ECON 3H03 McMaster University Forex Market Equilibrium Questions Question 1 (5 points): Suppose the Canadian exchange rate E (in terms of US$) is C$1.33 a

ECON 3H03 McMaster University Forex Market Equilibrium Questions Question 1 (5 points):

Suppose the Canadian exchange rate E (in terms of US$) is C$1.33 and the face values and the prices of the one-year government bonds in Canada and the United States are as follows.Canada: Face Value = C$12,000 and Price = C$11,650.49 United States: Face Value = US$10,000 and Price = US$9615.38Compute the nominal interest rate on the one-year Canadian and US bonds and the expected exchange rate next year consistent with uncovered interest parity.
Compute the marginal propensity to consume (for both domestic goods and foreign goods) and marginal propensity to save if the consumption function is C=1.5 + 0.8(Y- T) and the trade balance is TB = 5(1-[1/E]) – 0.2(Y-8).
The investment function is I= 3-10i. What is the investment when the interest rate is equal to 10% or 0.10? Assume government spending is given by G. Write down an expression for Aggregate Demand (D).
Assume that the forex market equilibrium is given by: i = ([1/E]-1) + 0.10, where the two foreign returns in the right-hand side are the expected depreciation, and the foreign interest rate. What is the foreign interest rate? What is the expected future exchange rate?
Finally, solve for the IS curve: using the above equations obtain an expression for Yin terms of i, G and T (eliminate E).

Question 2 (5 points):

Prime minter Justin Trudeau is concerned about the economic impact of COVID-19 pandemic on already sluggish Canadian economy. Governments across the country are spending unprecedently to help Canadians to survive through the pandemic. But nearly $146 billion pandemic response government spending has resulted in the unprecedented budgetary deficit.

To help stimulate the economy, increasing government spending (expansionary fiscal policy) and increasing money supply (expansionary monetary policy) is proposed. Compare the effects of these two policies in terms of their implications for the current account in the framework of the IS and LM model. (2 points)
Now, suppose that Canadian firms do not increase investment due to the lower interest rate rather decide to reduce investment expenditure today in new factories and office space. How will this decrease in investment affect output, interest rates, and the current account? (1.5 points)
Now suppose the Canadian firms are very optimistic and very responsive to the interest rate – the firms will cancel most of their changes in investment plans if the interest rate falls. How will this affect your answer in part B? (1.5 points)