Question

Draw a graph of the supply and demand for the U.S. dollar by the Australian market. Diagram the effect of each of the following on the exchange rate; state in words whether the effect is long, medium, or short run; and explain your reasoning.

a) More rapid growth in Australia than in the US

b) A rise in Australian interest rates

c) Goods are more expensive in the US than in Australia

d) A recession in the US

e) Expectation of a future appreciation in the American dollar

Answer 1

a) As Australia experiences more rapid economic growth than the U.S, disposable income in Austrlia rises, causing consumption to rise. Consumer confidence gradually rises as jobs become secured and plentiful. Canadian expenditures on imports rise. Thus the demand of USD increases to pay for American imports. The demand curve shifts right and the USD appreciates. This effect is medium run because effects of economic expansions and contractions -- the business cycle -- on exchange ratea run for a few years (usually less than a decade). .

b) The supply of US dollars to theAustralian market increases in response to the higher interest rates; the supply curve shifts right; the U.S dollar depreciates. This is a short run effect because the factors cause the interest rates to change are themselves short run processes. Good example are changes in government (fiscal and/or monetary) policies, expectations, and financial capital flows in and out of a country.

c) The Australian demand for US dollars decreases in response to higher prices for US goods. The demand curve shifts left causing the exchange rate to fall. The U.S dollar depreciates and the Australian dollar depreciates. This is a long run effect in part because the prices of goods move gradually. The higher the prices of goods in US could also be caused by government policies such as tariffs and quotas. In general, changing the government policies takes time. Goods arbitrage will eventually equalize the prices of goods between the two countries, but achieving purchasing power parity is a long run process.

d) The supply of US dollars decreases in respond to dop in US demand of imports due to recession. The supply curve shifts left; the U.S dollar appreciates; the Australian dollar depreciates. The effect of recessions and expansions on exchange rates can be considered medium term.

(e) The demand for US dollars increases in response to its expected rise in value; the demand curve shifts right; the U.S dollar appreciates; the Australian dollar depreciates. Like the effects of interest rates, the effects of expectations on exchange rates are short run. As everyone knows, expectations could change swiftly and could reverse course almost instantaneously. Some expectations could be unexpected and flimsy but they could have catastrophic effects on the exchange rates and financial sectors of the country.