3. Suppose that a car selling at $65,785.00 CDN in Canada, sells in France for €

Question

3.   Suppose that a car selling at $65,785.00 CDN in Canada, sells in France for €43,835 Euro. What is the implied Purchasing Power Parity, PPP exchange rate in terms of the Canadian dollar price of a Euro? If the current nominal exchange rate is $1.435 for each €, is the Canadian dollar currently over-valued or under-valued? Why do you think this? (4 Marks)

5.   The Mundell-Fleming model provides an explanation of the effect of fiscal and monetary policy within a small open economy – such as Canada. Carefully explain the impact of contractionary fiscal policy (a reduction in government spending) in Canada where the exchange rate policy is for a Floating or Flexible Exchange Rate Regime? (4 Marks)

Explanation / Answer

(1)

PPP Exchange rate = CN$65,785 / Euro 43,835 = CN$1.50 per Euro

Since current exchange rate is CN$1.435 which is lower than the PPP-implied Exchange rate of CN$1.50 per Euro, Canadian Dollar is undervalued.

This is possible because of following possible causes:

- Transaction costs in trading any commodity/good will distort the PPP flow, therefore actual exchange rate is different from PPP-implied exchange rate.

- Information asymmetry between traders in different countries will result in actual and PPP exchange rate being different.

- Tax rates can vary between countries, which will distort the actual and PPP exchange rate.

- Slow speed of transactions will distort the actual and PPP exchange rate.

Note: First question is answered.

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