Economics and Inflation Rates

Question

The equilibrium interest rate in Canada is 8%. Canada is a small open economy. The interest rate in the U.S. is 4%. Now suppose that the interest rate in the U.S. rises to 6%. What can explain this change in the U.S. interest rate?

Analyze the country of Canada: after the interest rate in U.S. becomes 6%, explain what happens in Canada with savings, investment, NCO, exchange rate and trade balance?

Answer 1

Interest rates can rise for a variety of reasons. The economy could be in an inflationary gap that usually leads to higher interest rates (the central bank lowers the money supply) to mitigate inflation risks. Anything that causes the demand for loanable funds to increase (e.g. government deficit spending) would also increase interest rates. Anything that results in an increase in the demand for money (e.g. higher price levels or income) and anything that results in a decrease in the supply of loanable funds (e.g. less savings) would also increase interest rates.

In this example, Canada still has a higher interest rate than the U.S. (8% vs 6%) so each of the transactions you mentioned (savings, investment, NCO, exchange rate, and trade balance) would be affected minimally. If the interest rate in the U.S. surpassed Canada, then more drastic changes would take place in these transactions. Higher interest rates attract more foreign capital which would increase the strength of the currency, thus causing more imports and less exports due to the more expensive exchange rate (causing a negative trade balance).