Question 3:

a. Draw a diagram of each of the three markets for Canada (a small open economy): 1- Money Market; 2 - Output Market; 3- Foreign Exchange Market. [in the output market, you may draw only the demand curve]. The other two markets are in equilibrium with the supply and demand intersection.

b. Now suppose that U.S income rises. As a result, Canada's exports to US increase. What happens to the position of AD curve in the output market in Canada [Show this on the diagram you drew in part a) above] if Bank of Canada allows the exchange rate to be flexible. [Clearly explain what happens in all the markets and all the variables including real interest rate and real exchange rate and show the effects on the diagrams as well].

c.How will your answer to part b) change if the Bank of Canada maintains fixed exchange rate policy? If necessary, draw the diagrams again and explain clearly what will happen to AD demand curve and the variables in other markets including real interest rate, and real exchange rate.