What is the exchange rate?
the price of one country’s currency in terms of another country’s currency
What is the trade weighted index?
a basket of currencies weghted according to their importance in trade flows within Australia
ADD DIAGRAMWhat is the foreign exchange market and foreign exchange? Describe in terms of Australia and the US
foreign exchange market:the market in which currencies of different countires are bought and sold
foreign exchange: is the exchange of another currency that is needed to carry out international transactions
- between Australia and US $ there are two groups of people
- those demanding US $ - an Aus importer of US g & s
- those demanding $A - an American buyer of Aus g & s
- demand for $US is matched by a supply of Australian dollars and vice versa
- in the example, the foreign excahnge market is made up of two sub-markets (i.e. an depreciate)
- if Aus increases its imports from the US, there will be an increase in the supply of $A and an increase in demand for $US. The $A will depreciate, the US will appreciate
What is appreciation and depreciation?
appreciation: if one unit buys more units of another currency
depreciation: if one unit buys less units of another currency
How are the exchange rate and balance of payments related?
the balance of payments records all international transactions while the exchange rate is the means by which these transactions are facilitated
- the fundamental factors underlying the value of a country’s exchange rate are determined by the state of its balance of payments
How are international transactions interrelated with the balance of payments?
- the demand for and the supply of a currency are determined by the international transactions that are recorded in the balance of payments
- demand for a country’s currency are represented by credits in both the current account and CaF account
- supply of a country’s currency are represented by debits in both the current account and CaF account
ADD DIAGRAMWhat are the determinants of the demand for and supply of currency?
demand for currency:
- exports of g & s
- receipts of income from overseas
- capital inflow - foreign investment
supply of currency:
- imports of g & s
- payment of income to overseas
- capital outflow - investment abroad
What is a floating exchange rate?
one whose value is determined by the market forces of supply and demand. Simply, the equilibrium price will change whenever the demand or the supply curves shift
- a floating exchange rate will mean that the total balance of payments will always balance. This is because with a free exchange rate the demand for currency (sum of credits) equals the supply of the currency (debits sum)
What is a clean float and what is a managed exchange rate?
clean float: when the currency is allowed to float free from the interference of the central bank
managed exchange rate: occurs whenever there is official intervention in the foreign exchange market by the Reserve Bank
What occurs if there is an increase in the supply/demand of $A and why?
increase in the supply of $A: lead to a decrease in value of the $A, due to
- increase in demand for Australian exports
- increase of foreign investment into Aus
- increase in income receipts from overseas residents
increase in the demand for $A: lead to an increase in value of $A, can be due to
- increase in spending on imports
- increase in foreign investment to foreign countries
- increase in income payments to overseas residents
What are methods of affecting the exchange rate?
- The RBA can act as either a buyer or seller of the currency: indirectly influencing it rate through the market system
- to prevent the exchange rate from falling to too low a level: RBA would enter market as a buyer of $A uses it reserves of foreign exchange to bid up the price
- to stop the currency from appreciating: it would sell $A, increasing the supply and hence reducing any upward pressure on the exchange rate
- Monetary policy: used to set short term interest rates
- if interest rates are increased, then foreign investment will be attracted to the Aus economy, increasing the demand for $A and appreciating the currency
What is a dirty float v. lightly managed float?
dirty float: whenever the central bank intervenes in the foreign exchange market to influence the movement of the currency/set its value in a particular ‘range’
lightly managed float: what the RBA claims to do, only entering the foreign exchange market occasionally with a view to ‘testing and smoothing’ the underlying trend in the exchange rate
What are the advantages of a free exchange rate and the balance of payments
- changes in demand and supply will be reflected by changes in prices, avoiding shortages and surpluses
- provides automatic adjustment in the balance of payments. The balance of payments will always balance as the exchange rate varies to change the prices of traded g & s and financial capital i.e. if there is an excess supply of $A, then a depreciation will raise the prices of imported g & s in foreign currencies. This will automatically help remove the excess supply.
