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|On the house? (Posted on 2003-10-31)
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).
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?
Submitted by SilverKnight
Rating: 3.7619 (21 votes)
The respective bar owners are losing money. Just because the government says money is worth something doesn't make it so.
As Popstar Dave mentioned in his comment, this does provide an arbitrage situation. (And he's correct in that it would not last long in a free floating currency environment, but this problem described an environment where the currency is NOT free floating, so it doesn't apply.)
Alan should give change of 9 American dollars, and Bob should give change of 9 Canadian dollars. (They should do this to avoid losing on the transaction.) And, as several have pointed out, they could keep the foreign currency and trade it (in the foreign country) for their own currency.
If Alan gives change of 10 Canadian dollars (instead of 9 American dollars), he is giving up something that CAN purchase the full equivalent of 10 American dollars.
Similarly, if Bob gives change of 10 American dollars (instead of 9 Canadian dollars), he is giving up something that CAN purchase the full equivalent of 10 Canadian dollars.
*** It is interesting to note, that it is for exactly this reason, among others such as the (in)stability and (high or) low devaluation of the currency, that in countries that don't allow the local currency to freely float, you find the citizens will hoard another country's currency (often U.S. dollars).
Lastly, as Marc Meyer hinted at... in the long run, if a country's banks 'honor' this arbitrage situation, then it is the country (tax payers) which pays for the loss.
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