Exchange Rates

Note: Questions about sectors, sector questions rely on elasticity to be mentioned.

• Also note trade weighted index has not been tested for a few years so it may pop up

An exchange rate is simply the price of one country’s currency in terms of another country’s currency.

Foreign Exchange Market

Foreign Exchange (Forex) - Used to describe foreign currency

The foreign exchange market is the market in which the currencies of different countries are bought and sold:

• Foreign exchange is the currency of another country that is needed to carry out international transactions
• The foreign exchange market between Australia and US consists of 2 groups of people: those demanding US dollars - an Australian importer of US goods; and those demanding Australian dollars – an American buyer of Australian goods.
• Demand for US dollars is matched by a supply of Australian dollars, while a demand for Australian dollars is matched by a supply of US dollars
  • I am an American buyer for Australian goods. I have American dollars with me. I go to the forex market, and sell my USD in exchange for AUD. Increases demand for AUD and increases supply of USD.
• An Australian farmer selling wheat wants to be paid in Australian dollars, while an American computer manufacturer prefers to receive US dollars.
  • Every seller wants to receive their own currency

Exchange Rates are almost always linked to trade balance.

We will focus on floating exchange rates:

• There are two basic methods for determining the price of a country’s currency – by allowing the market forces of supply and demand to freely set the value OR by artificially setting the price at a fixed rate.
• Australia has a floating exchange rate resume
• To influence exchange rates, the central bank may buy/sell currency to change the exchange rates.
  • When the currency is allowed to float free from the interference of the central bank (RBA), then it is referred to as a clean float
  • Whenever the central bank intervenes in the foreign exchange market to influence the movement of the currency, or to set its value in a particular ‘range’ then it is rereferred to as a ‘dirty float’.
• The reserve bank can indirectly lower the exchange rate by simply reducing interest rates - this would reduce the demand for the currency
• On the other hand, increasing the interest rates (by increasing the cash rate), more investments will be done (by foreign investors) as it is more appealing (more returns)

Australia’s Exchange Rate Resume

• The reserve bank of Australia claims that it only enters the foreign exchange market occasionally with a view to ‘testing and smoothing’ the underlying trend in the exchange rate
• This is sometimes referred to as a lightly managed float. (Answer in assessment as freely floating)

All transactions that result in an inflow of money into the Australian economy, in both the current account and the capital and financial account, represent a demand for a country’s currency

Transactions that result in an outflow of money, on the other hand, represent the supply of a country’s currency

Most international transactions are contracted in one of the key world currencies, for example, USD, Japanese Yen, Pounds Sterling (GBP) or the Euro (EURO).

• In terms of Australia’s Trade, around two thirds of exports and one half of imports are contracted in USD - The remainder of Australia trade is contracted in AUD
• Don’t get confused, for test purposes use AUD for Australia’s goods.

The Demand for a currency will be determined by:

1. Exports of goods and services
2. Receipts of income from overseas; and
3. Capital inflow (foreign investment into Australia)

The Supply of a currency will be determined by:

1. Imports of goods and services;
2. Payments of income to overseas; and
3. Capital outflow

Changes in BOP transactions involving goods, services, income or financial capital, will affect either the demand and/or supply of the currency and thus affect it’s value.

Exchange Rate & BOP

By leaving markets to adjust to changes in market conditions, shortages and/or surpluses are avoided

• A freely floating exchange is a perfect example of a competitive market where the price fluctuates in response to changes in the demand and supply of the currency.
• If there is an excess supply of AUD, the depreciation will raise the prices of imported goods and services in the domestic currency and lower the prices of exported goods and services in foreign currencies - This will automatically help remove the excess supply.

Exchange rate depreciate, makes our exports more competitive in foreign markets

• Trade Balance decrease, exchange rate depreciate, increase price of imports but also increased competitiveness in foreign markets, demand for imports should fall thus reducing the current account deficit.

Exchange rate appreciate, makes our imports more expensive to purchase in domestic markets

• Trade Balance increases, exchange rate appreciates, decrease price of imports but also decreased competitiveness in foreign markets, demand for imports should rise thus increasing the current account deficit.

Depreciation -> Improves Current Account Appreciation -> Decreases Current Account

TWI (Trade Weighted Index)

The TWI is a weighted average of a basket of currencies that reflects the importance of Australia’s trade by country.

