Question 1: 5 Points - Suppose The US Economy Is In A Recess

Question 1 5 Pointssuppose That Us Economy In Recession Explai

Question – 1. 5 points Suppose that US economy in recession, explain the effect of the recession in the nominal exchange rate (Canadian perspective): draw a graph of the foreign exchange market, demand & supply of US dollars, with exchange rate on the vertical axis (as discussed in the lecture). Does Canadian dollar appreciate or depreciate?

Question – 3. 6 points Answer the Following questions: (qs. a + b + c = 3 points. Qs. d = 3points) a) If foreign countries increase their interest rates then what will happen to the capital inflow in Canada? b) If US citizens sell Canadian bonds then what will be the impact on the Canadian currency c) Suppose it costs C$1.35 to buy one US$, and the price level or index in the US is 120. The price level or index in Canada is 115. What is the real exchange rate from Canada’s perspective? d) Consider a country with a fixed exchange rate that has a current account surplus of $20 billion, but a financial account deficit of $18 billion. Is its balance of payments in deficit or surplus? Why? Is the central bank buying or selling foreign currency?

Question - 4. 4 points Assume, the initial exchange rate is $1.20 Cdn for $1.00 US. After 10 years, the United States price level has risen from 100 to 200, and the Canadian price level has risen from 100 to 175. i) What was the inflation rate in each country? ii) What nominal exchange rate would preserve the initial real exchange rate? iii) Which country’s currency depreciated?

Question - 5. 5 points Suppose you can invest $1,000 Canadian for a year. Canadian one-year interest rates are 4 percent. In the United States one-year rates are 5 percent. The higher United States rates look attractive. If you keep your funds in Canadian dollars (invest in Canada), how much money will you have at the end of the year? If the exchange rate is $1.03 Cdn/$1 US then can you do better by buying a United States asset? What would be your decision if exchange rate becomes $1.009 Cdn/$1 US, would you buy US asset?

Paper For Above instruction

The economic recession in the United States has profound implications on the Canadian dollar's exchange rate due to interconnectedness in the global financial system. When the US economy enters a recession, several factors influence the nominal exchange rate from Canada's perspective, primarily through shifts in demand and supply of currencies in the foreign exchange market.

In the foreign exchange market, the exchange rate is determined by the intersection of demand and supply curves for US dollars. During a US recession, U.S. economic performance declines, leading to reduced demand for imports and potentially lower U.S. dollar demand from international investors. Concurrently, Canadian investors may reallocate their assets either domestically or abroad, influencing capital flows. From the Canadian perspective, when the US experiences recession, the demand for the US dollar tends to decline because American imports decrease, and investment flows may shift away from U.S. assets due to increased uncertainty. This causes a leftward shift of the demand curve for US dollars in the foreign exchange market.

Graphically, with exchange rate (C$ per US$) on the vertical axis, the demand curve for US dollars shifts leftward, while the supply curve may remain unchanged or shift depending on capital flows. The reduction in demand for US dollars causes the exchange rate to depreciate the US dollar relative to the Canadian dollar, meaning the Canadian dollar appreciates. Therefore, the Canadian dollar tends to appreciate during US recessions, making American goods relatively more expensive for Canadians.

Regarding international capital flows, if foreign countries increase their interest rates, this makes Canadian assets more attractive, leading to increased capital inflows into Canada. Higher interest rates in other countries attract foreign investment, which can increase demand for the Canadian dollar, causing it to appreciate. Conversely, if US citizens sell Canadian bonds, capital leaves Canada, reducing demand for the Canadian dollar and resulting in depreciation of the Canadian dollar, or appreciation of the US dollar.

The real exchange rate from Canada’s perspective considers both nominal exchange rate and relative price levels. It’s calculated as:

Real exchange rate = (Nominal exchange rate × Domestic price level) / Foreign price level

Given the nominal exchange rate of C$1.35 per US$, US price level at 120, and Canadian price level at 115, the real exchange rate is:

Real exchange rate = (1.35 × 115) / 120 ≈ 1.2979

This indicates the relative purchasing power between the two countries, showing the actual competitiveness of Canadian goods versus American goods from Canada's perspective.

The balance of payments (BOP) situation further influences currency valuations. If a country has a current account surplus of $20 billion and a financial account deficit of $18 billion, its overall balance of payments is in surplus. This positive balance encourages appreciation of the currency because foreign exchange inflows exceed outflows. In a fixed exchange rate system, the central bank would need to buy foreign currency to maintain the peg, leading to an increase in foreign exchange reserves and currency stabilization.

When examining the change in exchange rates over time, inflation differentials are crucial. If the U.S. price level doubles from 100 to 200 while Canada's rises from 100 to 175, it reflects differing inflation rates. The U.S. inflation rate over this period is 100%, whereas Canada's inflation rate is 75%. To preserve the initial real exchange rate, the nominal rate should adjust proportionally to inflation differences. The initial rate was $1.20 Cdn per US$. After ten years, the inflation differential suggests a depreciation of the US dollar or an appreciation of the Canadian dollar if the nominal rate remains unchanged.

Investing in foreign assets depends on interest rate differentials and expected future exchange rates. With a Canadian interest rate of 4% and U.S. interest rate of 5%, investment returns can be compared using the interest parity condition. If the current exchange rate is $1.03 Cdn per US$, investing in the U.S. yields a return of 5% plus potential gains from exchange rate movements. If the exchange rate shifts to $1.009 Cdn per US$, the relative attractiveness of U.S. investments depends on whether the currency appreciates or depreciates.

Trade models such as the theory of comparative advantage demonstrate that countries specialize based on factor endowments. Canada's abundance of capital (40 machines) and labor (200 workers) compared to the US (10 machines, 60 workers) influences their comparative advantages, with Canada being more capital abundant. Based on these factors, the production of steel (requiring more capital) is relatively capital-intensive, favoring exports from Canada if it maintains comparative advantage. Conversely, bread, which requires no capital but labor, may be more suitable for the US with its relatively abundant labor force.

Analyzing the implications of government interventions like tariffs, subsidies, and trade policies, the imposition of a tariff on foreign goods raises domestic prices, reduces imports, and generates government revenue but also introduces dead-weight loss, which is a net efficiency loss to society. Subsidies to domestic producers shift supply curves downward, increasing production and exports, but at a cost to the government budget. The trade-offs involve balancing the benefits of protecting domestic industries against the economic inefficiencies introduced by such policies.

Lastly, the terms of trade and factor endowments significantly influence trade patterns. Countries with abundant capital tend to export capital-intensive goods like steel, while labor-abundant countries export labor-intensive products like bread. Recognizing these patterns allows policymakers to foster comparative advantages, enhance economic efficiency, and improve trade balances.

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