Question

Assume a flexible exchange rate system in a world consisting of only two countries: Canada and Japan. The Canadian currency is the canadian dollar and the japanese currency is yen.

a. Show graph and explain the effects on the exchange rate of political instability in Canada

b. As a result of this change, will canada find japanese goods more expensive, less expensive, or just as expensive as before, explain.

Answer 1

Political Instability

The political instability generally refers to the turmoil in the political scenario of a country which has effects on many things such as Public sector, Private sector, Financial institutions etc.

Effect on Investment

The presence of political instability in a country makes it the least preferred in terms of the investment purpose as the rate of returns on the investment is uncertain and majority of people don't invest in such country and pull out their investment if they have already invested it there.

As it is given that there are only 2 countries in the world - Canada and Japan. So, due to the political instability in Canada, Japanese pull out their investments from Canada.

Effect on Exchange rate

   As the Japanese pull out their investment, the supply of yen S_¥ decreases to S_¥' as shown in the diagram below.

As the supply of yen decreases , the nominal exchange rate of canadian dollar increases against yen which means that the Canadian dollar ($) has depreciated.

The depreciation of Canadian dollar ($) means that now more units of canadian dollars are required to buy one unit of yen.

Thus the Canadians now find the Japanese goods more expensive.

Ans(b)