Chapter 21, Problem 3P

Subpart (a):

To determine

The equilibrium dollar price of Canadian dollar.

Explanation of Solution

The exchange rate is the rate at which one currency is exchanged with another currency. The flexible exchange rate is the most prominent exchange rate system that prevails in the economy. According to the flexible exchange rate system, the exchange rate will be determined by equating the demand for and supply of currency in the exchange rate market. Thus, the exchange rate will keep fluctuating according to the fluctuations in the demand for and supply of money in the market.

The demand for money and supply of money are equated with each other in order to calculate the flexible exchange rate of the economy. From the table given about the first year demand and supply of Canadian dollar, the only price which equates the quantity demanded to the quantity supplied is at price 115. At this price point, the quantity demanded and the quantity supplied of Canadian dollar is equal to 20. Thus, the equilibrium dollar price of Canadian dollar in year 1 is 115.

Economics Concept Introduction

Concept introduction:

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Flexible exchange rate: It is the rate of exchange which is determined by equating the demand for and supply of the currency in the market. Thus, the exchange rate will fluctuate according to the fluctuations in the demand for and supply of currency.

Appreciation: It is the process of increasing the value of a currency with respect to another currency.

Depreciation: It is the process of decreasing the value of a currency with respect to another currency.

Subpart (b):

To determine

The equilibrium dollar price of Canadian dollar.

Explanation of Solution

The year two Canadian dollar supply is given in the fourth column of the table and according to the values of the quantity demanded and the quantity supplied of the Canadian dollar in year 2, we can identify the dollar price which equates the quantity demanded and quantity supplied of the Canadian dollar in year 2 is at 120. At this price point, both the quantity demanded and the quantity supplied are equal to 15. Thus, the equilibrium dollar price of Canadian dollar in year 2 is 120.

Economics Concept Introduction

Concept introduction:

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Flexible exchange rate: It is the rate of exchange which is determined by equating the demand for and supply of the currency in the market. Thus, the exchange rate will fluctuate according to the fluctuations in the demand for and supply of currency.

Appreciation: It is the process of increasing the value of a currency with respect to another currency.

Depreciation: It is the process of decreasing the value of a currency with respect to another currency.

Subpart (c):

To determine

The equilibrium dollar price of Canadian dollar.

Explanation of Solution

The dollar price of Canadian dollar in year 1 was 115 and in year 2 was 120. This shows that the dollar price of Canadian dollar increased from 115 to 120 in the period of one year. This shows us that in order to purchase 1 Canadian dollar, 115 dollars were required in year 1 and it increased to 120 dollars in Year 2. Thus, in one year, the dollar price of Canadian dollar increased by 5 dollars. The process of increasing the value of the domestic currency with regards to the foreign currency is known as appreciation. Thus, Canadian dollar has appreciated relative to the dollar between year 1 and 2.

Economics Concept Introduction

Concept introduction:

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Flexible exchange rate: It is the rate of exchange which is determined by equating the demand for and supply of the currency in the market. Thus, the exchange rate will fluctuate according to the fluctuations in the demand for and supply of currency.

Appreciation: It is the process of increasing the value of a currency with respect to another currency.

Depreciation: It is the process of decreasing the value of a currency with respect to another currency.

Subpart (d):

To determine

The equilibrium dollar price of Canadian dollar.

Explanation of Solution

The dollar price of Canadian dollar increased from year 1 to year 2. This shows that 5 more dollars is required to purchase 1 Canadian dollar in year 2. Thus, the dollar has lost its value by 5. The process of losing the value of the currency related to another is known as depreciation. So, the dollar has depreciated relative to Canadian dollar between year 1 and year 2.

Economics Concept Introduction

Concept introduction:

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Flexible exchange rate: It is the rate of exchange which is determined by equating the demand for and supply of the currency in the market. Thus, the exchange rate will fluctuate according to the fluctuations in the demand for and supply of currency.

Appreciation: It is the process of increasing the value of a currency with respect to another currency.

Depreciation: It is the process of decreasing the value of a currency with respect to another currency.

Subpart (e):

To determine

The equilibrium dollar price of Canadian dollar.

Explanation of Solution

There are many reasons for the relative change in the price of currencies. They can be due to more rapid inflation in the US than in Canada, higher growth rate in the US than in Canada, or an increase in the real interest rate in the US over Canada.

Option (1):

The main reason for the change in the relative values of currencies in the international market is the rapid inflation in the US when compared to Canada. When there is inflation in the US, the prices of the US goods and services will increase and they will become costly in the international market. As a result, the Canada consumers will demand their domestic products due to higher prices of US products. This will reduce the demand for the US dollar. As a result, the dollar will depreciate its value which makes the relative change in the value of two currencies over the period. Thus, option (1) is correct.

Option (2):

When there is a higher interest rate in the US relative to that in Canada, the investors in Canada will shift their investment to the US in order to earn a higher interest income from their investment. This will increase the demand for the dollars and the supply of Canadian dollar, which will result in the appreciation of a dollar in the exchange market. Since the relative change in the situation is depreciation, this option cannot be true. Thus, option (2) is incorrect.

Option (3):

The faster growth of income in US over Canada’s can be a reason for the relative change in the exchange rate of the currencies. But, the higher growth of income will lead to faster growth of the US. This would result in a better rate of interest which will in turn lead to the appreciation of a dollar. Here, it is depreciation. Thus, option (3) is incorrect.

Economics Concept Introduction

Concept introduction:

Exchange rate: It is the rate at which one currency is exchanged for another currency.

Flexible exchange rate: It is the rate of exchange which is determined by equating the demand for and supply of the currency in the market. Thus, the exchange rate will fluctuate according to the fluctuations in the demand for and supply of currency.

Appreciation: It is the process of increasing the value of a currency with respect to another currency.

Depreciation: It is the process of decreasing the value of a currency with respect to another currency.