Interest Rate and Foreign Exchange Markets
a) Using a correctly labeled graph of the foreign exchange market for the Canadian dollar, show the effect of the change in real interest rate in Canada on the international value (the exchange rate) of the Canadian dollar (expressed as Mexican pesos per Canadian dollar).
The Interest Rates has a direct impact over the exchange rate of a country as any change in the interest rates announced by the central bank will influence the demand and supply of the currencies in the foreign exchange market. In other words, if the central bank of the country is concerned with the rising inflation in the economy and then increases the interest rates, this will have a positive impact over the home country currency as the exchange rate in relation to another currency will appreciate.
Here, the increase in the real interest rates in Canada will have a direct impact over the demand for Canadian Dollars. The diagram below will indicate as how the increase in real interest rates in Canada will affect the demand of Canadian Dollars and the exchange rates between Mexican Pesos and Canadian Dollars:
Quantity of Canadian Dollars
The diagram above is a graphical illustration as what happens when the central bank increases the real interest rates. Important to note that as the real interest rates of Canadian Dollar rises, the demand of the Canadian Currency rises, as the investors( primarily in those countries where interest rates are less than what being offered in Canadian Markets) are now willing to capitalize the high-interest rate opportunity in Canada. Similarly, just as other countries, investors in Mexico willing to cash in the opportunity, increases their demand for Canadian Dollars to profit more and, as a result, at higher demand, the price of Pesos per Canadian Dollar rises or in other words, the Canadian Dollar appreciates and the Mexican Pesos depreciates.
(B) How will the change in the international value of the Canadian dollar that you identified in part (a) affect Canadian exports to Mexico? Explain.
Referring to the above graphical illustration which indicates that the increase in the real interest rates in Canada has resulted in the appreciation of the Canadian Dollar will decrease the export of the nation to Mexico as now the Canadian Goods will turn expensive for the importers in Mexico.
For Instance, let us assume that before the announcement of hike in the real interest rates, the exchange rate between Mexican Pesos/ Canadian Dollar was 10. However, with an increase in the interest rates, the demand for Canadian Dollar in relative to Mexican Pesos increases and this turns the Canadian Currency strong and the Canadian dollar appreciates to 12. Now suppose if a Mexican trader was importing 100 units of Good X at the exchange rate of P/CAD= 10, at the new exchange price of 12, he would only be able to import 83 units. Thus, an increase in real interest rates will decrease the export to Mexico. Thinking the other way, if earlier 1 Canadian Dollar was able to purchase 10 Mexican Pesos, this means that the Canadian product which was selling for 1 CAD in Canada was selling for 10 Mexican Pesos in Mexico. However, now with the appreciation of Canadian Dollar, the price of that product to a Mexican trader increases to 12 Mexican Pesos. Assuming that the demand for the Canadian product is elastic in Mexico, higher prices will result in lower demand. Hence, the effect of the appreciation of the CAD would be damaging to Canadian exporters.
Works Cited
Bergen, J. V. (n.d.). 6 Factors That Influence Exchange Rates. Retrieved July 26, 2014, from http://www.investopedia.com/articles/basics/04/050704.asp
Exchange rate policy. (n.d.). Retrieved July 26, 2014, from http://www.economicsonline.co.uk/Managing_the_economy/Exchange_rate_policy.html
How Interest Rates affects Foreign Exchange Markets. (2012, January 24). Retrieved July 26, 2014, from http://www.ninestocks.com/2012/01/how-interest-rates-affect-foreign-exchange/
