Question

Australia's economy boomed from 2005 through the end of 2011, in part because of strong Chinese demand for its commodity exports such as iron ore. According to the short-run model presented in KOM Chapter 15, would you expect the Australian dollar (A$) to have appreciated or depreciated vis-à-vis the U.S. dollar (US$) during this period? Why? Illustrate your answer with a graph.

Answer 1

Growth in Australian economy will increase Australian import demand, and will increase US export demand. As a result, demand for US$ will increase (for Australians to pay for US imports) and demand for A$ will decrease. Lower demand for A$ will depreciate A$ vis-a-vis US $. The demand curve for A$ will shift leftward, decreasing exchange rate and decreasing quantity of A$.

In following graph, Exchange rate/value of A$ (P) and quantity of A$ (Q) are measured vertically and horizontally respectively. D0 and S0 are initial demand and supply curves of A$, intersecting at point A with initial exchange rate P0 and initial quantity of A$ Q0. As demand for A$ falls, D) shifts left to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of A$ Q1.