Illustrate a market of fictitious currency Zee

Question

Illustrate a market wherein the equilibrium dollar price of one unit of fictitious currency Zee is $5 (the exchange rate is $5 = Z1). Then illustrates on your diagram a decline in the demand for Zee.

a. Referring to this diagram, describe the adjustment options Canada would contain in maintaining the exchange rate at $5 = Z1 within fixed exchange rate system.

b. How would the Canadian balance of payments surplus i.e. formed (by the decline in demand) get resolved under a system of flexible exchange rates?

Answer 1

Graph of Zees

(a) The reduction in demand for Zees from D1 to D2 will build a surplus (bc) of Zees at the $5 price. In order to maintain the $5 to Z1 exchange rate, Canada have to undertake policies to shift the demand-for-Zee curve rightward or shift the supply-of-Zee curve leftward. To enhance the demand for Zees, Canada could employ dollars or gold to purchase Zees in the foreign exchange market; employ trade policies to raise imports from Zeeonia; or enact expansionary fiscal & monetary policies to enhance Canadian domestic output and income, therefore increasing imports from Zeeonia. Expansionary monetary policy would also decrease the supply of Zees: Zeeons would respond towards the resulting lower Canadian interest rates by falling their financial investing in Canada. Hence, they would not supply as several Zees to the foreign exchange market.

(b) Under scheme of flexible exchange rates, the bc surplus of Zees (the Canadian balance of payments surplus) will cause the Zee to appreciate and the dollar to appreciate till the surplus is eliminated (at the $4 = Z1 exchange rate illustrated in the figure).