12.1 Consider a country with a fixed exchange rate that has a current account surplus of $20 billion, but a financial account deficit of $18 billion.

(a) Is its balance of payments in deficit or surplus? Why?

(b) What change in official exchange reserves would you see? Why?

(c) Is the central bank buying or selling foreign currency?

(d) What effect does the central bank's foreign currency purchase or sale have on the monetary base? Explain why.

12.2 Assume the initial exchange rate is $1.20Cdn for $1.00US After 10 years, the United States price level has risen from 100 to 200, and the Canadian price level has risen from 100 to 175. What was the inflation rate in each country? What nominal exchange rate would preserve the initial real exchange rate? Which country's currency depreciated?

12.3 Suppose portfolio managers shift $100 million in assets under their control out of Canadian government securities and into United States government securities. What change would this portfolio shift make in the Canadian balance of payments?

12.4 What is the expected rate of appreciation of the US dollar if interest rate parity prevails and Canadian nominal interest rates are 1 percent higher than United States interest rates?

12.5 Suppose natural gas and crude oil prices were to drop sharply and expectations were they would remain low. Use a foreign exchange market diagram to show the effect on the Canadian/US dollar exchange rate?

12.6 Using a diagram to illustrate:

(a) The demand for foreign exchange and the demand curve for foreign exchange.

(b) The supply of foreign exchange and the supply curve for foreign exchange.

(c) The equilibrium exchange rate.

12.7 Use a foreign exchange market diagram with a flexible or floating exchange rate to show:

(a) How a decline in exports would affect the foreign exchange rate.

(b) How exports and imports would change to give balance of payments equilibrium at the new equilibrium exchange rate.

(c) The effects, if any, on the holdings of official reserves.

12.8 Use a foreign exchange market diagram to show:

(a) Equilibrium with a fixed exchange rate. (b) The effect of a decline in exports on conditions in the foreign exchange market when the exchange rate is fixed.

(c) The amount of the purchase or sale of foreign exchange reserves required if the central bank defends the fixed exchange rate.

(d) The effects of a change in the holdings of official reserves and the monetary base as a result of the defence of the fixed exchange rate.

12.9 Use AD/AS and foreign exchange market diagrams to show why monetary policy is powerful and fiscal policy is weak when a country has a flexible exchange rate regime.

12.10 Use AD/AS and foreign exchange market diagrams to show why the choice of a fixed exchange rate makes fiscal policy a more powerful tool for demand management. What happens to the domestic money supply when a government austerity program cuts its expenditures on goods and services and raises taxes?r