Question

Fixed Exchange Rates a. Assume that Canada adopts a fixed exchange rate and that there is a rise in the world interest rate (Rw). Explain the impact on the money supply and foreign reserves of the Bank of Canada. Can policy makers use domestic open market operations to counteract the impact in any way?

b. Suppose there is a one off rise in the foreign price level P*. Assuming the Purchasing Power Parity holds, use the DD-AA model to show that the exchange rate will rise immediately in proportion to the rise in P*. How will this impact the internal and external balance of a country, assuming that it is in balance before the rise in P*?

c. If domestic and foreign currency bonds are perfect substitutes and investors’ preferences change such that they want to hold more foreign currency bonds how does this impact the risk premium on domestic bonds? Does a floating or fixed exchange rate minimize the impact on output and why?

Answer 1

a. Assume that Canada adopts a fixed exchange rate and that there is a rise in the world interest rate (Rw). Now as the Rw is higher then the domestic Interest rate it cause less inflow of foreign investment into the country and more outflow from the country. It means that there is a less supply of foreign currency into the country and higher demand of foreign currency within the economy. As a result there is an upward pressure on value of foreign currency to rise. But government adopted the fixed exchange rate system so to counter this upward pressure on value of foreign currency, Central bank need to increase the supply of foreign currency in the economy which cause fall in foreign currency reserve of the economy. Yes, Bank of Canada can use domestic open market operation by selling government bonds to the public which cause fall in money supply as a result Demand for foreign good decreases which cause demand of foreign currency as well as its value to fall.