Use diagrams of the Market for Loanable Funds and the Market for Foreign Currency to describe what would happen to the net capital outflow, the Canadian real exchange rate and net exports in each of the following scenarios:
--- Instead of using diagrams it would be great if you can just explain what happens for each
1. Canadian citizens start saving more as a result of the introduction of Tax Free Savings Accounts
2. There is an increase in the perceived risk of holding Canadian assets. (10 marks)
1. When Canadian citizens start saving more due to the introduction of Tax-Free Savings Accounts, it affects the market for loanable funds and has implications for both net capital outflow (NCO) and net exports.
In the market for loanable funds, the increased saving leads to a higher supply of loanable funds. This is because the tax-free savings accounts incentivize individuals and households to save more of their income rather than consume it. As a result, the supply curve of loanable funds shifts to the right.
The increase in the supply of loanable funds reduces the equilibrium interest rate in the economy. This lower interest rate makes domestic investment relatively cheaper compared to foreign investment, resulting in a decrease in net capital outflow (NCO). NCO represents the difference between capital inflows and capital outflows, so with a decrease in NCO, there is a reduction in the amount of capital flowing out of the country.
The decrease in net capital outflow affects the market for foreign currency. In order to finance the lower net capital outflow, the demand for foreign currency decreases. This leads to an appreciation of the Canadian real exchange rate – the relative price of Canadian goods and services compared to foreign goods and services. The appreciation of the Canadian dollar makes Canadian exports more expensive for foreign buyers and imports cheaper for domestic consumers.
Consequently, the combination of decreased net capital outflow and an appreciating Canadian real exchange rate leads to a decrease in net exports. Net exports represent the difference between exports and imports, and the decrease in net exports suggests that the value of exports is falling relative to the value of imports.
2. When there is an increase in the perceived risk of holding Canadian assets, it affects the market for foreign currency and has implications for net capital outflow (NCO) and the Canadian real exchange rate.
The increased perceived risk makes foreign investors less willing to hold Canadian assets. This reduces the demand for Canadian dollars and shifts the demand curve for foreign currency to the left in the market for foreign currency. Consequently, the Canadian real exchange rate depreciates – the relative price of Canadian goods and services decreases compared to foreign goods and services.
The depreciation of the Canadian dollar makes Canadian exports cheaper for foreign buyers and imports more expensive for domestic consumers. As a result, there is an increase in net exports.
In terms of net capital outflow (NCO), the decrease in foreign investors' willingness to hold Canadian assets reduces the capital inflows into the Canadian economy. This decreases net capital outflow, as there is less capital flowing into the country.
To summarize, an increase in the perceived risk of holding Canadian assets leads to a depreciation of the Canadian real exchange rate, an increase in net exports, and a decrease in net capital outflow.