises from the fluctuations in the exchange rate between two currencies. If an individual borrows money in one currency with a lower interest rate and invests in another currency offering a higher interest rate, they might profit from the difference - but only if exchange rates remain static or move in their favor. An unfavorable move in exchange rates can significantly increase the cost of repayment, potentially outweighing any gains from interest rate differentials. This is particularly the case in countries experiencing high inflation rates, where the currency value might depreciate rapidly.

Therefore, it's essential to consider both the nominal interest rate and currency risk when planning financial transactions spanning multiple currencies. Without incorporating the latter into your planning, you may find that currency movements have eaten into your profits, or worse, resulted in a financial loss.