Question

Use the foreign exchange model to explain the impact of an increase in US interest rates on the Australian dollar?

Answer 1

Australia has a floating exchange rate.

The exchange rate is the price of one currency expressed in terms of another currency.

Two most common measures of the Australian dollar exchange rate are:

i) Bilateral exchange rate against the US dollar (AUD/USD).

ii) Trade-weighted index (TWI). The TWI is not a price in terms of a single foreign currency, but a price in terms of a weighted average of a basket of currencies.

The TWI will therefore give a measure of whether the Australian dollar is rising or falling on average against the currencies of Australia's trading partners.

This is often a better measure of general trends in the exchange rate than any one bilateral exchange rate, such as that against the US dollar, since the Australian dollar could be rising against the US dollar but falling against other currencies.