Question

In: Economics

1. All else equal, if Canada raises its interest rates, A) the dollar depreciates. B) the...

1. All else equal, if Canada raises its interest rates,

A) the dollar depreciates.

B) the U.S. demand for Canadian dollars increases.

C) the Canadian supply of Canadian dollars increases.

D) Both A and B.

E) Both A and C.

2. Suppose the exchange rates between the United States and Canada are in long-run equilibrium as defined by the idea of purchasing power parity. If the law of one price holds perfectly, then differences between U.S. and Canadian rates of inflation would

A) have no effect on nominal exchange rates.

B) be completely offset by changes in the real exchange rate.

C) be completely offset by changes in the nominal exchange rate.

D) violate the conditions for the law of one price.

E) lead to a change in the real purchasing power of each country's currency when it is converted to the other country's currency

Expert Solution

Answer (1) : Correct option is option (D)

Option (D) : both A and B.

Answer (2) : Correct option is option (C)

Option (A) : be completely offset by the changes in the nominal exchange rate.

Explanation :-

In simple words, the price of borrowing money is termed as interest rate. According to Fisher equation, (1 + nominal interest rate) = (1 + real interest rate) + (1 + inflation rate). It means Real interest rate is reported after correction for inflation and nominal interest rate is reported without correction for inflation. When Canada raises it's interest rate (all else equal), then the demand for Canadian dollars for sale should decrease, the demand for Canadian dollars should increases and so, Canadian dollar's value should decrease. Hence, the U.S. demand for Canadian dollars increases and the dollar depreciates. Nominal exchange rate is the rate at which two countries can be traded with each other and inflation rate is the percentage change in the average level of prices over a period of time. Since the difference in U.S.and Canadian rate of inflation (in the given conditions) changes is completely offset by the changes in domestic currency price of the foreign currency. Hence, it is right to say, that it is completely offset by the changes in nominal interest rate. So, it's the correct option.

Rahul Sunny answered 2 years ago

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