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Homework answers / question archive / Graph the demand for and supply of Australian dollars for euros and label each axis
Graph the demand for and supply of Australian dollars for euros and label each axis. Show graphically and explain the effect of an increase in Australian government budget deficits that increase Australian interest rates on the demand for and supply of dollars and the resulting change in the exchange rate of euros for Australian dollars. Why might the change in the exchange rate lead to a current account deficit?
Answer: We can show the demand and supply of Australian dollar for Euros. In the following diagram we can show the demand and supply of Australian dollar.
In the above figure in the vertical axis we measure the exchange rate of Australian dollar with Euro. In the horizontal axis we measure the quantity of Australian dollar traded in the market. The initial equilibrium is at E0, where demand for Australian dollar and supply of Australian dollar intersect each other. The initial exchange rate (Aus$/€)0 and initial quantity of Australian dollar traded is Q0.
In this situation we take the situation where Australian government increase the budget. It means Australia increase their government spending and as a result of increase in government spending the domestic rate of interest will increase. It is because Government wants to meet the budget deficit through selling government bonds. This selling of government bonds increase the supply of bonds which reduces bond prices and that results increase in interest rate.
As a result of increase in domestic interest rate more people want to invest in Australia because of higher rate of return in Australia. As more people in Europe wants to invest in Australian dollar the demand for Australian dollar will increase. As a result of increase demand of Australian dollar the the demand for Australian dollar will shift rightward. In the following diagram we can show this scenario.
In the above diagram initial equilibrium is at E0 similar to above. The new demand of Australian dollar has been shown by D1. Now D1 and initial supply i.e S0 has intersect each other at E1. So new equilibrium is at E1. Corresponding to equilibrium point E1, the new exchange rate is (Aus$/€)1 . The amount of Australian traded is Q1.
We get the new exchange rate (Aus$/€)1 is higher than (Aus$/€)0 and new quantity of Australian dollar traded Q1 is larger than before. As a result of increase in Australian exchange rate i.e as a result of appreciation of Australian dollar and in another way we can say after the depreciation of Euros for Australian dollar there will be an impact on export and import in Australia.
Due to appreciation of Australian dollar the exchange rate of Euros will decrease i.e there will be depreciation of Euros. It will result in increase in import from Eurozone to Australia and decrease the export from Australia to Eurozone. As import increases because of goods and services cheaper in Eurozone area due to depreciation of Euro and export will be costlier from Australia because there need to pay more Euros. So this increase in interest rate generating the current account deficit in Australia by increasing import and decreasing export. The fall in export and increase in import means there will be current account deficit in Australia.
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