Question

Assuming that the RBA prediction of Australian inflation are correct, but the Canadian economic activity and inflation decline substantially. Please explain the effect on the Australian/Canadian exchange rate through Purchasing Power Parity and International Fisher Effect.

Answer 1

If the inflation of Aus Dollar remains same and the Canadian inflation decreases then the Australian/Canadian Exchange rate will decrease. This is because when inflation of one country decreases with respect to other then the currency appreciate with respect to other currency.
Future Aus/Canadian dollar rate =Spot Rate*(1+Inflation of Aus)/(1+Inflation of Canada)
This is as per purchasing power parity. As per international fischer effect the interest rate of Canada will fall with respect to Aus and hence Aus Dollar will depreciate with respect to Canadian Dollar.