Question

Suppose nominal interest rates in the Canadian financial markets start to rise. Using the Fisher equation and Purchasing Power Parity, explain how the Bank of Canada can use its knowledge of the foreign exchange market to achieve a steady inflation rate.

Answer 1

Increase in rate of interest in economy, usually implies the tight monetary policy. rise in interest rate will cause inflow of capital from elsewhere to earn profits from higher interest rate. it will cause rise in value of currency or domestic currency shall appreciate in international market.

import will rise and inflation rate is further expected to rise due to huge demand. Hence, bank of canada can expect inflation to rise in future. Thus, it should use tight monetary policy to tame over inflation.