Question

In view of the Coronavirus epidemy, the Bank of Canada along with most advanced nations’ central banks has cut its policy interest rate by 1.5% to 0.25%.

1. Explain the Bank of Canada’s intention and motive behind this policy.
2. Employing the model of interest parity, discuss with the help of a diagram the expected impact of these interest cuts on the exchange rate (Canadian dollar).
3. Now explain how the expected change in the Canadian dollar is hoped to affect Canada’s net exports (NX) and Canada’s GDP.

Answer 1

a) By cutting policy interest rate, Bank of Canada intends to inject more money supply in the economy. This is expansionary monetary policy. During Coronavirus epidemy, people have income cut and therefore drop in aggregate demand in the economy. Through interest rate cut the Bank of Canada along with other central banks of advanced nations want to boost up lending capacity of the commercial banks such that they can provide loan to common people at low cost. In this way central banks are trying to keep money in the hands of people to spend more so that total production capacity and production can be restored.

b) when all other factors remain same, decrease in interest rate decreases the value of the domestic currency. Lower interest rate makes foreign investment unattractive. Therefore, Canadian economy may observe a drop in capital inflows if the interest rate below world average. As i_d domestic interest rate falls, demand for domestic assets will fall and expected return on Canadian dollar will also. Hence demand for Canadian dollar curve shifts to the left. Currency depreciates. Exchange rate falls from E₁ to E_{2 in the figure below.}

c) As Canadian dollar is expected to depreciates, this will make Canadian export attractive in the world market as export is expected to become cheaper. Then export from Canada is likely to increase improving the trade balance. Net export of Canada (NX) will thus improve due to currency depreciation.

GDP = Y = C+ I+ G+ NX

As net export is a component of GDP, increase in NX will increase GDP of Canada.