Question

Refer to the following table, in which Q_d is the quantity of loonies demanded, P is the dollar price of loonies, Q_s is the quantity of loonies supplied in year 1, and Q_s′ is the quantity of loonies supplied in year 2. All quantities are in billions, and the dollar-loonie exchange rate is fully flexible.

Qd	P	Qs	Q's
10	125	30	20
15	120	25	15
20	115	20	10
25	110	15	5

a. What is the equilibrium dollar price of loonies in year 1?

b. What is the equilibrium dollar price of loonies in year 2?

c. Did the loonie appreciate, or did it depreciate relative to the dollar between years 1 and 2?

d. Did the dollar appreciate or did it depreciate relative to the loonie between years 1 and 2?

e. Which one of the following could have caused the change in relative values of the dollar (used in the United States) and the loonie (used in Canada) between years 1 and 2: (1) More rapid inflation in the United States than in Canada, (2) an increase in the real interest rate in the United States but not in Canada, or (3) faster income growth in the United States than in Canada?

Short answer

1. The equilibrium dollar price is 115.

2. The equilibrium dollar price is 120.

3. The loonie has appreciated relative to the dollar.

4. The dollar has depreciated relative to the loonie.

5. The dollar in the U.S. has depreciated, and loonies in Canada have appreciated because of income growth and more rapid inflation in the United States than in Canada.

Step-by-step solution

Equilibrium dollar price of loonies in year 1 

The intersection of demand for loonies’ curve and the supply of loonies’ curve determines the equilibrium dollar price of loonies.The exchange rate can be determined at this supply and demand equilibrium.

The equilibrium dollar price of loonies in year 1 can be obtained when the quantity of loonies demanded is equal to the quantity of loonies supplied in year 1(Q_s). Thus, at a price equal to $115, the demanded and supplied quantities are equal to 20, making it the equilibrium dollar price.

The exchange rate will be 1 loonie = $115

Equilibrium dollar price of loonies in year 2

The equilibrium dollar price of loonies in year 2 can be obtained when the quantity of loonies demanded is equal to the quantity of loonies supplied in year 2 (Q’_s). Thus, at a price equal to $120, the demanded and supplied quantities are equal to 15, making it the equilibrium dollar price.

The exchange rate will be 1 loonie = $120

Reason for appreciation of loonie relative to the dollar

The purchasing power of loonies has increased by $5 from year 1 to 2. Thus, from the exchange rates in the year 1 and 2, it is evident that loonies have appreciated relative to the dollar.

Reason for depreciation of the dollar relative to the loonie

The dollar purchasing power has decreased from year 1 to 2 (because one requires $5 more to purchase 1 loony). Thus, from the exchange rates in the year 1 and 2, it is evident that the dollar has depreciated relative to loonies.

Reasons for a currency value to appreciate or depreciate

Faster income growth and more rapid inflation in the United States than in Canada caused the dollars to depreciate and consequently appreciate loonies used in Canada between years 1 and 2.

Due to the rise in national income in the United States, Americans will buy more domestic and foreign goods. If the U.S. economy is expanding rapidly and the Canadian economy is stagnant, the U.S. imports Canadian goods, and therefore U.S. demands for loonies will increase. The dollar price of loonies will rise so that the dollar will depreciate.

On the other hand, due to inflation, U.S. consumers will seek out more of the now relatively lower-priced Canadian goods, increasing the demand for loonies. Canadian consumers will purchase less of the now relatively higher-priced U.S. goods, reducing the supply of loonies. This combination of increased demand for loonies and reduced supply of loonies causes it to appreciate and the dollar to depreciate.

Thus, options (1) and (3) are correct.

Reason for incorrect option: Changes in relative interest rates between two countries may alter their exchange rate. If the real interest rates in the U.S.increase, Canadian citizens will find the United States a more attractive place in which to loan money directly or loan money indirectly by buying bonds and hence supply loonies in the foreign exchange market to obtain dollars. The increase in the supply of loonies results in its depreciation and consequently appreciate the dollar.

Thus, option (2) is incorrect.