**Bank of Canada Raises Interest Rates Amid Economic Recovery**

• Axis and labelling is correct 1 mark
• Demand curve increasing to the right indicating an appreciation 1 mark
• Reasoning indicated from the text 1 mark

• Assume, exporting firms in canada are operating at point $a$ initially with price $P_1$ and quantity $Q_1$.
• Due to the appreciation of the currency, this means that canadian dollars become expensive relative to foreign currency, and therefore domestic goods and services of Canada are now more expensive to foreign buyers.
• Hence, their demand for this exporting goods and services falls causing the demand curve to shift left from $D_1$ to $D_2$ and thus causing a downward pressure on price as it signals to suppliers/exporters there is a surplus.
• Therefore they are incentivized to lower prices until $P_2$ and a new equilibrium is found at point $b$ with a lower quantity $Q_2$
• Hence the appreciation of the currency caused the demand to fall for exporting firms

Award 2 marks for diagram OR explanation

Award 2 marks for diagram AND explanation

• Initially, assume the economy is at equilibrium point $a$ with a price level $PL_1$ and real GDP $Y_1$.
• If interest rates rise, this makes the cost of borrowing money larger (and the 'income' for lending money larger) such that people will likely borrow and thus spend less while saving more.
• Therefore the consumption and investments in aggregate would decline causing the aggregate demand to decrease, shifting the curve to the left from $AD_1$ to $AD_2$.
• This would put downward pressure on the price level causing $PL_1$ to fall and in the short run, it would decrease the real GDP from $Y_1$ to $Y_2$ till point $b$ indicating a slow, or hindered economic growth.

Award 2 marks for diagram OR explanation

Award 2 marks for diagram AND explanation

• If the United States were to impose production subsidies, it could make US goods cheaper to produce and export, giving US exporters a competitive advantage. 1 mark
• Since 75% of Canada’s exports go to the US (as shown in Table 2), Canadian exports to the US may face increased competition. This could lead to a reduction in demand for Canadian goods, particularly in industries like automobiles and crude oil, which are major export categories to the US. 1 mark
• Since US is the imports the largest amounts from Canada (as shown in Table 2), the impact of this trade protection policy would be significant to Canada compared to if it were another country imposing this protection. 1 mark
• This would likely hurt Canada’s trade balance and potentially slow down its economic growth, as exports would decline and the current account deficit could worsen. 1 mark
• This lower demand for canadian goods and services will not only affect the current account but likely also cause a depreciation in the exchange rate since the demand for CAD would fall relative to the significant US dollar. 1 mark

Award Maximum 4 Marks

this question talks about USA's domestic producers not Canada's

• Initially, the domestic price $P_d$ of steel is above that of the world $P_{world}$ and this US is forced to accept this price which causes the quantity supplied to be at $Q_{s1}$ and quantity demanded at $Q_{d1}$.
• This excess demand is imported, including being imported from Canada.
• When the government decides to place a tariff on Canadian steel, depending on how large of an exporter Canada is, this will cause the price to rise by the amount of the tariff (assuming Canada is most of 'world') to a new price $P_{world}+tariff$
• Hence, the quantity supplied increases to $Q_{s2}$ and the quantity demanded decreases to $Q_{d2}$. This causes the excess demand to decrease and thus the imports that US makes from Canada falls.
• Hence domestic producers are likely better off with higher prices and quantity while consumers lose out on cheaper prices and options for steal.

Award 2 marks for diagram OR explanation

Award 2 marks for diagram AND explanation

Answers may include:

Definition

• Current account deficit: A situation where the value of a country’s imports of goods, services, income, and transfers exceeds the value of its exports.
• Appreciation: An increase in the value of a currency in a floating or managed exchange rate system, making imports cheaper and exports more expensive.
• Economic growth: An increase in a country's real output (real GDP) over a period time.

