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?

I believe it was Marc Meyer who gave the correct solution; the governments are picking up the tab. Many responders presumed a lot of circumstantial info, such as that "the bar already had a stockpile of foreign currency which was obtained at the former 1:1 cost basis." Nowhere in the problem was a loss via cost basis implied. If a Canadian bar is giving US currency as change, there is no reason to assume that they are not getting it from a local bank that day, at the current exchange rate. Otherwise there is no limit to the bar's "loss" you could infer with your imagination. Maybe they had $11.11M US stockpiled under the bar, and lost $1M as they frittered it all away as change for CAN$.

In reality whoever actually changes the currency from one form to another loses. This would be the banks, which are essentially the government.

No matter how much cash you can wheedle through this obviously stupid system, ultimately it is the government who eats it, if the exchange rates never change again.

Think of the most extreme example possible. Let's say there were 1 billion US dollars and 1.11 billion Canadian dollars EXISTING in print. What if someone took every single US dollar and exchanged them for 1.11B $CAN? Then they took the 1.11B $CAN and exchanged them back into $US? The government would be forced to print more money to honor the exchange. Yes, this inflates the economy and devalues the US dollar (theoretically.)

Bottom line is, the buck stops (literally) with the US Treasury and their Canadian equivalent.

Posted by John on 2003-11-05 16:48:49