Question

The recent outbreak of COVID-19 has major impact on the Canadian money and financial markets. To ensure the financial markets are functioning smoothly, the Bank of Canada pumped liquidity into the system. At the same time, firms now only accept credit cards or mobile payment apps such as Goggle Pay, Apple Pay, PayPal as means of payments. Many expect this would have a long-lasting impact on the Canadian financial system.

1. a) “According to the asset approach to the exchange rate, there will be an overshooting of C$ against the US$. Besides, this overshooting of C$ might put an upward pressure on the cost of living in Canada.” True/False/Uncertain, explain with the aid of ONE diagram for the asset approach to the exchange rate. (15 points)

2. b) In the context of the monetary approach to the exchange rate,what happen to the price levels in both Canada and the U.S. and the C$/US$ exchange rate? Explain. (5 points)

Answer 1

COVID-19 and the economy

The COVID-19 pandemic represents a serious health threat to people around the world and a significant disruption to daily life. It is having a major impact on the global and Canadian economies. Every sector of the Canadian economy is affected. Some sectors, such as the energy, travel and hospitality, and service industries, are being particularly hard hit.

The public health actions needed to contain the spread of the virus, such as school closures, states of emergency, and social distancing measures, while necessary, are themselves going to significantly impact economic activity.

However, it’s important to underscore that while the impact is large, it will be temporary. Authorities around the world have taken bold and necessary measures to contain the spread of the virus and to support people and businesses through a very challenging time.

A)...

Asset Approach to Exchange Rate Determination

The interest parity condition can be used to develop a model of exchange rate determination. That is, investor behavior in asset markets which generates interest parity can also explain why the exchange rate may rise and fall in response to market changes.

The first step is to reinterpret the rate of return calculation described above in more general (aggregate) terms. Thus instead of using the interest rate on a one year CD, we will interpret the interest rates in the two countries as the average interest rates currently prevailing. Similarly, we will imagine that the expected exchange rate is the average expectation across many different individual investors. The rates of return then are the average expected rates of return on a wide variety of assets between the two countries.

Next we imagine that investors trade currencies in the foreign exchange market. Each day some investors come to a market ready to supply a currency in exchange for another while others come to demand currency in exchange for another.

Consider the market for British pounds(£) in New York depicted in the adjoining diagram. We measure the supply and demand of £s along the horizontal axis and the price of £s (i.e. the exchange rate E$/£) on the vertical axis. Let S£ represent the supply of £s in exchange for dollars at all different exchange rates that might prevail. The supply is generally by British investors who demand dollars to purchase dollar denominated assets. However, supply of £s might also come from US investors who decide to convert previously acquired £ currency. Let D£ the demand for £s in exchange for dollars at all different exchange rates that might prevail. The demand is generally by US investors who supply dollars to purchase £ denominated assets. Of course, demand might also come from British investors who decide to convert previously purchased dollars. Recall that which implies that as E$/£ rises RoR£ falls. This means that British investors would seek to supply more £s at higher £ values but US investors would demand fewer £s at higher £ values. This explains why the supply curve slopes upward and the demand curve slopes downward.

The intersection of supply and demand specifies the equilibrium exchange rate, E1, and the quantity of £s, Q1, traded in the market.

B)...

Foreign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency. As a result, movements in exchange rates can have a powerful effect on incentives to export and import, and thus on aggregate demand in the economy as a whole.

For example, in 1999, when the euro first became a currency, its value measured in U.S. currency was $1.06/euro. By the end of 2013, the euro had risen (and the U.S. dollar had correspondingly weakened) to $1.37/euro. Consider the situation of a French firm that each year incurs €10 million in costs, and sells its products in the United States for $10 million. In 1999, when this firm converted $10 million back to euros at the exchange rate of $1.06/euro (that is, $10 million × [€1/$1.06]), it received €9.4 million, and suffered a loss. In 2013, when this same firm converted $10 million back to euros at the exchange rate of $1.37/euro (that is, $10 million × [€1 euro/$1.37]), it received approximately €7.3 million and an even larger loss. This example shows how a stronger euro discourages exports by the French firm, because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country. From the point of view of the U.S. economy, the example also shows how a weaker U.S. dollar encourages exports.

Since an increase in exports results in more dollars flowing into the economy, and an increase in imports means more dollars are flowing out, it is easy to conclude that exports are “good” for the economy and imports are “bad,” but this overlooks the role of exchange rates. If an American consumer buys a Japanese car for $20,000 instead of an American car for $30,000, it may be tempting to argue that the American economy has lost out. However, the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories. Whoever buys those dollars will have to use them to purchase American goods and services, so the money comes right back into the American economy. At the same time, the consumer saves money by buying a less expensive import, and can use the extra money for other purposes.

Fluctuations in Exchange Rates

Exchange rates can fluctuate a great deal in the short run. As yet one more example, the Indian rupee moved from 39 rupees/dollar in February 2008 to 51 rupees/dollar in March 2009, a decline of more than one-fourth in the value of the rupee on foreign exchange markets. Figure 1 earlier showed that even two economically developed neighboring economies like the United States and Canada can see significant movements in exchange rates over a few years. For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade—which in many countries adds up to half or more of a nation’s GDP—sharp movements in exchange rates can lead to dramatic changes in profits and losses. So, a central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.

One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Most international loans are measured in a few large currencies, like U.S. dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like U.S. dollars, but then lend in their own domestic currency. The left-hand chain of events in Figure 1 shows how this pattern of international borrowing can work. A bank in Thailand borrows one million in U.S. dollars. Then the bank converts the dollars to its domestic currency—in the case of Thailand, the currency is the baht—at a rate of 40 baht/dollar. The bank then lends the baht to a firm in Thailand. The business repays the loan in baht, and the bank converts it back to U.S. dollars to pay off its original U.S. dollar loan.