Macroeconomics Answer Needed!

Question

Using the macroeconomic model for a small open economy studied, analyze the impact of the following event on Canadian savings, investment, exchange rate and trade balance in the Canadian economy:

event: in the U.S., the federal government ran very large budget deficits.

Explain thoroughly with words

Answer 1

Canadian savings and investment is driven primarily by their country's interest rates (as rates rise --> savings increases but capital investment decreases and vice versa.) When the U.S. federal government builds up budget deficits that are not financed through tax increases, this increases interest rates in the U.S. because the supply of loanable funds decreases. With less money available for loans, interest rates have to rise to attract financial capital (in this case, it could come from Canada). Investors in Canada will seek a higher rate of return as they notice U.S. interest rates rising. They will invest in the U.S. and leave Canada, which forces them to buy U.S. dollars and sell Canadian dollars. Thus, the U.S. dollar appreciates and the Canadian dollar depreciates. Canadian exports become cheaper as their currency depreciates so they will export more goods which leads to a surplus in the trade balance. This increases Canada's aggregate demand which lead to an increase in price levels, which often lead to higher interest rates. These higher rates will then create more savings in Canada and less capital investment.