Question

3. 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

Answer 1

When the demand for real money decreases this shifts the LM curve to the right to LM' and the equilibrium goes from point E to E'. At this point there is a deficit of BOP because of the capital outflow as the interest rate in the domestic country is lower than the world and investors would seek higher return. Because the exchange rate is fixed, so the government will buy canadian dollars and sell foreign currency so as to maintain the exchange rate. This will shift the LM back to its original level. And there would be no change in exchange rate, real otuput and real interest rate.

interest rate LM -output Y Y