Draw a graph of the supply and demand dollar by the U.S market. Diagram the effect of each of the following on exchange rates, state in words whether the effect is long, medium, or short run, and explain your reasoning.
1. More rapid growth in Canada than in the U.S.
2. A rise in U.S interest rates.
3. Goods are more expensive in Canada than in the U.S.
4. A recession in the U.S.
5. Expectations of a future depreciation in the Canadian dollar.
1. The Canadian supply of currency to the U.S market increases in response to the rise in Canadas demand for American exports. The supply curve shifts right; the U.S dollar appreciates; the Canadian dollar depreciates. This effect is medium run because effects of economic expansions and contractions -- the business cycle -- on exchange ratea run for a few years (usually less than a decade). As Canada experiences more rapid economic growth than the U.S, disposable income in Canada rises, causing consumption to rise. Consumer confidence gradually rises as jobs become secured and plentiful. Canadian expenditures on imports rise.
2. The supply of Canadian dollars to the U.S market increases in response to the higher interest rates; the supply curve shifts right; the U.S dollar appreciates; the Canadian dollar depreciates. This is a short run effect because the factors cause the interest rates to change are themselves short run processes. Good example are changes in government (fiscal and/or monetary) policies, expectations, and financial capital flows in and out of a country.
3. The U.S demand for Canadian dollars decreases in response to higher prices for Canadian goods. The demand curve shifts left causing the exchange rate to fall. The U.S dollar appreciates and the Canadian dollar depreciates. This is a long run effect in part because the prices of goods move gradually. The higher the prices of goods in Canada could also be caused by government policies such as tariffs and quotas. In general, changing the government policies takes time. Goods arbitrage will eventually equalize the prices of goods between the two countries, but achieving purchasing power parity is a long run process because of the following factors:
a) Shipping, insurance and other transportation may be prohibitively expensive;
b) trade barriers such as tariffs, quotas, import license, and inspection fees may be too high; and
c) A substantial number of goods may not be traded. All of these play a significant factor for purchasing power parity tp exert influence only in a long run.
4. The U.S demand for Canadian dollars decreases in response to the drop in demand for imports; the demand curve shifts left; the U.S dollar appreciates; the Canadian dollar depreciates. As explained in 1 above, the effect of recessions and expansions on exchange rates can be considered medium term.
5. The demand for Canadian dollars decreases in response to its expected loss in value; the demand curve shifts left; the U.S dollar appreciates; the Canadian dollar depreciates. Like the effects of interest rates, the effects of expectations on exchange rates are short run. As everyone knows, expectations could change swiftly and could reverse course almost instantaneously. Some expectations could be unexpected and flimsy but they could have catastrophic effects on the exchange rates and financial sectors of the country.
See table 10.3 for a summary of the short, medium and long run factors that determine exchange rates.