2.Now assume that Australian dollar is pegged to the UK pound with the exchange rate of EA/U = 1.5. The Reserve Bank of Australia (RBA) maintain this exchange rate all the time.

MS1

A

MD1

i$

4%

M1/P1

DR1

A

FR1

Returns(in $)

4%

1.5 M $/P$ E$/

i E$/

T T Time Time

i1=4% E1=1.5

T+1 year T+1 year

3

(A) What should be the interest rate in Australia today, i$, to maintain the par value of the exchange rate at AU$1.5 per pound ()? Explain the reason. [4 marks]

(B)Should the RBA raise or reduce the money supply in Australia today to maintain the par value of the exchange rate at AU$1.5 per pound ()? Explain the reason,. [4 marks]

(C)What should be the Australian money supply in the long-run to maintain the par value of the exchange rate at $1.5 per 1? Explain the reason. [4 marks] Hint: Use the money monetary model to solve for M