Econ 305 Week 11 Review Questions
J. Knowles, SFU
November 22, 2025
1. According to Statistics Canada, Canada’s trade deficit with the world, for
goods and services combined, hit an all-time record deficit of $7.1 billion
in April 2025, largely due to a large drop in merchandise exports, as a
result of US tari!s.
(a) Use the GDP expenditure equation and the definition of national
saving, S= Y - (C +G), to explain what this implies for capital flows
and whether Canada is borrowing or lending from the rest of the
world.
(b) Is it better for Canada to have a trade deficit or a trade surplus?
(hint: when is it good to have a student loan?).
(c) Suppose the government decides that the trade deficit must be reduced, and proposes import restrictions (tari!s or quotas) to achieve
this. Using the open economy IS-LM model, explain how e!ective
this policy is likely to be, given that Canada has a floating exchange
rate and free capital flows.
(d) Suppose the government decides instead on a ’fiscal stimulus’ policy,
meaning an increase in G. Would this policy help to reduce the trade
deficit and increase GDP? Which of the two policies is better?
2. To maintain a fixed-exchange-rate system, if there is a negative shock
to demand for the domestic currency, then the central bank must trade
foreign currency. What kind of trade must the central bank do, and what
is the e!ect (explain!) of the domestic money supply?
3. Suppose that the expected marginal product of capital ( MPK ) in Canada
(and nowhere else) were to suddenly increase. If capital flows freely across
countries , explain what happens to the trade deficit and the exchange
rate.
1. In Figure 1, a small open economy is initially at equilibrium A with IS*1,
LM*1, equilibrium exchange rate e2, and equilibrium output Y1. Suppose
there is an increase in government spending.
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Figure 1: Question 1
(a) Suppose the economy has a floating exchange rate. Where will the
new short-run equilibrium be on the diagram above? Explain why
the economy goes to this point (why do e and Y change?).
(b) Suppose the economy has a fixed exchange rate. Where will the new
short-run equilibrium be on the diagram above? Explain why the
economy goes to this point. (why do e and Y change?).
2. In Figure 1, a small open economy is initially at equilibrium A with IS*1,
LM*1, equilibrium exchange rate e2, and equilibrium output Y1. Suppose
there is a monetary expansion .
(a) Suppose the economy has a floating exchange rate. Where will the
new short-run equilibrium be on the diagram above? Explain why
the economy goes to this point. (why do e and Y change?).
(b) Suppose the economy has a fixed exchange rate. Where will the new
short-run equilibrium be on the diagram above? Explain why the
economy goes to this point. (why do e and Y change?).
3. In Figure 2, a small open economy is initially in equilibrium at A with IS*1,
LM*1. Holding all else constant, suppose domestic consumers develop
greater preferences for imported goods.
(a) For each of the following scenarios, mark a letter Xa or Xb on the diagram to indicate the new short-run equilibrium. Explain any changes
in e and Y?.:
i. with a floating exchange rate.
ii. with a fixed exchange rate.
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Figure 2: Question 3
4. Consider Canada as a small open economy in a fixed-exchange rate regime.
Suppose that the equilibrium value of the domestic interest rate r equals
the international rate r→ .
(a) Explain (include a diagram) how an increase in capital inflows affects the exchange rate in a small open economy with a flexible-rate
regime. How does the Central Bank( CB ) in a fixed-exchange rate
regime respond to keep the currency stable? In both cases, be sure
to distinguish e!ects on supply and demand of domestic (C$) and
foreign currency.
(b) There is currently a recession, and the government would like to use
monetary policy to return the economy to full employment. Using
the IS*-LM* model, describe the impact of a monetary expansion
on output, the exchange rate and the interest rate of a monetary
expansion in a small open economy with a flexible-rate regime. Is
this kind of policy likely to succeed in returning the economy to full
employment?
(c) Now consider the fixed-exchange rate regime. Using the IS*-LM*
model, describe how the impact of a monetary expansion di!ers from
what you wrote above.
(d) Suppose that the recession were to persist over a long period of time.
Would the government be able to sustain this policy (under a fixedexchange rate regime) indefinitely? (hint: how does the government
fix the exchange rate?).
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(e) Would trade restrictions be a more e!ective and sustainable policy
in the case of a very long-lasting recession?
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