Imagine inflation in Australia is rising at a much faster rate than in China, making Chinese products relatively cheaper for Australians and other foreigners. Which of the following effects is likely?

Question

BlackTom AI · Accepted Answer

Relative price changes driven by differing inflation rates determine demand for currencies. If Australian inflation rises much faster than Chinese inflation, Australian goods become relatively more expensive while Chinese goods become relatively cheaper to both Australians and other foreigners.

Step-by-step reasoning:
1. Higher Australian inflation → Australian-produced goods and services cost more in nominal terms compared with Chinese goods. This reduces demand for Australian exports and increases demand for Chinese exports from buyers who substitute toward cheaper Chinese products.
2. To buy more Chinese goods, foreigners (including Australians) must obtain Chinese currency (or transact in a currency tied to Chinese trade). That raises the demand for the Chinese currency.
3. Increased demand for Chinese currency relative to the Australian dollar drives up its price (nominal appreciation). Simultaneously, weaker demand for Australian goods reduces demand for the Australian dollar, causing it to depreciate.
4. This outcome is consistent with purchasing power parity intuition: a country with higher inflation tends to see its currency weaken relative to countries with lower inflation.

Why (a) is correct:
- Because cheaper Chinese goods cause higher demand for the Chinese currency, the Chinese currency appreciates relative to the Australian dollar.

Why the other options are incorrect:
- (b) The Australian currency will appreciate: incorrect — higher Australian inflation makes AUD less competitive, so it tends to depreciate, not appreciate.
- (c) Foreigners will buy more Australian exports, and less Chinese exports: incorrect — the opposite substitution occurs; cheaper Chinese goods mean foreigners buy more Chinese exports.
- (d) Australia will sell more exports to China: incorrect — with Australian goods relatively more expensive, Australia is less likely to increase exports to China.

Final confirmation: The correct answer is (a) The Chinese currency will appreciate.

Imagine inflation in Australia is rising at a much faster rate than in China, making Chinese products relatively cheaper for Australians and other foreigners. Which of the following effects is likely?Single choice

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