Question

Question 5

The Conference Board of Canada computes the monthly Index of Consumer Confidence. When confidence rises, consumers tend to increase their purchases and reduce their savings.

Between January and February 2020, the index rose by 5% and reached its highest level since August 2019. Use the long-run model of a small open economy to illustrate graphically the impact of this increase in consumer confidence on consumption, Canadian loanable funds, the CAD-USD exchange rate and the Canadian trade balance. Currently, Canadian net exports are negative. Be sure to label: i. the axes ii. the curves iii. the initial equilibrium values iv. the direction the curves shift v. the new long-run equilibrium values.

Draw the graphs by hand on paper. Include the following graphs: consumption function, the market for Canadian loanable funds and the market for CAD

Answer 1

National income identity is: Y= C+I+G+NX, where NX are Imports-Exports.Since this is a long run model, Y is fixed. Since this is a small open economy, real interest rate is same as world interest rate and is exogenous. Currently, NX is negative, which menas C+I+G is more than total income Y. Also, there are capital inflows to cover trade deficit.

An increase in confidence means that consumer tend to reduce savings and increase purchases. So, consumption rises. For a fixed income Y*, consumption rises frm C to C*:

Income(Y) Consumption

Since savings fall, so supply of loanble funds also fall, which will raise the interest rate. But since this is a small economy, a rise in interest rate would attract capital inflows, so interest rate remains the same. There is no change in quantity of loanable funds:

interest rate R world quantity of loanable funds

Effect on exchange rate: Capital inflows increases the supply of foreign exchange (dollar). So, supply of foreign echange increase(new supply curve in blue) and exchange rate for CAD-USD appreciates.

Exchange rate Supply of foreign exchange Demand for foreign exchange Quantity of foreign exchange

Since exchange rate appreciates, ceteris paribus, exports fall. So, trade balance worsens