(A) Using a CLG of the foreign exchange market (FOREX) for the Canadian Dollar, show the effect of the higher real interest rate in India on each of the following.
FOREX Cheat Sheet is here.
(i) Supply of the Canadian dollar. Explain.
If the interest rate in India rises above the Canadian interest rate then Canadians will move their money (capital flows) to India to get the higher interest rates. But you have to be careful, the question is actually asking about the Supply of Canadian dollars in the FOREX, NOT the supply of Canadian dollars in Canada.
Think of it like this,,,, The FOREX is a place in the sky. "I know but be patient".
On one side is Canada with its 5% interest rate on the other is India with its 8% interest rate.
Now Canadians would like to invest their money in interest assets to get the 8%. What is an interest asset? Bond. So Canadians would like to buy Indian bonds that promise to pay 8% a year.
But, the Indian banks do not accept Canadian dollars. So the Canadian investors must exchange their Canadian dollars for Indian Rupees in the FOREX. "In the sky"
Now, since Canadians are dumping their Canadian dollars in the FOREX, the supply of Canadian dollars is increasing. Why?
Capital Flows "I know, in AP economics Capital means machinery not cash/money" but not all of the world has taken AP economics.
Capital Flows from countries with lower interest rates to countries with higher interest rates. Why? If I take my money from a bank in Canada, where my money is earning 5% a year and move it to a bank in India where my money will earn me 8% a year then I will be financially better off. Always seeking higher earnings.
(ii) The value of the Canadian dollar, assuming a flexible exchange rate.
If the supply of Canadian dollars is increasing in the FOREX, then the value of the Canadian dollar $ will fall. Supply increases then value falls relative to the Indian Rupee ₹.
(B) Using a graph of the loanable funds market in Canada, show how the increase of the real interest rate in India affects the real interest rate in Canada.
Understand, that the loanable funds market graph is a model of the cash in banks. If cash is leaving Canada and travelling to India, then the supply of loanable funds in the banks in Canada is decreasing. Therefore the RIR (real interest rate) in Canada is rising.
Recognise, that when speaking about the supply or demand of Canadian dollars or Indian Rupees the College Board is speaking to the supply/demand in the FOREX.
Loanable Funds is the supply/demand of Canadian dollars/Indian Rupees in that country's banks.