In the past year inflation has been increasing in many countries. For simplicity, assume that there are only two countries in the World: Australia and the US. Their central banks adjust monetary policy rates to control inflation.

However, inflation has recently grown significantly, from 3.5% to 5.1% in Australia and from 4.7% to 8.5% in the United States.

The (nominal) short-term policy rates have been raised recently from 0.10% to 0.85% in Australia and from 0.25% to 0.75% in the USA.

Consider the Australian Dollar (AUD) vs. the US Dollar (USD) and assume, for simplicity, that all the the rates in this long question are all annual:

1. Suppose that, going forward, the Federal Reserve further increases the policy rate but the RBA does not change its policy rate. How is this likely to affect the exchange rate between the Australian Dollar and the US Dollar (after the further increase of policy rates in the United States)?

2. Explain in your own words the information provided by the Big Mac Index in relation to one of the theories of exchange rate determination studied in the course, as well as the possible limitations of this index. (5 points)