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. Increase in the money supply would reduce the rate of interest in the money market and as the rate of interest is lowered in the economy, this will reduce rate of return on investment and thua make Canadian bonds less attractive to the foreigners.

b. False. This will reduce the demand of the currency and thus lead to depreciation of the currency in the foreign exchange market.

c. The depreciation of currency would lead to increase in the Net Exports of the nation as exports become cheaper and imports become expensive.

d. This will reduce rate of interest in USA and thus foreign inflow in Canada and thus increase in the demand of Canadian currency would lead to appreciation of Canadian currency and decrease in Net Exports.