Final answer:
The supply of dollars curve in the foreign exchange market shifts right when the government increases its deficit by issuing Canadian dollar bonds, due to increased demand and reduced supply of U.S. dollars by international investors.
Step-by-step explanation:
In the foreign exchange market, the supply of dollars curve shifts to the right if the government increases its budget deficit, financing it with a new issue of Canadian dollar bonds purchased by the Bank of Canada. Imagine that the U.S. government increases its borrowing, and these funds are sourced from international financial investors. In response to the government bonds issuance, these investors will need more U.S. dollars, thus increasing their demand for U.S. dollars in the foreign exchange markets, shifting the demand curve from Do to D1. Concurrently, they will be less likely to supply U.S. dollars, resulting in the supply of U.S. dollars curve shifting from So to S1. This shift leads to a strengthening of the equilibrium exchange rate from 0.9 euro/dollar to 1.05 euros/dollar.