Question

While Monetary Policy can have three "goals," it only has one "tool" to implement policy. That makes it particularly difficult for the central bank - the Bank of Canada - to manage any more that "one" goal. In Canada's case, the Bank of Canada's "goal" is to maintain an inflation-Target of 2 percent per year within an operating band of 1 to 3 percent. As a result, Canada maintains a FLEXIBLE or FLOATING current regime in international markets. i. Carefully explain HOW and WHY maintaining the Bank of Canada's Inflation-Target goal would (1) Make a Canadian FIXED EXCHANGE REGIME problematic or difficult to maintain; and (2) What would be the impact on the Canadian Dollar Exchange Rate if Monetary Policy was to reduce the key policy rate? (4 Marks)

Answer 1

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Question:

Answer:

Inflation:

It is macroeconomic indicator that measure the change in price during the specific time period. When price level increase, its increase inflation and vice versa. When inflation increase then its decrease the purchasing power of money or currency and vice-versa.

Fixed Exchange Rate Regime:

A fixed exchange rate regime a regime in which exchange rate is determine by the central bank or government authority. I this regime the central bank direct intervene in the foreign exchange market and fix the exchange rate with other major currency in the favor of economy.

Floating Exchange Rate Regime:

In this regime the exchange rate is determine by market by market factors (demand and supply) and central bank or other authorities do not intervene in the foreign exchange market .

Foreign exchange rate and inflation:

When inflation decrease, it means aggregate demand decrease. So, central bank increase the money supply in the economy that decrease the cost of money or interest rate. Decreasing interest rate increase the demand for money. Increasing demand for money increased aggregate demand in the economy that increase GDP growth rate and price level (inflation). But decreasing interest rate make the domestic market less attractive for foreign investor because of lower the rate of return. So, decreased interest rate decreased the inflow of foreign capital that decrease the demand for domestic currency and currency get depreciated. When inflation rate is high, it means aggregate demand is high. So, central bank decrease the money supply in the economy that increase the cost of money or interest rate. Increasing interest rate decrease the demand for money. Decreasing demand for money increased aggregate demand in the economy that increase GDP growth rate and price level (inflation). Increasing interest rate make the domestic market more attractive for foreign investor because of higher rate of return. So, Increased interest rate increased the inflow of foreign capital that increase the demand for domestic currency and currency get appreciated.

Now come on the question:

1). Answer:

Suppose current inflation rate is 0.75% and central bank want to increase inflation rate at target level (2%) then central bank will increase money supply that will reduce the domestic interest rate and decreased domestic interest rate will reduce the inflow of foreign capital and domestic currency will depreciated. Depreciated currency will increase the cost of import and decreased the purchasing power of money or currency. Now it will creat the problem for the central bank to manage its exchange rate in fixed exchange rate policy. Now if the central bank want to manage its exchange rate then the central bank will sell the foreign currency that will increased the demand for domestic currency. Increased demand for domestic currency will appreciate the domestic currency. But if the central bank has not sufficient reserve of foreign assets or currency then the central will face more and more problem.

2). Answer:

When inflation decrease, it means aggregate demand decrease. So, central bank increase the money supply in the economy that decrease the cost of money or interest rate. Decreasing interest rate increase the demand for money. Increasing demand for money increased aggregate demand in the economy that increase GDP growth rate and price level (inflation). But decreasing interest rate make the domestic market less attractive for foreign investor because of lower the rate of return. So, decreased interest rate decreased the inflow of foreign capital that decrease the demand for domestic currency and currency get depreciated. Here CAD will depreciated because of lower demand of CAD in foreign exchange market.

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