Question

We live in an open economy with international capital mobility

1. If Bank of Canada increases the money supply would that make Canadian bonds attractive to foreigners or not? Explain.

2. Increasing the money supply would lead to the appreciation of the Canadian dollar. True or false? Explain

3. Based on your answer to “b” above, what will happen to net exports?  Explain

4. Ignoring what Bank of Canada did, assume that the Federal Reserve (the US Central Bank) increases the US money supply what is the likely effect on Canada? Explain.

Answer 1

a) If bank of Canada increases money supply then that would decrease the interest rate for bonds. Decrease in the intereste rate implies decrease in the gains from bond and that cannot not make Canadian bonds more attractive , instead it would make it lesser attractive.

b) False.

Since increase in money supply will make Canadian bonds unattractive, foreigners will decrease their demand for Canadian currency which they needed otherwise to buy Canadian bonds, instead they may pull out there investment from Canadian market leading to decrease in demand for Canadian currency and hence fall in its relative value thats is depreciation of Canadian currency.

c)When Canadian Currency depreciates the value of its exports abroad decreses, it sells cheaper in foreign market due to which exports rises. Similarly, price of imports increases as depreciation of domestic currency leads to increase in the relative value of foreign currency and hence import falls . Net export = Export - Import . Since Exports increases, imports falls, net export increases due depreciation of Canadian currency.

d) If Federal Reserve increases money supply then interest rate of bonds and stocks in US market falls, foreigners to US, which includes Canadians, may stop injecting money or rather they may withdraw money from US market, which would ultimately decrease the demand of US currency and lead to depreciation of US currency. Meanwhile, it may happen that the investments withdrawn from US is invested in Canada, if Canadian interest rate for bond remains above that of US after increase in money supply by Federal Reserve which would consequently means increase in demand for Canadian currency and hence its appreciation . Depreciation of US currency implies appreciation of Canadian currency, since appreciation/ depreciation is a relative term. This could increase the import in Canada and decrease export from Canada.