Suppose that Canada pegs its currency to the U.S. dollar at a rate of $C1 = $US1 and that Canada is a major exporter of crude oil to the United States. The increase in the price of oil that occurred in the second half of 2007 is likely to:
A) cause Canada to adopt a contractionary monetary policy and the United States to adopt an expansionary monetary policy.
B) cause Canada to adopt an expansionary monetary policy and the United States to adopt a contractionary monetary policy.
C) cause both Canada and the United States to adopt contractionary monetary policies.
D) cause both Canada and the United States to adopt expansionary monetary policies.

Question

Quizplus · Accepted Answer

The increase in oil prices would lead to a higher demand for Canadian dollars (to pay for the more expensive oil), potentially causing the Canadian dollar to appreciate relative to the U.S. dollar. To maintain the peg at $C1 = $US1, Canada would need to adopt a contractionary monetary policy to reduce the money supply and prevent the appreciation. Conversely, the U.S. might adopt an expansionary policy to counteract the economic slowdown caused by higher oil prices.

Suppose That Canada Pegs Its Currency to the U