Question

Suppose the United States imposes tariffs on Canadian products. This has the effect of making Canadian goods more expensive in the U.S. Explain how this trade policy would affect the aggregate demand curve in Canada under each of the following conditions. Use diagrams of money market, the foreign exchange market and the output market for a small open economy in your answer and explain all the details clearly.

1. The Bank of Canada has adopted a flexible exchange rate.
2. The Bank of Canada has adopted a fixed exchange rate. (only explain, no new diagrams required)

Answer 1

Here the Canadian imports are expensive in US market. Thus the import rate in US will fall down. US imposed tariff plans to control the import from Canada. If Canada having a flexible exchange rate system, they will reduce the exchange rate and make export cheaper and import expensive. Then the reduction in exchange rate will reduce the domestic interest rate and increase the level of production in Canada. Thus the export level increased there is cheaper export to US and they US market will get Canadian products at cheaper rate. D D' EO E1 YO Y1 Output The reduction in exchange rate will shift the DD curve to right under flexible exchange rate. This reduction in exchange rate will increase the level of output and increase the export at cheaper rates. Thus the economic growth of Canada increased. In case of fixed exchange rate, the tariff by US will negatively affect the economic growth in Canada. This will reduce the economic growth. There is a rise in output in Canada but it only consumed by the Canadian people, there is no chance for export.