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In the past year inflation has been increasing in many countries. For simplicity, assume that there are only two countries in the World: Australia and the US. Their central banks adjust monetary policy rates to control inflation.

However, inflation has recently grown significantly, from 3.5% to 5.1% in Australia and from 4.7% to 8.5% in the United States.

The (nominal) short-term policy rates have been raised recently from 0.10% to 0.85% in Australia and from 0.25% to 0.75% in the USA.

Consider the Australian Dollar (AUD) vs. the US Dollar (USD) and assume, for simplicity, that all the the rates in this long question are all annual:

What can you tell about the relationship between spot exchange rate and 1 year forward exchange rate based on the information about nominal interest rates alone? Explain your reasoning in words. (5 points)

Calculate the (approximate) real interest rate in both countries and the real interest rate differential between Australia and the United States before and after the increase of inflation and interest rates. Compare the two countries and describe the change. (5 points)

Suppose that, going forward, the Federal Reserve further increases the policy rate but the RBA does not change its policy rate. How is this likely to affect the exchange rate between the Australian Dollar and the US Dollar (after the further increase of policy rates in the United States)? Explain. (5 points)

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. (5 points)

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