Suppose that US Federal Reserve implements a contractionary monetary policy that leads to higher interest rates...

Suppose that US Federal Reserve implements a contractionary monetary policy that leads to higher interest rates in the US. At the same time, the US economy is experiencing an expansion. Can one use this information to predict what will happen to the USD/AUD exchange rate?

Expert Solution

Exchange rate: unchanged

At contraction:

The exchange rate decreases.

Interest rate is high. This will attract foreign investment – the USD would be demanded more than AUD. Suppose earlier we got 1 USD per AUD; therefore, the exchange rate was, USD/AUD = 1 USD / 1 AUD = 1. Now suppose it becomes 0.75 USD per AUD; hence, the exchange rate becomes USD/AUD = 0.75 USD / 1 AUD = 0.75 (decreases). This increases the value of USD and decreases the value of AUD.

At expansion:

The exchange rate increases.

This is just opposite of above. An expansion creates inflationary stage in the economy. People would be reluctant to hold USD, since its purchasing power reduces, and would be interested to hold AUD, since it has higher purchasing power. This decreases the value of USD and increases the value of AUD. The effect is the increasing exchange rate in the form of USD/AUD.

Since both these happens at a time. The exchange rate once decreases and then increases, making the net effect 0, unchanged.

Rahul Sunny answered 2 years ago

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