Question

PART A:

U.S. and Canada's currencies pesos and dollar, being traded in the foreign exchange market. If nothing changes, explain how value of pesos may change (appreciate or depreciate) due to the following two events.

a) Interest rates are higher in Canada than they are in the U.S.

b) GDP grows faster in the U.S. than they do in Canada.

PART B:

Bank Z has a total deposit of $2,600 million. Required reserve ration is set at 4%.

a. How much of the total deposit can bank Z loan out?

b. By how much will money supply change if bank Z, and all subsequent banks, are able to loan out their entire excess reserves as the result of the entire $2,600 million deposit.

Answer 1

(PART A)

Peso is Mexican currency, not Canadian. To avoid confusion, I'm answering the questions as "US currency" or "Canadian currency."

(a) Higher interest rate in Canada will increase foreign investment in Canada, which will increase the demand for Canadian currency, shifting its demand curve rightward, and will increase the supply of US currency, shifting its supply curve rightward. As a result, Canadian currency will appreciate and US currency will depreciate, increasing exchange rate in Canada and decreasing exchange rate in US.

(b) Higher growth rate in US will increase US GDP, which will increase US import demand and will increase Canadian export demand, which will increase the demand for Canadian currency, shifting its demand curve rightward, and will increase the supply of US currency, shifting its supply curve rightward. As a result, Canadian currency will appreciate and US currency will depreciate, increasing exchange rate in Canada and decreasing exchange rate in US.

(PART B)

(a) Amount lent ($ million) = Deposits x (1 - Reserve ratio) = 2,600 x (1 - 0.04) = 2,600 x 0.96 = 2,496

(b) Increase in money supply ($ million) = Deposits / Reserve ratio = 2,600 / 0.04 = 65,000