Question

Using the foreign-exchange equilibrium model, explain how a change in the interest rate and an expected future exchange rate would affect the current exchange rate of the Australian dollar vis-a-vis Chinese Yuan.

Answer 1

1) due to a change in interest rate

The motivation for an investment, whether domestic or foreign, is to gain a return. If rates of return in a country look relatively good, then that country will tend to attract more funds from abroad. oppositely, if rates of return in a country look relatively very low, then funds will tend to move to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in Australia as compared with China. Thus, financial investments in Australia promise a higher return than they previously did. As a result, more investors will demand Australia dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply Australian dollars to foreign exchange markets. Demand for the Australia dollar will shift to the right, from D₀ to D₁, and supply will shift to the left, from S₀ to S₁, as shown in Figure. The new equilibrium (E₁), will occur at an exchange rate of nine yuan/dollar and the same quantity of $8.5 billion.

2) due to the expected future exchange rate

Demand for the Australian dollar shifts to the right, from D₀ to D₁, as investors become eager to purchase Australian dollar. Conversely, the supply of Australian dollar shifts to the left, from S₀ to S₁, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 10 yuan/Dollor to 12 yuan/Dollor and the equilibrium exchange rate rises as the equilibrium moves from E₀ to E₁.

Exchange Rate Market for Australian dollar Reacts to Expectations about Future Exchange Rates. An announcement that the Australian dollar exchange rate is likely to strengthen in the future will lead to greater demand for the Australian dollar in the present from investors who wish to benefit from the appreciation. Similarly, it will make investors less likely to supply the Australian dollar to the foreign exchange market. Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.

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