Suppose that on January 1, the cost of borrowing French francs for the year is 18%. During the year, U.S. inflation is 5%, and French inflation is 9%. At the same time, the exchange rate changes from FF 1 = $0.15 on January 1 to FF 1 = $0.10 on December 31. What was the real U.S. dollar cost of borrowing francs for the year?
Answer. During the year, the franc devalued by (.15 – .10)/.15 = 33.33%. The nominal dollar cost of borrowing French francs, therefore, was .18(1 – .3333) – .3333 = -21.33% (see Chapter 12). For each dollar’s worth of francs borrowed on January 1, it cost only $0.7867 to repay the principal plus interest. With U.S. inflation of 5% during the year, the real dollar cost of repaying the principal and interest is $0.7867/1.05 = $0.7492. Subtracting the original $1 borrowed, we see that the real dollar cost of repaying the franc loan is -$0.2508 or a real dollar interest rate of -25.08%.
