You are an economic advisor to Australia’s Prime Minister. Australia is an open economy with free...

You are an economic advisor to Australia’s Prime Minister. Australia is an open economy with free capital mobility. The P.M. wishes to know why he can’t maintain a fixed exchange rate with the United States and at the same time reducing interest rates in Australia to fight a recession.

Explain why the P.M. can’t have both a fixed exchange rate an independent interest rate policy at the same time. (Use either uncovered interest parity or an FX market graph in your answer)

Expert Solution

There cannot be independent interest rate policy with fixed exchange rate system. The reason for this is that there is a very close and direct relationship between the two.

If the interest rate is reduced in the economy, the demand for domestic currency for investment purposes by foreign investors will reduce. This means that the value of the domestic currency will reduce and it will not remain the same in the exchange rate market. There will be depreciation of the exchange rate and this means that the value of exchange rate will not be fixed.

Thus lower interest rate will depreciate the exchange rate and higher interest rate will appreciate the exchange rate. So there cannot be fixed exchange rate with independent interest rate policy.

Rahul Sunny answered 2 years ago

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