Question

Suppose as a result of the COVID-19 outbreaks and the subsequent extensive lockdown measures, the Australian economy goes into a deep recession. Assume also that China has somehow avoided the recession as it could successfully contain the virus in the early stage of the spread. Use the exchange rate market model and relevant diagrams to answer the following questions.

(a) All else equal, how is this economic weakness in Australia likely to affect the value of the dollar against the Chinese yuan?

(b) How might your answer to 3(a) be different if the RBA reacts to the recession by an interest rate cut? Assume that China hasn’t changed its monetary policy.

need diagram thank you to support

Answer 1

As a result of the outbreak, the Australian economy goes into a deep recession, and China has avoided going into a recession. This will imply that demand for Australian currency would reduce as the economy is expected to fall into recession.

(a) Thus the economic weakness in Australia is likely to affect the value of the dollar against the Yuan as the demand for the dollar would reduce, which would depreciate the dollar against the Yuan.

Thus demand for dollar falls from D to D₁ and thus the exchange rate depreciates as one is able to get less yuan for 1 AUD.

(b) If there is an interest rate cut, then demand for the currency would decline all the more as investors would get a lower interest rate and return by investing in Australia, whereas they would get a higher return in China as the interest rates are not cut. Thus the currency would depreciate all the more and there would be less yuan received in exchange for the dollar.