Suppose that Canada decides to peg its dollar ($C, or the loonie) to the U.S. dollar at an exchange rate of $C1 = $US1. What might the U.S. Federal Reserve do to offset the macroeconomic effect of the leftward shift in the U.S. IS curve?
A) It would increase the money supply.
B) It would decrease the money supply.
C) It would not change its monetary policy.
D) It would not change its fiscal policy.

Question

Quizplus · Accepted Answer

If Canada pegs its dollar to the U.S. dollar, it means that the exchange rate is fixed at $C1 = $US1. This creates a situation where the Canadian and U.S. economies are closely linked, and changes in one economy affect the other.

Assuming that the leftward shift in the U.S. IS curve is caused by a decrease in exports to Canada (due to the appreciation of the Canadian dollar), the Federal Reserve would want to offset this effect by increasing the money supply. By increasing the money supply, the Federal Reserve would decrease interest rates, which would stimulate investment and consumption in the U.S. economy, and thereby shift the IS curve back to the right.

Alternatively, the Federal Reserve could use other monetary policy tools to achieve the same effect, such as open market operations or changes in the discount rate. The key is that the Federal Reserve would need to intervene to offset the macroeconomic effect of the exchange rate peg between Canada and the U.S.

Suppose That Canada Decides to Peg Its Dollar ($C, or the Loonie)