Suppose that Canadian real GDP is equal to potential output, the price level is stable, and the exchange rate is equal to e₀, its market-clearing value. There is then an upturn in the world demand for construction materials, especially lumber.

a. Draw a diagram of the foreign-exchange market. Assuming that Canada has a flexible exchange rate, show the likely effect on Canada’s exchange rate of the increase in world demand for construction materials.

b. Explain the Bank of Canada’s participation in the foreign-exchange market if Canada’s exchange rate is fixed at e₀.

c. Now draw an AD/AS diagram for the Canadian economy. What is the likely effect of the shock on Canadian GDP under the conditions in part (a)?

d. On the same AD/AS diagram from part (c), show the effect of the shock on Canadian GDP under the conditions of part (b).

e. Explain how a flexible exchange rate acts as a shock absorber, insulating the economy from both positive and negative shocks.