Question

The coronavirus is currently wreaking havoc on the world economy. There are many reasons for this, so let's simplify by focusing on just one. Suppose the primary effect of the coronavirus is to create “uncertainty”, which leads investors to increase their demand for “liquidity” (i.e., it increases the demand for money relative to other assets). Use the DD-AA model to show how this would affect the US economy. What happens to US output and the value of the dollar? US policymakers are currently debating whether to respond by cutting interest rate or increasing government spending. Which of these policy responses would Canada favor? Which would China favor? (Hint: The Canadian dollar oats against the US dollar, whereas the RMB is pegged to the US dollar).

Answer 1

IMPACT OF CORONA

AA-DD model merges the money market, the forex market and G$S market into one supermodel.

The AA-DD model is a diagram consisting of two curves, the AA curve representing an asset market derived from the money market and the foreign exchange market. DD curve representing the goods market. Equilibrium of the AA-DD model refers to superequilibrium.

Figure 16-12: Maintaining full Employment After a Temporary Fall in Demand for Domestic Products DD2 DD A fall in world demand for our output shifts DD to DD2 Exchange Y falls to Y2 below Yf, Rate, E E depreciates to E? Temporary fiscal expansion restores eq'm back to 1, no E3 -- Change in E DD1 DDS - -- Temporary monetary expansion restores Y back to Y' but causes further E depreciation. -=XN AA2 E1 - AA1 Y y Output, 38

The above diagram shows the corona's impact on the AA-DD model.

the disease COVID-19 is having a disruptive effect on the US economy. it disrupts the global supply of goods making it hard for US firms to fill orders. It also reduces the labour supply in one end and on the other slows the demand for US products and services. According to the IMF managing director, this outbreak is the world's most pressing uncertainty.

Thus the policymakers in the US should immediately undertake a number of steps to address any economic fallout from the virus. The burden of meeting this challenge falls squarely on Congress and the Trump administration. To its credit, the Federal Reserve has aggressively cut interest rates, but monetary policy will likely have a very limited effect since interest rates are already low and have been so for some time. To put the U.S. economy on steady footing, CAP recommends that Congress and the Trump administration engage in fiscal stimulus and embrace five key principles for economic policy action in response to the coronavirus, they are

• Do no harm
• Put more resources in public health efforts
• Assure business and remediate harm when necessary
• Calm financial markets
• ease the risk for households and vulnerable population

US sovereign debt has rallied sharply as the collapse in oil prices and intensifying concerns over the coronavirus outbreak sends investors piling into havens. The benchmark 10-year Treasury yield dropped 0.375 percentage point to 0.36 percent, marking a new record low borrowing cost for American sovereign debt. Debt at other maturities has also rallied in price, with yields on two and 30-year Treasuries falling sharply. Across the Atlantic, bonds considered to be sheltered during times of market tumult also rallied. The 10-year German Bund yield dropped 0.126 percentage point to minus 0.845 percent -- also a historic low. Investors have raced into the perceived safety of US and German government debt over the past few weeks as riskier asset markets, like equities, have faced severe ructions. The US 10-year yield has dropped 1.5 percentage points so far in 2020, the heaviest fall since the global financial crisis in 2008. The move has come as the Federal Reserve has already cut overnight borrowing costs by half a percentage point in the biggest reduction since the crisis. Investors have said further action may be necessary from the Fed and other central banks as they attempt to buttress the global economy.(https://www.ft.com/content/f3db4bfe-ed33-3300-80ea-c0fdfd2dc7e7)

Since the world market is facing a major crisis there aren't enough dollars for executing trade and transactions. hence the trade-weighted dollar index more than 4%. the broad dollar index measures the value of the dollar against many baskets of currencies such as euro, pound, yen, Canadian dollar, Swiss France and Swedish krona.

US Federal Reserves announced to set up financing channels with 9 other central banks, including Reserve Bank of Australia and Monetary Authority of Singapore for stabilizing the currency market.

The number of aspects worrying some analysts are:

1. Bad news for emerging market assets – With many currencies like the Brazilian real, Indian rupee and Indonesian rupiah plunging to record lows, the next move to watch for is a G20 level currency intervention. With the Fed funds rate in the U.S. down to near zero and most emerging market central banks cutting rates aggressively, the yield advantage for those countries’ currencies has withered away.
2. Negative for US exports – At a time when President Donald Trump has repeatedly said he doesn’t like a strong dollar, the rally will be detrimental for U.S. exports, especially once the pandemic curve flattens and consumer and industrial demand bounce back.
3. Top reserve currency of the world – According to the IMF, more than 61% of all foreign bank reserves are in U.S. dollars. Plus, nearly 40% of the world’s debt is in dollars. Together with the euro, the two currencies dominate 80% of global reserves. The Chinese renminbi, despite the country being an integral part of global trade, makes up less than 2% of global currency reserves. That creates over-dependence on the U.S. greenback.
4. Euro-dollar parity – Foreign exchange markets are watching this currency pair closely. Divya Devesh, the forex analyst at Standard Chartered, said he sees diverging economic performance between the United States and Europe. “We project full-year 2020 GDP growth of -3.0% in the euro-area versus -0.3% in the U.S.,” he said in an email. “Expected economic underperformance is likely to weigh on the euro.” ( https://www.cnbc.com/2020/03/24/us-dollar-to-test-105-against-basket-of-currencies-says-analyst.html)

The Canadian dollar continues to derive direction from oil price action, coronavirus headlines, and Canadian and U.S. government fiscal stimulus plans. There is no cure for COVID-19, and that means no cure for financial market volatility. The TSX lost 6.57%, but it was a better performance than the Dow Jones Industrial Average. The Dow Jones Industrial Average lost 4.55% and finished with a 9.72% loss. Those stock market moves, oil price action, and fiscal stimulus, actions bounced the USD/CAD in a $1.4160 - $1.4665 range.

The Canadian dollar is collateral damage in the oil price war and prices plunged in Asia, alongside the crude price slide.

Oil price movements and coronavirus headlines will ensure there will not be a shortage of intraday FX volatility this week. There are over 330,000 COVID-19 cases globally.

Canada had 1,426 confirmed cases (as of March 22) and Canadian authorities expect the domestic number to rise exponentially. However, Prime Minister Justin Trudeau said on Sunday Canada is not at the point where the government needs to take emergency measures to force people to stay at home.(https://www.baystreet.ca/forex_trader/2244/USDCAD--Canadian-Dollar-Infected-by-COVID-19)