• Measures the Australian dollar against a group of other currencies other than one other currency
• The most important currencies in Australia’s TWI are the Chinese renminbi, the Euro, the US dollar and the Japanese yen.
• It is important to remember though, that the TWI does not fluctuate as much (it is less volatile) since it is an average of Australia’s major trading currencies.

In 2022, the US increased their interest rates so our exchange rate against US decreased

Factors Affecting Exchange Rate

Anything that affects the demand/supply of the AUD (or any other currency) with affect the exchange rate

• Movements in the Terms of Trade (and commodity prices)
  • This has a major influence on Australia’s exchange rate. The AUD is known as a commodity currency because Australia’s exports are dominated by commodities such as iron ore, coal and natural gas. When the terms of trade increase (or commodity prices), the D(AUD) increases and the currency appreciates
• Relative Interest Rates (the interest rate differential)
  • If interest rates in the United States rise relative to Australia, then there will be a decrease in capital inflow to Australia and an increase in capital outflow. This means the S(AUD) will increase causing a strong currency depreciation
• Relative Inflation Rates
  • Inflation reduces the competitiveness of industries in the traded goods sector. A high inflation rate relative to other countries is likely to decrease the exchange rate – the D(AUD) will decrease while the S(AUD) will increase.
• International Capital Flows
  • If investors believe Australia to be a relatively more attractive destination for their funds compared to other economies then D(AUD) will increase and the Australian dollar would appreciate
• Domestic Economic Growth (Less influence since volume of imports is less than that of exports… aus economy much smaller than the global economy)
  • Strong economic growth in Australia will lead to an increase in demand for imports, which will increase the S(AUD) causing a currency depreciation; but at the same time, a stronger economy will attract foreign investment which will increase the D(AUD) increasing the exchange rate
• World Economic Growth
  • An increase in global GDP (esp. our trading partners such as China), increase the national income. increasing the demand of our exports, which part of it are commodities, which increases the D(AUD) and appreciates the currency

Commodity Prices is the first key driver of Australia’s exchange rate.

The second key driver is Australia’s interest rate differential with the United States.

• Fall in Australia’s interest rate differential with the US should cause the AUD to depreciate.
• Interest rate differential affects the flow of foreign investment between countries.
  • International investors seek out the highest return for their funds

Effects of Exchange Rate Movements

Currency Depreciation

One advantage to an economy is that a depreciation bestows a competitive advantage through the relative price effects on exports and imports.

The prices of Australian goods and services in foreign currency (Australian exports) fall while the prices of overseas goods and services (Australian imports) in Australian currency rise.

The depreciation will encourage resources to flow into the traded goods industries – both export and import competing industries.

• Import competing industries are domestic industries that are selling the same item that are made overseas

A depreciation should increase exports and decrease imports, increasing aggregate demand in the economy.

Hence, a depreciation can work to reduce a trade deficit or increase a trade surplus.

A depreciation is therefore good news for Australian exporters and domestic producers who compete against imports.

• At the same time, a deprecation hurts consumers since they must pay higher prices for imported goods such as cars, petrol, household appliances and overseas travel
• A depreciating currency is also potentially inflationary because the higher priced imports feed into the consumer price index (cost push inflation)
• At the same time the increase in net exports will have an expansionary effect on the economy, increasing income and spending which may increase demand pull inflation.

Currency Appreciation

An appreciation harms Australian exporters because it results in Australian exports becoming more expensive to overseas buyers.

• At the same time, an appreciation reduces the prices of overseas goods to Australian producers and consumers
• Domestic manufacturers are disadvantaged because consumers are attracted to lower priced imports
• But many Australian businesses that sell imported goods will benefit, such as department stores (Myer, David Jones) white goods-goods retailers (Harvey Norman, the Good Guys), and electronic stores, (JB Hifi, Officeworks)

Australian wishing to travel overseas are always pleases when they see the Australian dollar appreciating helping to reduce their travel costs.

• An appreciation is therefore likely to decrease the trade balance.
• An appreciation will have a contractionary effect on the economy because it will reduce net exports and decrease aggregate demand, and reduces national income, Ec Growth, GDP, Employment
• At the same time, an appreciation will reduce the inflation rate by reducing the price of imports.