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fixed exchange rate regime

A)Show how an increase in personal and federal income taxes ultimately affects the Bank of Canada's balance sheet.

b)How are the Bank of Canada's transactions in the foreign exchange market from part (a) reflected in the balance of payments account?

c)Would the impact of the tax cut be larger or smaller under a floating exchange rate regime? Use the AA-DD diagrammatic analysis to answer this question.

Solution Preview

a) An increase in personal and federal income taxes is a contractionary fiscal policy, which will decrease output and hence decrease the demand for real money. Given a fixed level of money supply, the latter will put a downward pressure on the interest rate and hence an upward pressure on the exchange rate.
<br>To fix the exchange rate, the central bank must be willing to sell domestic currency in the foreign exchange market in whatever amounts are ...

Solution Summary

This job uses the AA-DD diagrammatic analysis to answer.

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