Suppose that the annual growth rate of nominal money supply is 1% in New Zealand and 5% in the Australia, and the annual growth rate of real GDP is 2% in New Zealand and 4% in Australia. According to the monetary model of exchange rate, the New Zealand dollar would __________ against the Australian dollar on an annual basis in the long run.
Question
Suppose that the annual growth rate of nominal money supply is 1% in New Zealand and 5% in the Australia, and the annual growth rate of real GDP is 2% in New Zealand and 4% in Australia. According to the monetary model of exchange rate, the New Zealand dollar would __________ against the Australian dollar on an annual basis in the long run.
Solution
The monetary model of exchange rate suggests that the exchange rate between two countries is determined by the supply and demand for money in those countries. According to this model, if the money supply grows faster than the real GDP, the currency will depreciate, and if the money supply grows slower than the real GDP, the currency will appreciate.
Here's how to determine the direction of the New Zealand dollar against the Australian dollar step by step:
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First, calculate the excess money supply growth in each country, which is the growth rate of the money supply minus the growth rate of real GDP. In New Zealand, the excess money supply growth is 1% (the growth rate of the money supply) minus 2% (the growth rate of real GDP), which equals -1%. In Australia, the excess money supply growth is 5% (the growth rate of the money supply) minus 4% (the growth rate of real GDP), which equals 1%.
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Then, compare the excess money supply growth in the two countries. If the excess money supply growth is higher in one country, the currency of that country will depreciate against the other country's currency. In this case, the excess money supply growth is higher in Australia than in New Zealand.
Therefore, according to the monetary model of exchange rate, the New Zealand dollar would appreciate against the Australian dollar on an annual basis in the long run.
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