Exchange rates
Introduction
ERs play a central role in the relationships between individual economies and the global economy
all trade + financial relationships between countries mediated through exchange of currencies
- ER movements have significant impact on IC, trade flows, investment decisions, inflation, and other factors in economy
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exchange rate - price of Australia’s currency in terms of another country’s currency
price at which trade and investors can swap Australia’s currency for another currency
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ERs are necessary as exporting firms want to be paid in their own currency → importers need to convert their domestic currency into foreign currency to make payments
currency conversion occurs in foreign exchange market → forces of supply and demand OR the government, determine ER
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systems to determine ER → floating system, fixed rate system, and flexible peg
- currency union is another option for countries with similar regional interests eg. euro (currency of 19 EU members)
Australia’s floating exchange rate system
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1983 → AU switched from managed flexible peg to a floating exchange rate
- regarded one of the most important structural changes in AU economic history as it opened up the economy to global financial flows
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floating exchange rate → value of the economy's currency is determined by forces of demand and supply in FOREX markets (not govt. intervention)
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value of A$ in terms of US$ at US$0.80
- A$1 will buy US80 cents
- US$1 buys A$1.25
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demand for A$ is represented by people who wish to buy A$
supply of A$ is represented by people who wish to sell A$
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| demand for A$ affected by: | supply of A$ determined by: |
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| the size of financial flows into AU from foriegn investors who wish to invest in AU and need to convert their currency into A$ \n level of AU interest rates relative to overseas interest rates relatively ↑ Australian IR make AU a more attractive location for foreign savings and increase demand for A$ \n availability of investment opportunities in AUif there are more opportunities for overseas investors to start new businesses or buy into businesses, demand for A% will ↑ \n expectations of future movements of the A$expectations of a future A$ will increase current demand for A$ by speculators → contributing to expected appreciation \n demand for AU exports → foreigners need to convert their currency into A$ to pay for exports; demand determined by: \n changes in commodity prices + ToT → increase in commodity prices and improvement in ToT = ↑ value of AU exportsfinancial markets will respond to these changes by increasing value of the dollar with an expectation that value of exports will increase over the short to medium term \n demand for AU exports influenced by IC of domestic exports and AU’s inflation rate relative to overseas if domestic firms are competitive in global markets and our inflation rate is relatively low, AU exports will be relatively cheaper and more attractive to foreign buyers \n changes in global economic conditionsdemand for AU commodity exports highly dependant on growth rates of AU trading partners when global economy is on an upturn, demand and prices for AU exports will rise \n tastes and preferences of overseas consumers will affect demand for AU exports | level of financial flows out of AU investors who wish to invest overseas and need to sell A$ to purchase foreign currency \n level of AU interest rates relative to overseas IRrelatively lower IR will make investing savings overseas more attractive and increase supply of A$ \n \n availability of investment opportunities overseasgreater opportunities to start business overseas or to purchase shares in overseas companies will ↑ financial outflows and increase supply of $A \n speculators in FOREX market who expect value of A$ to go down will sell A$ → increasing supply of A$ and contributing to anticipation depreciation \n domestic demand for imports → AU importers who buy from overseas need to sell A$ to obtain foreign currencies and make import payments; demand determined by: \n level of domestic income → strong EG and rising incomes and employment will result in ↑ demand for imports, ↑ supply of $A \n domestic inflation rate and competitiveness of firms who compete with imports if AU domestic inflation rate is higher and import-competing firms are uncompetitive, imports will be relatively cheaper and demand for imports will be higher \n tastes and preferences of domestic consumers change over time increasing preference for g/s from overseas will raise the supply of $A on FOREX market |
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APPRECIATION
caused by an increase in demand or decrease in supply
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DEPRECIATION
caused by decrease in demand or increase in supply
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floating ER also acts as an ‘automatic stabiliser’ to help protect the economy from external booms or busts
eg. mining boom in AU from early 200s to early 2010s
- increase in demand for AU resources pushed up commodity prices, which caused A$ to appreciate
- this meant industries that did not benefit from the mining boom saw their costs increase by demand for output fall
- appreciation of A$ helped economic re-allocate labour and capital to mining sector → reducing inflationary pressures and maintaining a stable employment level within the economy
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TWI
AU has many exchange rates (one for each currency of countries where FOREX transaction are required)
- this means our ER may be appreciating against some currencies, and depreciation against others
comparison of the value of the dollar against only one currency eg. USD, can create misleading impression of trend in the value of AUD
- just as there are unique factors influencing AUD, there are also factors influencing value of USD
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Trade Weighted Index (TWI) indicates how the value of A$ is moving against all currencies in general
TWI is a measure of the value of the AUD against a basket of foreign currencies of major trading partners - these currencies are weighted according to their significance to Australia’s trade flows
currencies of the countries that are more prominent in AU trade are given higher weighting so they have a greater influence on the TWI
during last two decades, relative significance of ER with Japanese yen and USD has declined, while ER with Chinese renminbi has become more important
limitation of TWI
weighting is only based on volumes of trade regardless of the currency in which exports and imports are invoiced
AU often sells commodities in USD when trading with another country → around ⅔ of AU’s exports and around ½ of imports are priced in USD
- this means the A$/US$ ER is far more important than the weight it receives in TWI
while there are often sustained trends in TWI (eg, appreciation after 2002-03 and depreciation after 2011-12), there are also breaks in a sustained trend
- dollar depreciated in 2008-08 and appreciated in 2016-17: breaking a LT trend
