Question

Because of the strength of long-run Asian demand for its mineral exports, markets conclude that the Australian real exchange rate will have to be permanently higher. Australian monetary policy is already much tighter. Draw a diagram showing the likely evolution over time of the exchange rate of the Australian dollar against sterling.

Short answer

The Australian dollar is expected to appreciate and settle at a permanently higher exchange rate against sterling.

Step-by-step solution

Diagram Axis Setup

We begin by setting up our diagram. The vertical axis represents the exchange rate of the Australian dollar (AUD) against the British pound sterling (GBP or just referred as sterling), while the horizontal axis represents time. This setup allows us to analyze how the exchange rate evolves over a period.

Initial Exchange Rate Level

Identify the initial equilibrium exchange rate level before the expectations of higher long-run demand for Australian minerals. Mark this level on the vertical axis as the starting point at the beginning of the timeline.

Effect of Strong Long-Run Demand Expectation

Market concludes that the Australian real exchange rate will have to be permanently higher. Therefore, position a new equilibrium exchange rate level higher than the initial level to reflect the expected higher demand for Australian minerals which leads to a stronger AUD.

Effect of Tighter Australian Monetary Policy

Australian monetary policy is already tighter, which typically means higher interest rates. This should cause an immediate appreciation of the AUD against sterling, leading to a steeper increase on the graph towards the new equilibrium level that markets anticipate.

Transition to New Equilibrium

Between the initial position and the new permanent equilibrium, draw a transition path showing a gradual appreciation toward the new higher exchange rate level. The steepness of this path may reflect the rate at which investors expect equilibrium adjustments to occur due to market confidence.

Permanent Higher Exchange Rate

Finally, from the new equilibrium point, draw a flat line indicating the stable, permanently higher exchange rate that markets expect as a result of anticipated stronger demand and the current monetary conditions.

Key concepts

Real Exchange Rate

The real exchange rate is a key concept in understanding currency valuation between two countries. It reflects the relative price of goods between countries. In our scenario, the real exchange rate of the Australian dollar (AUD) against the British pound sterling (GBP) is predicted to rise because of long-term demand for Australian minerals.

This increase means that Australian goods are expected to become relatively more expensive compared to British goods. Essentially, if the real exchange rate is permanently higher, it shows improved purchasing power for Australians abroad. Real exchange rates can also influence consumers' decisions as they may find foreign goods cheaper or more expensive than domestic goods.

• Relative Price: Reflects the purchasing power of one currency against another.
• Permanently Higher: Indicates a structural change in the economy, in this case driven by strong demand.

Understanding the dynamic of real exchange rates helps in predicting how competitive a country's exports can be and how cost-effective imports will be, contributing to broader economic foresight.

Monetary Policy

Monetary policy is crucial for controlling inflation and influencing the economy's overall performance. In Australia, tighter monetary policy translates to higher interest rates. These higher rates typically lead to an appreciation of the currency.

The reasoning is straightforward: higher interest rates provide better returns on investments denominated in that currency. When Australia implements a tight monetary policy, higher returns attract more foreign capital, strengthening the AUD.

• Higher Interest Rates: They make the currency more attractive to investors.
• Currency Appreciation: An effect of raising interest rates, thereby increasing the currency's value.

Through monetary policy, central banks can influence the exchange rate indirectly, as interest rates are a primary tool. Understanding how it interplays with currency valuation is vital for anyone analyzing economic trends.

Interest Rates

Interest rates are fundamental in influencing exchange rates as well as the flow of capital across borders. When Australia tightens monetary policy, leading to higher interest rates, it creates an environment where holding the Australian dollar becomes more lucrative for investors.

Higher interest rates act as a magnet for foreign investments due to the potential for greater returns, thus increasing demand for the Australian dollar. This shift in demand leads directly to currency appreciation.

In the exchange rate diagram, tighter monetary policy was shown to lead to an immediate appreciation of the AUD against the GBP before transitioning to a new equilibrium.

• Investment Flows: Directly influenced by changes in interest rates, affecting currency strength.
• Currency Strength: Enhanced when interest rates are higher compared to other countries.

Grasping how interest rates can impact currency values and, by extension, the broader economy, is crucial for effective exchange rate analysis and decision-making in international finance.