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Fixed or flexible rate for Canada?

 

At this point, the Bank of Canada could significantly influent the impact by choosing either a fixed exchange rate or flexible exchange rate approach.

If the Bank of Canada allows the exchange rate to be flexible, Canadian dollars will appreciate due to the higher money demand.  The appreciation makes Canadian product relatively more expensive than foreign products; therefore, net export decreases.  This decrease in net export reduces demand of money, which reduces Canada’s interest rate, until Canada’s interest rate equals the world interest rate.  At last, the government purchase will have no lasting effect on the aggregate demand because of the crowding out effect on net export.

If the Bank of Canada, instead, chooses to fix the exchange rate by purchasing foreigner currency in the market for foreign-currency exchange, and increases the supply of dollars, which reduces Canada’s interest rate until it equals the world interest rate.  The supplies of money offset changes in interest rate and exchange rate, and therefore eliminate the crowding out effects on either net export or investment. 

 

 

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