Question

a-Use the model of the foreign exchange market to explain the relatively high value of the Australian dollar.

b. Suppose the Reserve Bank of Australia raises interest rates. What effect will this have on aggregate demand (AD), aggregate supply (AS), inflation and output in Australia?

c. Explain the advantages & disadvantages of exchange rate pegging?

Answer 1

a) The foreit exchange model illustrates how exchange rate is determined by the interaction of people who want to trade in their currency (supply of currency)with people people who want to obtain that currency (demand for that currency)

The demand for currencies is derived from the demand for a country's exports and from speculators looking to make a profit on exchanges in currency values. The supply is determined by the domestic demand for imports from abroad. The equilibrium exchange rate is the rate which equates demand and supply.

With increase in exports of Australia ,the demand curve shifts to the right and Push up the exchange rate resulting in high value of Australian dollar. Which is shown in below graph

exchange rate - Q Q Quantity

b) Effects of increase in interest rates by Reserve Bank of Australia on :

• Aggregate demand : when interest rates rise,the increased cost of borrowing tends to reduce capital investment ,as a result ,total aggregate demand decreases
• Aggregate supply: Increase in interest rate increases aggregate supply
• Inflation: As interest are increased consumers tend to save as returns from savings are higher with less spending the economy slows and inflation decreases.
• Output: A higher interest rate leads to decrease in investment ,a decrease in the demand for domestic goods and a decrease in output

c) advantages and disadvantages of exchange rate pegging

Advantages

• Stable basis for planning
• Credible and disciplined monetary policy
• Reduced volality

Disadvantages

• Increased foreign influence
• Difficulty in automatic adjustment
• Speculative attacks