|Author||Topic: Excellent ECON question|
|Suppose the money supply in Canada has grown by 3%, 4% 5% in 2004, 2005 and 2006 respectively. Over the same period, the budget deficit has grown from approx. $13o bn to 182 bn.
In an effort to control the economy, policy makers are suggesting a sudden change to either a restrictive monetary or fiscal policy. What effect would the sudden policy change have on the Canadian currency and capital account?
Monetary Policy Fiscal Policy
a) Capital account surplus Currency appreciation
b) Currency appreciation Capital account deficit
c) Capital account deficit Currency depreciation
d) Currency depreciation Capital account surplus
|I'm thinking A, and here's why, but please by all means correct me if I'm wrong.
In order to control the budget deficit, which is growing as the money supply continues to shift to the right, the central bank would want to reduce the amount of currency, thereby raising interest rates, increasing the supply of money at those interest rates and decreasing the demand for money. That increase in interest rates is unappealing to consumers who could save now and get more later and for businesses who would have to finance their loans at higher interest rates. This would cause a decrease in aggregate demand, which is reflected in the exchange of goods and services component of the current account which would go into a deficit. The capital account therefore would move in the opposite direction toward a surplus. The currency in all of this would appreciate because the interest rate received on the currency is greater than it was before, thereby increasing foreigners' demand for it, which in turn is shown through the surplus in the capital account which accounts for the flow of funds into a country from abroad.
I think I got that down - that sound right to you guys?