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Oil is an international commodity; whose price Canada takes as given. Starting around mid-2013 crude oil prices fell fairly quickly, stabilizing in mid-2015. Around the same period of time, the Canadian dollar depreciated relative to the US dollar.
(1) Use the IS-LM-FX model to explain why a decline in oil prices might lead to a depreciation of the Canadian currency.
(2) As a Central Banker what would you do to counteract this impact? Using your answer from part (1), what should happen to interest rates after the decline in oil prices? Obtain historical data on the Bank of Canada's benchmark interest rate. Does the bank's action appear consistent with your own recommendation?
(3) Oil prices have currently plummeted due to a price war between Saudi Arabia and Russia. Obtain recent data on the CAD/US exchange rate and compare it to your IS-LM-FX predictions from part (1). Has it behaved in the way that you would expect? Why or why not? Of the models we have studied, is IS-LM-FX the right model to use to think about this question? Why or why not? If not, what is a better theory we have studied?
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