Question

In view of the Coronavirus epidemy, the Bank of Canada along with most advanced nations’ central banks has cut its policy interest rate by 1.5% to 0.25%.

(a)   Explain the Bank of Canada’s intention and motive behind this policy.

(b)  Employing the model of interest parity, discuss with the help of a diagram the expected impact of these interest cuts on the exchange rate (Canadian dollar).

Now explain how the expected change in the Canadian dollar is hoped to affect Canada’s net exports (NX) and Canada’s GDP

Answer 1

a) By cutting policy interest rate, Bank of Canada intends to inject more money supply in the economy. This is expansionary monetary policy. During Coronavirus epidemy, people have income cut and therefore drop in aggregate demand in the economy. Through interest rate cut the Bank of Canada along with other central banks of advanced nations want to boost up lending capacity of the commercial banks such that they can provide loan to common people at low cost. In this way central banks are trying to keep money in the hands of people to spend more so that total production capacity and production can be restored.

b) when all other factors remain same, decrease in interest rate decreases the value of the domestic currency. Lower interest rate makes foreign investment unattractive. Therefore, Canadian economy may observe a drop in capital inflows if the interest rate below world average. As i_d domestic interest rate falls, demand for domestic assets will fall and expected return on Canadian dollar will also. Hence demand for Canadian dollar curve shifts to the left. Currency depreciates. Exchange rate falls from E₁ to E_{2 in the figure below.}

Exchange Rate Quantity of Canadian Dollar

c) As Canadian dollar is expected to depreciates, this will make Canadian export attractive in the world market as export is expected to become cheaper. Then export from Canada is likely to increase improving the trade balance. Net export of Canada (NX) will thus improve due to currency depreciation.

GDP = Y = C+ I+ G+ NX

As net export is a component of GDP, increase in NX will increase GDP of Canada.

Answer 2

A.

The intention and motive of Bank of Canada is to encourage consumption and investment spending as borrowing becomes cheaper in the market with decrease in rates. It is supported by the increase in money supply. So, it will give boost to the economy and real GDP will either increase or maintained at the satisfactory level in the wake of COVID-19 pandemic.

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B.

The exchange value of Canadian dollar will decrease. It will lead to the more amount of Canadian dollar required for one unit of USD or Euro or other major currency.

Exchange Rate Quantity of Canadian Dollar

Above diagram shows the movement from S to S1 when supply of Canadian Dollar increases in the market and exchange rate decrease.

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C.

It will makes exports to be cheaper and imports to be expensive. As a result, export increases and import decreases. It makes NX to increase in the economy, leading to increase in real GDP of Canadian economy.