Question

Oil is an international commodity, whose price Canada takes as given. Starting around mid-2013 crude oil prices fell fairly quickly, stabilizing in mid-2015. Around the same period of time, the Canadian dollar depreciated relative to the US dollar.

Use the IS-LM-FX model to show how a decline in oil prices might lead to a depreciation of the Canadian currency.

Answer 1

Ans. A decrease in oil prices leads to decrease in cost of production which increases aggregate supply at each price level. This leads to increase in output and decrease in price level. This decrease in price level increases real money supply which decreases interest rate. This decrease in interest rate makes Canada a less attractive destination for investment leading to increase in net capital outflow which decreases the demand for Canadian dollar or increase in demand for US dollar, hence, depreciation of Canadian dollar.

On graph, increase in real money supply leads to shift in LM curve rightwards from LM to LM’. This increases output to Y’ from Y and interest rate decreases from i to i’.

On foreign exchange diagram, the demand for US dollar increases, shifting the demand curve for US dollar to right. This increases exchange rate from e to e’. Hence, leads to depreciation of Canadian dollar.

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