Question

Suppose the Bank of Canada releases a policy statement today which leads people to believe that the Bank will be enacting expansionary monetary policy in the near future. Everything else held constant, the release of this statement would immediately cause the demand for Canadian assets to ________ and the Canadian dollar to ________.

A) increase; appreciate

B) decrease; appreciate

C) increase; depreciate

D) decrease; depreciate

Answer 1

ans:) d) decrease; depreciate

explanation: When a expansionary monetary policy is conducted, it will lead to an increase in money supply in the economy through what ever tool canadian bank decides to. Once, the money supply is increased in an economy it will lead to fall in interest rate; the fall in interest rate is justified is when in money market since the supply have increase it will cause a disequalibrium between demand and supply of money, so interest rate will fall to make demand for the money also to increase.

below is the diagram for money market, we can see an increase in supply of money will shift the supply curve to the right, which will cause a reduction in interest rate.

Since interest rate is reduced, this yield on the bonds or assets will fall this will cause a decrease in demand for assets and an increase in demand for money. How shift in LM curve will cause a fall in interest rate is shown in this IS- LM diagram.

Since interest rate is reduced, this will cause decrease in demand for foriegn investments in Canada. This will cause fall in demand for Canadian currency. So, exchange rate falls ,i.e, currency will depreciate. Which is denoted down, this diagram is from Mundell fleming model, which shows the effect of monetary and fiscal policy on exchange rate and the income.