In the previous question, the Australian interest rates increased from 6 to 11 percent. According to the IFE, what is the underlying factor that would cause such a change? Give an explanation based on the IFE of the forces that would cause a changein the Australian dollar. If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain.
According to the IFE, the increase in interest rates by 5 percentage points reflects an increase in expected inflation by 5 percentage points.
If the inflation adjustment occurs, the balance of trade should be affected, as Australian demand for U.S. goods rises while the U.S. demand for Australian goods declines. Thus, the Australian dollar should weaken.
If U.S. investors believed in the IFE, they would not attempt to capitalize on higher Australian interest rates because they would expect the Australian dollar to depreciate over time.