Anincrease in the money supply where prices are constant will decreasethe interest rates, depreciating the interest rates of the country.This will make Canadian output cheaper about the US. Cheaper goodsand services in Canadian market imply that there will be an increasein US demand for the Canadian goods and services increasing domesticoutput. This can be shown by a shift from E1 to E2.
Expansionarygovernment policies that are an increase in the spending by thegovernment will increase the output of Canada, which will in turnincrease the demand for real monetary assets. An increase in thedemand for real monetary assets increases the interest ratesappreciating the currency of Canada about that of the US. This causesa change in the supply curve from DD to DD1 as shown below.a
Anincrease in money supply does not change the prices in the short run. This will lead to an increase in money in circulation, and thecitizens of a given country will expect higher inflation in the end. Here, the interest rates decrease leaving to the depreciation of thecurrency. In the long run without PPP, an increase in the moneysupply will increase the price levels. Here, there will be noinflation but the economy will transit into long run equilibriumexpectations of an increase in prices causes a depreciation of thecurrency.
Here,the demand for US products about Canada increases as real exchangerate depreciates. In the long run, the American products are cheaperas compared to the Canadian products.
Exchangerate overshooting indicates excessive fluctuation of the nominal ratein response to the money supply. An increase in the nominal exchangerate directly raises the domestic price levels.
Fiscalpolicy is where the government influences an economy through taxationand its spending levels. Where Canadian’s economy is in recession,the government has an aim of maintaining steady prices, having ahigher employment level and the growth of the economy. The Canadiangovernment can reduce the tax levels increasing the level of incomeof companies. This will in turn make companies employ more personnelsince they can now afford to pay them. The increase in employmentlevels implies that the prices of goods and service have reducedmaking them affordable to the citizens of Canada. A government canalso increase its spending levels, which will increase the moneysupply in the economy. An increase in money supply causes a leftwardshift in the aggregate demand curve. This will occur when theCanadian government has reached full employment. To reduce the gapbetween aggregate demand and aggregate supply, the government ofCanada increases their spending levels, which will increase theaggregate demand curve.
Ifthe Canadian government taxes imports, the goods and services of aforeign country about that of Canada will become expensive. To avoidthis, the government of Canada introduces fiscal policies andcontrols. Here, the government cuts down taxes, which will in turnmake imports cheaper about exports increasing the aggregate demandfor imports. This implies that the Canadian currency will buy moregoods and services about another foreign currency. Lower inflationrates can also cause expansionary fiscal policy. When the exchangerate of Canada about other foreign currencies strengthens, theimports of Canada become cheaper. This means that Canada will spendless money on goods and services from a foreign country. This willmake other foreign countries lower their prices so that they can beable to compete with Canada increasing the standards of living of thecitizens of Canada. Fiscal policy also affects the balance ofpayments. Higher exchange rates will make Canada import more ratherthan they export causing a contractionary effect on the economy. This implies that since the currency of Canada is strong theirexports will be considered expensive about other foreign countriesmaking them buy fewer goods and services from Canada. In the longrun, this will lower the gross domestic product of Canada makingCanada more difficult to compete with other countries lowering therevenue hey receive from trade. The government of Canada can alsoincrease its spending levels. When the Canadian government increasesits spending levels, prices of goods in Canada become cheaper aboutother countries increasing the standards of living of its citizens. Other countries will reduce the prices of their goods and services tocounteract with that of Canada that will turn making imports cheaper. Lastly, the Canadian government can control its prices level toalter the levels of imports and exports. When a country increasesits prices, exports will be expensive but when it lowers, its pricesother countries will want to lower their prices making importscheaper.