Question

Graph the demand for and supply of Australian dollars for euros and label each axis. Show graphically and explain the effect of an increase in Australian government budget deficits that increase Australian interest rates on the demand for and supply of dollars and the resulting change in the exchange rate of euros for Australian dollars. Why might the change in the exchange rate lead to an increase in Australia’s current account deficit?

Answer 1

I­­f expansionary fiscal policy leads to a budget deficit, this may increase domestic interest rates. An increase in Australian interest rates would increase the desire by overseas investors to invest in financial assets in Australia relative to the rest of the world. The demand for dollars would rise, causing the exchange rate for the dollar to rise, i.e. the A$ would appreciate.

See diagram below. The higher exchange rate would increase the Euro price of Australian goods and services and decrease the A$ price of European goods and services. This may result in a decrease in Australian exports, an increase in imports from Europe, and hence a decrease in net exports (X-M) leading to a current account deficit.