- balance of payments does not affect the domestic money supply and this is highly desirable because it means that monetary policy will be more effective
- helps to reduce swings in the current account balance. Known as the J curve effect - swings in the current account depend on elasticity. If the demand for exports/imports were price inelastic, then a price change would have little effect on the quantities traded so that a depreciation may not initially reduce trade. However, if the depreciation is large enough, the price effects will over time cause net exports to increase, reducing the trade deficit. Usually a rise in the CAD will lead to an exchange rate depreciation, increasing the price of imports and decreasing the price of exports. Demand for imports should fall and demand for exports should increase assuming demand is elastic, reducing the CAD. If demand is relatively inelastic, a rise in import $ may actually lead to an increase in import payments. Similarily if export $ rise, then lower prices may initially decrease export receipts. The result is that a depreciation may increase the CAD
- can help to insulate the domestic economy from external shocks
- currency depreciation - helps to hield economy from a negative external shock i.e. GFC. Reduces the prices of Australia’s exports and provides Aus exporters with a competitive advantage in overseas markets. Has an expansionary effect on the economy, which can help insulate it from an overseas recession
- currency appreciation - helps to shield the economy from positive external shocks i.e. increased economic growth in China and India boosting world commoditt prices, causing Aus mining boom. This increased mining investment, raised national income and wages. This would normally lead to high inflation, but the high $A helped to slow the economy by inducing export prices and reducing import prices. The non-mining sector of the economy was weakened by the high dollar and this reduced inflationary pressures as well
What are the disadvantages of a free exchange rate and the balance of payments?
the major disadvantage of free exchange rates is that they increase the degree of uncertainty for buyers and sellers and uncertainty effectively increases the cost of international transactions. Exporters may be unsure of how much money they will receive when they sell abroad/what their price will be. Importers will also feel not certain how much it is going to cost them to import a given amount of foreign goods
What are factors affecting the exchange rate?
- 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 have a negative influence on the exchange rate
- movements in the terms of trade - when the t.o.t improve, the curency appreciates and vice versa
- domestic economic growth - strong economic growth in Aus leads to an increase in demand for imports (investment + consumption) leads to a currency depreciation
- world economic growth - a pick up in the world economy leads to an increase in demand for AUstralia’s major exports of commodoties increases commodity prices and demand for $A leads to currency appreciation
- relative interest rates (interest rate differential) - if interest rates in Australia are higher than elsewhere, especially the US, then foreign investment will increase and appreciate the currency
- international capital flows - if investors found Aus to be a relatively more attractive destination for their funds compared to other economies then the $A would appreciate
What are key factors affecting the Australian dollar?
Commodity prices
- commodities make up 67% of Aus exports, changes in these prices have a significant effect on export values and ultimately on Aus national income (exports contribute about 20% of GDP)
- there is a strong positive correlation between movements in commodity prices of the $A. A general increase in commodity prices, ceteris paribus, will result in an appreciation of the $A
Interest rate differential (with the US)
- measured by the difference in each rates between 2 countries, an increase in the IRD will lead to, ceteris paribu, an inflow of foreign investment as international investors seek out the highest returns for their funds which leads to an increase in demand for $A and an appreciation
ADD GRAPHHow would an exchange rate appreciation occur and what are the effects?
Situation 1
cause: increased demand
- increased exports
- increased income credits
- increased capital flow
- higher terms of trade
- higher IRD
- lower relative inflation
- improvement in international competitiveness
Situation 2
cause: decrease in supply
- decreased imports
- decreased income credits
- decreased capital outflows
What are the costs and benefits of a currency appreciation?
costs
- Aus exports become more expensive to overseas buyers
- domestic manufacturers and retailers are disadvantaged because consumers are attracted to low priced imports
- contractionary effect on economy as it will reduce exports and decrease aggregate deman
- reduces trade surplus/increases trade deficit - CAD increase
benefits
- reduction in price of overseas goods to Australian producers and consumers
- reduced travel costs for AUstralians
- reduces inflation rate by reducing prices of imports
What are the costs and benefits of a currency depreciation?
costs
- consumer must pay higher prices for imported goods
- can be inflationary because the higher priced imports increase CPI and net exports which will boost national income thereby increasing spending in the economy
benefits
- economy receives a competitive advantage through the relative price effects on exports and imports. Aus exports fall while AUs imports in $A rise
- encourages resources to flow into the traded goods industries - both export adn import competing indutries
- increases exports, decreases imports, increases aggregate demand, reducing CAD
- benefits Australian exporters and domestic producers competing against imports
