(30 marks)Imagine that Australia and the US are the only 2 countries in the world. The demand for and supply of Australian dollars is given by:

= 20,0005,000+ 10,000( )

= 10,000 + 2,00010,000( )

whereis Australia's nominal exchange rate measured as $US per $A;is Australia's real interest rate andis the US real interest rate. Assume that, initially, Australia's real interest rate is 10% and the US real interest rate is 5%.

Calculate Australia's equilibrium nominal exchange rate and the quantity of $A traded.(4 marks)

Say Australia fixes its exchange rate at=5. What action must the Reserve Bank of Australia

where all quantities are measured in Australian dollars ($A).

3

(RBA) take in the foreign exchange market in order to maintain this fixed rate? Assume all else

remains unchanged.(5 marks) c. If the Reserve Bank of Australia does not engage in the foreign exchange market actions used in

solutions from parts (a), (b) and (c). In words, explain the move from the flexible exchange rate

part (b), what monetary policy action would it have to take in order to maintain the fixed exchange rate specified in part (b)? Calculate the quantity of $A that would be traded. Also assume that the US Central Bank does not alter its monetary policy in response to the RBA's monetary policy action.(5 marks)

d. In one foreign exchange market diagram of the $A (i.e. ploton the vertical axis), illustrate the

equilibrium in part (a) to the equilibria in part (c).(6 marks) e. Assume that the national savings (NS) and investment (I) functions for Australia are given by:

= 1000 + 2000+ 500

= 5000500500

i. Calculate Australia's capital account balance, current account balance and balance of payments and, when the $US-$A exchange rate is fully flexible(5 marks)

ii. Calculate the Australian capital account balance, balance of payments and current account balance, when the exchange rate is maintained at=5as in part (b) above.(5 marks)