Alan and Bob each own a bar. Alan's is in very northern New York, and Bob's is just across the border in Canada.

As it turns out, at the beginning of this problem, a Canadian Dollar is worth exactly the same as the U.S. Dollar, and people are quite accustomed to using them interchangeably (including banks).

But, alas, the U.S. Government and the Canadian government get in a spat. So, the U.S. "devalues" the Canadian dollar 10%, so now they will treat it as worth 90 cents (U.S. currency). In retaliation, Canada does the same and "devalues" the U.S. dollar 10%, so they treat it as worth 90 cents (Canadian currency).

Enter Charlie.

Charlie goes to Alan's bar and purchases a 1 dollar drink and pays with a 10 dollar bill (U.S.). He receives, in change, a 10 dollar bill (Canadian). He then walks across the border to Bob's bar and purchases another 1 dollar drink, paying with a 10 dollar bill (Canadian), and he receives, in change, a 10 dollar bill (U.S.).

Charlie proceeds to continue doing this until he finds himself quite intoxicated.

I think it obvious that Charlie is gaining on these transactions. The question is.... WHO (if anyone) is losing out on these transactions?

The governments of both countries pay for the drinks.
after 1 transaction the canadian barman will have
10 CANADIAN, and be out 10 US and 1 drink. In order to serve our drinker again, he needs to go to the bank, give them 9 CAN and get 10 US back.
The bank can get its supply of US from either tourists/commercial transactions, or from a governmental source. No tourists/commercial (or few) will be available, because the bank is offering 9 CAN for 10 US, while in the States 11 CAN can be had for the 10 US. So the govt central bank needs to supply the US currency, at 10US = 9 CAN, but it needs to replenish that supply from Stateside sources at a rate of 10US=11CAN, losing 22% on each transaction (to people like Charlie!)
Similarly, when in the States, the US Govt pays for Charlie's drinks.

Posted by Marc Meyer on 2003-10-31 11:35:25