At a level of exchange rate, what is the balance of payment in the following case? The demand for Canadian dollars(CAD) for the US dollar(USD) in the foreign exchange market is given by the equation D=10-2e where e is measured in USD per CAD. The supply of Canadian dollars in this market is given by the equation: S=5+3e
The demand for Canadian dollars in exchange for US dollars in the foreign exchange market is given by D = 10 - 2e and the supply of Canadian dollars for US dollars is given by S = 5 + 3e. Here e is the exchange rate or USD/CAD.
If the supply is equal to the demand, there is neither an inflow of US dollars into Canada nor any outflow of CAD into the US. For this : 10 - 2e = 5 + 3e or e = 1.
If the exchange rate is greater than 1, the supply is greater than the demand. This changes the rate and it moves towards the equilibrium exchange rate of 1 if it is not controlled artificially.
If an exchange rate greater or lesser than 1 is maintained, something that can be done by the Central Banks of either the US or Canada, there can be a positive or negative balance of payment depending on the exchange rate that is being targeted.
Let the Central bank of Canada interfere here. If the excess demand as a result of an exchange rate less than 1 is being maintained it would have to sell CAD for USD resulting in a positive balance of payment. If the exchange rate being targeted is greater than 1 it would have to buy CAD in exchange for USD and this would result in a negative balance of payment.
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