Question

Q5: Consider Australia running a current account deficit
a/ Evaluate the statement “a current account deficit is a tax burden on future generations”. Explain
your working and answer in words.
b/ Calculate the nominal exchange rate using the purchasing power parity concept when the foreign price level (for a typical easily transportable basket of goods) is $100USD and the domestic price level is $150AUD. Explain your working and answer in words.
c/ Calculate the real interest rate if inflation is 3%pa and nominal interest rate is 2%pa. Explain your working and answer in words.

d/ Explain how increasing the RBA cashrate could increase the nominal exchange rate. Explain your working and answer in words.

Answer 1

a/. A current account deficit is a situation when country's expenditure on its imports is more than that on its exports. It is not harmful for a country untill there is a surplus in the capital account, since the surplus in capital account can be used to finance the deficit in current account. But if the deficit in current account is financed through borrowings over a long period of time, it may have a negative impact on the economy since borrowings need to be paid in future and it comes with an interest rate along with it. To repay these borrowings the country may use certain measures like selling of government securities in open market, borrow from international organisations, increase the tax rates, etc. Thus current account deficit may increase the tax burden on the future generations.

b/. Using the PPP concept, nominal exchange rate is calculated as,

S = P1/P2

Where S - exchange rate for Australian dollar to US dollar

P1 - price level in Australia

P2 - price level in US

Therefore, from the given values in the question, we can calculate

S = 150/100 = 1.5.

c/. We can calculate real interest rate by substracting inflation rate from nominal interest rate. Therefore using the above information, real interest rate will be equal to 2-3 = -1%p.a. Thus the real interest rate is negative in the country because inflation rate is more than nominal interest rate.

d/. Cash rate is the rate at which RBA lends money to the commercial banks of the country. This is adjusted by RBA in order to keep a check on the inflation and exchange rate of the country. When the RBA increases the cash rate, it reduces the overall supply of Australian dollar in the country, thus when the supply of domestic currency is reduced in a ln open economy, due to its demand being unchanged in the foreign market, the nominal exchange rates increases of the Australian dollar.