Suppose that beef sells for US$15 per kg in the USA and A$20 per kg in...

Suppose that beef sells for US$15 per kg in the USA and A$20 per kg in Australia. Assume the exchange rate was A$1.2 per US$1

If a lot of people behaved like you and the exchange rate between the US$ and A$ was a flexible rate, what would happen to the exchange rate? What would the equilibrium exchange rate be if the US dollar price and the Australian dollar price for beef stayed the same?

Expert Solution

When compared to Australian dollar, it is quite evident that the US dollar is in more demand in the currency market. As the demand is more than the supply, the US dollar is more valuable than the Australian dollar. Hence making the US Currency stronger or increasing the exchange rate from A$1.2 per USD. To give more intuition, consider the real exchange rate of Australian dollar with respect to USD = 1.2*15/20 = 0.9. This gives an idea about the purchasing power.

When the US dollar and Australian dollar for beef remains the same, the exchange rate is 1. This is given by Law of one price. The law of one price is the foundation of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. In our case the basket of identical goods is 1kg of beef. Hence the exchange rate is unity.

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Rahul Sunny answered 2 years ago

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