Question

Predict whether the following factors would cause the exchange rate of the Canadian dollar to strengthen or to weaken. Sketch a supply and demand diagram of the exchange rate market for the Canadian dollar to illustrate your answer.

1. Interest rates go up in the United States
2. Financial investors expect the Canadian dollar to depreciate in the next few months
3. Canadian inflation falls relative to other countries
4. Interest rates fall in Canada
5. The Canadian dollar is below the PPP exchange rate

Answer 1

In each graph, exchange rate (P) and quantity of Canadian dollars (CAD) (Q) are shown along vertical and horizontal axis, respectively. D0 and S0 are initial demand and supply of CAD, intersecting at point A with initial exchange rate P0 and quantity of CAD Q0.

(1)

Higher interest rate in US will increase foreign investment in US and decrease foreign investment in Canada. Demand for CAD will decrease, shifting demand curve leftward, decreasing exchange rate and increasing quantity of CAD. At the same time, supply of CAD will increase (as Canadians sell CAD to buy US dollar for investing in US), shifting supply curve rightward, decreasing exchange rate and decreasing quantity of CAD. The net effect is a definite decrease in exchange rate (CAD depreciates) and net effect on quantity is uncertain.

In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower exchange rate P1 and new quantity of CAD Q1.

१० ।

(2)

Investors expecting CAD to depreciate will decrease the demand for CAD. The demand curve for CAD shifts leftward to D1. Exchange rate will decrease and quantity of CAD will decrease, depreciating CAD.

In following graph, D0 shifts left to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of CAD Q1.

3 9.

(3)

Lower inflation rate in Canada will increase foreign demand for Canadian goods, which will increase the demand for CAD. The demand curve for CAD shifts rightward to D1. Exchange rate will increase and quantity of CAD will increase, appreciating CAD.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of CAD Q1.

90 91 9

(4)

Lower interest rate in Canada will increase foreign investment by Canadians and decrease foreign investment in Canada. Demand for CAD will decrease, shifting demand curve leftward, decreasing exchange rate and increasing quantity of CAD. At the same time, supply of CAD will increase (as Canadians sell CAD to buy US dollar for investing in US), shifting supply curve rightward, decreasing exchange rate and decreasing quantity of CAD. The net effect is a definite decrease in exchange rate (CAD depreciates) and net effect on quantity is uncertain.

In following graph, D0 shifts left to D1 and S0 shifts right to S1, intersecting at point B with lower exchange rate P1 and new quantity of CAD Q1.

१० ।

(5)

If CAD is below PPP rate, it means CAD is undervalued. Investors will increase the demand for CAD. The demand curve for CAD shifts rightward to D1. Exchange rate will increase and quantity of CAD will decrease, appreciating CAD.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of CAD Q1.

90 91 9