Question

Suppose as a result of the COVID-19 outbreaks and the subsequent extensive lockdown measures, the Australian economy goes into a deep recession. Assume also that China has somehow avoided the recession as it could successfully contain the virus in the early stage of the spread. Use the exchange rate market model and relevant diagrams to answer the following questions.

(a) All else equal, how is this economic weakness in Australia likely to affect the value of the dollar against the Chinese yuan?

(b) How might your answer to 3(a) be different if the RBA reacts to the recession by an interest rate cut? Assume that China hasn’t changed its monetary policy.

Answer 1

a. The economic weakness in Australia will reduce the demand for dollars in the Australian dollar market. As the demand for dollars decreases, the demand curve will shift leftwards in the foreign exchange market and this will shift the point of equilibrium from point E1 to point E2 where equilibrium exchange rate has decreased. This leads to depreciation of dollars and appreciation of Yuan.

b. Interest rate cut by the Central bank will lead to fall in the returns on investment in Australian economy which lead to Net capital outflow from the economy and reduction in the demand of Australian currency further. This reduction in the demand for Australian dollars will lead to depreciation of Australian currency in the foreign exchange market.Thus, value of currency depreciates further with the interest rate cut by the Central bank.