Answer the following questions. Each sub-part of the question is not related to

Question

Answer the following questions. Each sub-part of the question is not related to the other part. Be sure to provide a written explanation in order to receive full credit. a) The foreign exchange market is in equilibrium, and there is a change in the consumption preference such that Canadian households decide to buy fewer American goods. If the Bank of Canada (BOC) wants to keep the exchange rate from changing, what should it do? What happens to the stock of official reserves held by the BOC? What happens to the balance of payments after the intervention by the BOC? Explain. (10 points) b) Suppose you are a currency trader, and he observes the following exchange rates in the spot market: S£/US$ = 0.5133 SUS$/€ = 1.4568 S£/€ = 0.7192 ? You observe there is an arbitrage opportunity in trading £ and €, what should you do to capture the arbitrage profit? What is your arbitrage profit (measured in £)? Explain. (6 points) ? Also, discuss the adjustment mechanism (i.e., explain how the transactions you would eliminate the arbitrage profit). (9 points)

Explanation / Answer

a) As given in question this implies fall in imports this would shift the IS( goods market curve) to right. Rightward shift implies pressure on exchange rate to appreciate . This means inflow of foreign capital( our economy is offering more interest than available in foreign country) so demand for home currency would increase central bank will supply the home currency and will buy foreign currency . This will increase the money supply shifting LM curve to right such that we are once again at equilibrium state such that domestic interest rate is equal to foreign rate and output level is higher.

As discussed above foreign reserves will increase as central bank will supply domestic currency and will buy foreign currency.

There is uncertainty about balance of payment because Initially fall in imports would imply improvement in balance of payment but latter on Increased income will imply more imports. So overall effect will depend upon whether initial fall is more than latter increase.

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