Question

Let the demand for loanable funds for domestic investment be Id = 400 − 25r, the supply of loanable funds from domestic savings be Sd = −360 + 120r and the demand for domestic currency intheForeign-CurrencyExchangemarketbeNX =2100−425(rex)intheUS(rreferstothereal interest rate and rex refers to the real exchange rate). Answer the following questions:

1. (a) (12 points) Suppose that rw = 8. Calculate the equilibrium real exchange rate. Draw a graph representing the equilibrium in the market for loanable funds and another graph representing the equilibrium in the Foreign-Currency Exchange market.

2. (b) (12 points) Suppose that lenders think there is a high chance that domestic investors will default so they require a 2% additional return on their loans. Calculate the new equilibrium real exchange rate. Draw a graph representing the new and old equilibria in the market for loanable funds and another graph representing the new and old equilibria in the Foreign- Currency Exchange market.

3. (c) (10 points) Assume that the real exchange rate is as in part 1. Also, assume that PUS = 1and PCAN = 2 as well as that there are no transportation costs and all goods are tradable. Suppose that there is a Canadian investor looking to invest C$1, 000 by buying goods in one market and selling them in the other. What is the maximum profit the investor can make if she takes advantage of the arbitrage opportunity (express profits in C$)?

Answer 1