Examine interest rate trends between AUD/USD, Utilize a fundamental (static) aggregate demand–aggregate

Question

In Australia, the RBA uses the Cash Rate to conduct its monetary policy. Likewise, the US Central Bank uses the Federal Funds rate as its main monetary policy tool. The figure below shows the movements in these key interest rate variables in Australia and the USA in recent years.

a)     Examine the interest rate trends in https://www.rba.gov.au/media-releases/2023/mr-23-30.html to assess changes in monetary policy within the USA and Australia. What was the main goal the central banks in these two countries were trying to accomplish?

[Hint: You may look at the statement by the RBA Governor about the Nov-2023 monetary policy decision: https://www.rba.gov.au/media-releases/2023/mr-23-30.html .]

b)     Utilize a fundamental (static) aggregate demand–aggregate supply diagram to explain how these policy changes aim to attain this goal, both in the short and long run. Assume the economy is initially operating at the full employment level.

c)     Given the information provided in the figure, what predictions can be made regarding changes in the AUD/USD exchange rate since the beginning of 2022? Illustrate your answer using a foreign exchange market diagram.

Answer 1

Monetary policy is an important instrument for achieving price stability. I think both governments are trying to bring proper adjustment between the demand for and supply of money. A high interest rate is anti inflationary in nature. The classical economists believed that there was always full employment in the economy. Unemployment is due to wage rigidity. So general cut in money wages would move the economy to the full employment kevel. Given the short run and long run AD/AS curve, both governments can maintain constant competitiveness by offsetting differential inflation across their countries. In the long run, their floating exchange rates return to the purchasing power path.