(10 marks) The two-panel diagram below shows the determination of the equilibrium interest rate in Canada (Rs) and the equilibrium exchange rate between the Canadian dollar and the euro (Es/e). The Canadian money market is initially in equilibrium at point 1 in the bottom panel, while the FX market is initially in equilibrium at point 1' in the top panel. The initial equilibrium levels of the Canadian interest rate and the dollar/euro exchange rate are R's and Es/e, respectively. Ese return on dollar deposits ELSE expected rate of return on a euro deposit R'S Rates of return in $ terms M/P = L(Rs. Y) M/P M/P Canadian real money holdings a) Now suppose there is a sharp fall in the price of oil which results in two simultaneous changes: i) a reduction in oil production in western Canada which leads to a decrease in Canadian national income ( Y); and ii) an expectation that the Canadian dollar will depreciate in the future, resulting in an increase in the expected exchange rate ( TE's/E). On the diagram above show the effects of these two changes on the money market and the FX market. Assume no change in the Canadian real money supply (M/P), and no change in the euro interest rate (Re). (Use the number 2 to identify the new points of money market equilibrium and FX market equilibrium and the new equilibrium values of the Canadian interest rate and the dollar/euro exchange rate.) [4 marks] b) Explain: i) how and why the equilibrium Canadian interest rate (Rs) changes as you have shown in answer to part a); and ii) how and why that change in interest rate brings the Canadian money market (shown in the lower panel of the diagram) back into equilibrium? [6 marks] MacBook Pro