Refer to the figure below to answer the following questions.

Figure 25.3.1
-In Figure 25.3.1,suppose the demand for dollars temporarily decreases so that the demand curve shifts to D2.To maintain the target exchange rate,the Bank of Canada
A)sells dollars.
B)buys dollars.
C)must violate both interest rate parity and purchasing power parity.
D)must raise the target exchange rate.
E)must lower the target exchange rate.

Question

Refer to the figure below to answer the following questions.
  
Figure 25.3.1
-In Figure 25.3.1,suppose the demand for dollars temporarily decreases so that the demand curve shifts to D2.To maintain the target exchange rate,the Bank of Canada
A)sells dollars. 
B)buys dollars. 
C)must violate both interest rate parity and purchasing power parity. 
D)must raise the target exchange rate. 
E)must lower the target exchange rate.

Quizplus · Accepted Answer

If the demand for dollars decreases, then the supply of Canadian dollars increases relative to the supply of U.S. dollars. This would cause a depreciation of the Canadian dollar. To maintain the target exchange rate, the Bank of Canada must buy Canadian dollars (sell U.S. dollars) in the foreign exchange market. This would increase the demand for Canadian dollars and offset the decrease in demand caused by the initial shock. Therefore, the correct answer is B. The bank does not need to violate either interest rate parity or purchasing power parity, nor does it need to adjust the target exchange rate.

Refer to the Figure Below to Answer the Following Questions