Question

Question 3 (10 Marks): Assume that Canada is a small open economy which uses a system of fixed exchange rates. The economy is in equilibrium when there is a sudden decrease in real money demand. Explain what will happen to the exchange rate, output, and the real interest rate in the short-run and in the long-run. Question 4 (10 Marks): Assume that Canada is a small open economy which uses a system of flexible exchange rates. The economy is in equilibrium when there is a sudden decrease in real money demand. Explain what will happen to the exchange rate, output, and the real interest rate in the short-run and in the long-run.

Answer 1

We use the IS-LM-BP model or the Mundell-Fleming Model to answer this question.

The IS curve captures the market for goods and services. The curve depicts the equilibrium condition where the supply of goods and services is equal to the demand.
Y = C+I+G+NX, where Y = produciton, C = consumption, I=investment, G = government spending and NX = net exports or exports less imports.

The LM curve depicts the equilibrium state of the money market where the demand for money is equal to the suppl of money.
M/P = L(i,Y), where M is the amount of money and P is the price, L is the demand function for money which is dependent of the real interest rate, i and the real income, Y.

The BoP or balance of payments curve depicts the equilibrium state of the balance of payments, meaning the various combinations of interest rate and income level where the current account and capital account offset each other.

In this problem, we assume thaat the BP curve is perfectly mobile, i.e. it is horizontal. Perfect mobility of the BP curve means that financial assets are perfect substitutes of each other and a slight change in the domestic interest rate from the foreign interest rate would result in infinite capital flows.  

Q.3

LM. Q. Bet Fixed Exchange Rate The decrease in real money demand shifts the LM curve to the right, and economy goes from point E to E. At E, there is a deficit in the Bop - as domestic investore seek to purchase higher returning foreign assets. There is infinite capital out flow, putting pressure on the Canadian dollar .. The Bank of Canada has agreed lo, and hence it buys the exchange to maintain exchange rate at unwanted dollars & sells foreign As the central bank buys the dollar, there is decrease in money supply and LM1 Shifes the initial LMo t h a Hence, output there and is real no effect on interest rate. exchange rate, reel

Q.4

2.4 Flexible .LMo Exchange Rate B in Decrease the right point E the from to real money demand shifts the LM chowe to LMo to LM, Economy gou from point to foreign rate, At E domestic interest rate is less than hence, there is capital out flow. The decrease demand for dollare due to I the dollar to depreciate to increases). this causes As lo increases, domestic goods become in international market shifting the is right as net exports will increase relatively cheaper curre to the IS. shifts to IS1 where capital out flow is halted (domestic interest rate equals that of foreign). New equilibrium is at E" where output has increased to Y1 from Yo Therefore, exchange rate increases, real output increases in the long run.