4.2 The 2-panel diagram below shows the determination of equilibrium interest rate in Canada and the equilibrium exchange rate between the Canadian dollar and the euro. The Canadian money market (bottom panel) is initially in equilibrium at point 1, while the foreign exchange (FX) market (top panel) is initially in equilibrium at point 1?.The initial equilibrium level of the Canadian interest rate is shown as R¹_$ and the initial equilibrium value of the dollar/euro exchange rate is shown as E¹_$/?.

Now suppose that there is a decrease in the expected exchange rate (E^e_$/?) and that, simultaneously, the Bank of Canada decides to change monetary policy to maintain the equilibrium value of the exchange rate unchanged at its initial value (E¹_$/?).

Ese return on dollar deposits 1' E SE #expected return on euro deposits Rates of return in $ terms -MP - L RD) M/P Canadian real money supply (MS/P) Canadian real money holdings