Impact on Export Competitiveness and Current Account Balance

Reduced Export Demand Due to Appreciation

• The appreciation of the Canadian dollar increases the price of Canadian goods in foreign currencies, making exports less competitive.
• Canada’s total exports amount to US$180B**, with major contributions from **oil (US$50.2B) and automobiles (US$45.8B) (Table 1). These sectors are price-sensitive, particularly oil, where global demand is highly elastic.
• With 75% of exports going to the US (Table 2), the exchange rate against the US dollar is critical. A stronger CAD against the USD reduces demand for Canadian goods in the US, potentially worsening the current account deficit, which already stands at 3.6% of GDP.

Diagram: Exchange Rate and Net Exports

• An appreciation shifts the exchange rate curve upward, leading to lower exports (X) and higher imports (M), reducing net exports (X−M) and potentially shifting AD leftward.

Limitations

• Exporters in non-price-sensitive or high-value sectors, like technology or specialized machinery, may be less affected by currency appreciation.
• If global oil prices rise, it may offset the impact of a stronger CAD on oil export volumes.
• Canada’s export strength also depends on US demand, which may remain strong despite price increases.

Effect on Imports and Purchasing Power

Cheaper Imports Improve Consumer Welfare

• An appreciated currency makes foreign goods and services cheaper, benefiting consumers and import-reliant businesses by reducing input costs.
• This may increase imports, further widening the current account deficit, especially if domestic demand rises alongside economic recovery.

Stronger CAD and Tourism Outflows

• Canadians are more likely to travel abroad, increasing import of services and reducing domestic tourism income, worsening the services balance component of the current account.
• Domestic industries relying on tourism and hospitality may experience reduced revenues, especially in border cities and seasonal destinations.

Impact on Aggregate Demand and Economic Growth

Reduced Net Exports and Slower Growth

• A stronger CAD reduces net exports, one of the key components of aggregate demand (AD = C + I + G + (X−M)).
• Lower net exports may offset gains in consumption and investment, especially as interest rates rise (from 0.5% to 0.75%) to curb inflationary pressures.
• Higher borrowing costs reduce consumer spending and business investment, slowing down the rate of GDP growth.

Diagram: AD/AS Model

• A fall in net exports causes a leftward shift of the AD curve, lowering real output and potentially increasing cyclical unemployment, especially in export sectors like manufacturing and energy.

Limitations

• The initial GDP growth rate of 3.5% in Q1 2017 suggests a strong underlying economy, with robust consumer spending and investment.
• Short-term slowdown may be limited if domestic demand remains high and interest rate hikes are gradual.
• Long-term growth depends on the supply-side factors (e.g., productivity, innovation), not just net exports.

Potential Impact on Inflation and Central Bank Policy

Appreciation Reduces Inflationary Pressure

• A stronger currency lowers import prices, reducing cost-push inflation, especially for imported inputs and energy.
• This may support the Bank of Canada’s inflation targeting objective (2%), particularly as inflation has been below target.
• Reduced inflation may limit the need for further interest rate increases, stabilizing consumption and investment.

Limitations

• If inflation expectations remain low, real interest rates rise, potentially leading to monetary tightening effects even without nominal rate hikes.
• If wage growth accelerates, demand-pull inflation may emerge despite lower import prices.

Overall Evaluation

Strengths

• Appreciation improves import affordability, reduces inflation, and enhances consumer purchasing power.
• Slows inflationary pressures during recovery, giving monetary authorities room to maneuver.
• Strong underlying economic conditions may absorb the export losses in the short term.

Weaknesses

• Export sectors (especially oil, auto, agriculture) may face reduced competitiveness, weakening net exports and worsening the current account deficit.
• Services balance may deteriorate due to higher outbound tourism.
• Reduced net exports and rising interest rates could constrain aggregate demand, slowing real GDP growth.

Conclusion

The appreciation of the Canadian dollar poses short-term challenges for Canada’s current account and economic growth by reducing export competitiveness and increasing imports. However, these effects are partly offset by strong domestic demand, improved import affordability, and moderating inflation. The net impact depends on the persistence of appreciation, the pace of monetary tightening, and the resilience of export markets, particularly the US. In the medium term, the Bank of Canada must balance external competitiveness with price stability and growth sustainability.