Reference no: EM133057344

There are only two countries in the World: Canada and Australia. 

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 Canada.

Consider the Australian Dollar vs. Canadian  Dollar exchange rate:

1. What can you tell about the relationship between spot and forward rates based on the information above?
2. Suppose inflation and inflation expectations increase markedly in the Canada, and this prompts a monetary policy intervention from the the Bank of Canada on domestic rates, but the RBA does not change policy. How is this likely to affect the value of the Canadian dollar relative to the Australian Dollar in the long run? Explain.
3. What will this mean for the Australian Trade Balance from now on and for capital flows into Australia? Explain.
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.