There are only two countries in the World: Australia and the United States. Their central banks set inflation targets around 2% and typically adjust monetary policy rates to reach these targets. However, in the past few months, significant concerns have emerged due to the increase of inflation above 2%, and inflation expectations are currently trending upwards in both countries. The (nominal) short-term policy rates are at 0.10% in Australia and at 0.25% in the United States.

Consider the Australian Dollar vs. US Dollar exchange rate:

1. What can you tell about the relationship between spot and forward rates based on the information above? (1 point)

2. Suppose inflation and inflation expectations increase markedly in the United States, and this prompts a monetary policy intervention from the Fed on domestic rates, but the RBA does not change policy. How is this likely to affect the value of the US dollar relative to the Australian Dollar in the long run? (2 points)

3. What will this mean for the Australian Trade Balance from now on and for capital flows into Australia? Explain briefly. (2 points)

4. 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. (3 points)