Answer the following questions. Each sub-part of the question is not related to the other part. Be sure to provide a written explanation in order to receive full credit. a) The foreign exchange market is in equilibrium, and there is a change in the consumption preference such that Canadian households decide to buy fewer American goods. If the Bank of Canada (BOC) wants to keep the exchange rate from changing, what should it do? What happens to the stock of official reserves held by the BOC? What happens to the balance of payments after the intervention by the BOC? Explain. (10 points)
b) Suppose you are a currency trader, and he observes the following exchange rates in the spot market: S£/US$ = 0.5133 SUS$/⬠= 1.4568 S£/⬠= 0.7192 ? You observe there is an arbitrage opportunity in trading £ and â¬, what should you do to capture the arbitrage profit? What is your arbitrage profit (measured in £)? Explain. (6 points) ? Also, discuss the adjustment mechanism (i.e., explain how the transactions you would eliminate the arbitrage profit). (9 points)