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TRENDS IN AUD
2001: depreciation to US47 cents
2003-08: appreciating strongly as commodity prices increased
2009: fell sharply as GFC destabilised international currency markets (lost ⅓ of value against USD)
2011: recovered with appreciation of US$1.10
mid 2010s: began to depreciate into range between US70-80 cents
2020: COVID saw dollar depreciate to US55 cents
2011: recovered to just under US80 cents
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commodity prices have played critical role in volatility of ER
- AU’s ToT influenced by price of commodities (mineral and metal resources comprising half of all exports)
- during resources boom, commodity prices soared to over 3x pre-2003 value → ↑ demand from trade and speculative investment in AU dollar
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2000s resources boom would be a 40% increase in commodity prices in LT and 315% appreciation in AUD → the AUD will remain above pre-2003 levels for foreseeable future
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other causes for AUD recent volatility
when AU cash rate is greater than that of other advanced economies, foreign investors become more likely to invest their savings into AU
- known as ‘carry trade’ → provided strong support for AUD for last two decades
when IR have been low, this reduces demand for the currency
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Reserve Bank intervention in the foreign exchange market
the RBA sometimes plays a role in influencing the value of the currency
RBA cannot change the value of the AUD in the LT but it can smooth out swings in the dollar relating to ST factors
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dirtying the float
when RBA feels that a large ST change in the ER (possibly due to excessive speculation) will be harmful to domestic economy, it may intervene in FOREX market, as a buyer or seller, to stabilise the A$
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to prevent a rapid appreciation - RBA will sell A$
to curb a rapid depreciation - RBA will buy A$, putting upward pressure on the ER
2008 - A$ lost ⅓ of its value against USD; RBA purchased $3.3b of A$ to moderate the depreciation and provide support in the FOREX market
RBA was able to sell $3.4b of A$ in 2009 as currency recovered in value
forex interventions also generated profits that contributed to the RBA’s dividend payment to the government
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limitations
RBA’s ability to intervene through buying A$ is limited by the size of its foreign currency holdings
the sum total of RBA’s foreign currency reserves is relatively small
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monetary policy decisions
monetary policy initiatives are an indirect way of influencing the ER and are rarely used for this purpose
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to curb a rapid depreciation - may increase the demand of A$ by raising interest rates
↑ IR will attract more foreign savings, which must be converted into A$ → increase demand for A$ and put upward pressure on ER
however, this policy will only be effective for a limited time
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it is unusual to change IR to influence currency; prime focus of MP is to influence the domestic economy esp. the inflation rate
- however, ER movements may be so large that they can affect stability of economy or level of inflation
- eg. 10% depreciation leads to up to 0.5% increase in inflation for two years
Fixed exchange rate systems
before 1976 - AU operated on a fixed exchange rate system in which the A$ was pegged to the UK pound sterling, USD, and the TWI at different times
from 1976 to 1983 - AU had a variation of fixed ER known as the managed flexible peg
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fixed exchange rates
under this system, the gov. or RBA officially sets the ER (it would not be left up to supply and demand)
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gov. can attempt to maintain a fixed ER by buying or selling foreign currency in exchange of A$
in the diagram above, it would be buying the excess supply of A$ at US80 cents
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limitations
when AU operated under this system, the RBA obtained the necessary foreign reserves by insisting that all foreign exchange holdings be lodged with them
the risk with this system is that to prop up the value of the A$, the RBA would exhaust its foreign reserves by continually exchanging them for excess supply of A$ → could lead to collapse of trade in the currency
fixed ERs limits the ability of the central bank to influence IRs, used for MP
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the govt. could also ‘officially’ change the ER → so that it was closer to the real market value
it would devalue the A$ when it lowered the ER and revalue the A$ when it increased the ER
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Exchange rates and the balance of payments
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how the balance of payments influences the ER
under floating ER, quantity of A$ supplied must always equal quantity of A$ demanded
- net outflow of funds on CA (supply of A$) equal the net inflow of funds on the KAFA (demand for A$)
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if values of imports increased while exports remained unchanged → worsening the CAD → cause an increase in supply of A$ (importers will be selling more A$ to buy foreign currency) → depreciation of currency → given level of financial inflows will be able to buy more A$ → positive balance on the KAFA would increase in terms of A$ to match bigger CAD
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any other increase in outflow on the CA would most likely lead to a depreciation of the A$ and an increase in the surplus on the KAFA
improvement in the CAD would result in an appreciation of the A$ and a decrease on the KAFA surplus
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effect of BoP on ER depends on perceptions of financial markets
if financial markets are concerned that an increase in CAD is not sustainable, they may be less willing to buy AU assets → value of AUD will fall further as capital inflow in reduced
if financial markets believe the CAD is sustainable and they have confidence in AU’s future eco prospects, AUD may appreciate despite increases in CAD
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most significant influence on ER movements is how financial markets choose to react to developments in economic indicators eg. the BoP
difficult to predict reactions → results in greater instability of FOREX markets as market sentiment can quickly change
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effects of a change in the ER
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valuation effect - appreciation or depreciation of currency causes an immediate change in the AUD value of foreign debt that is borrowed in foreign currencies OR foreign assets held by Australians
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economists favour ER values that reflect the true forces of supply and demand
- these forces would result from exchanges of g/s and finance between AU and rest of the world, NOT including changes due to speculation
- speculators who b/s A$ in anticipation of a change in currency distort ER movements, and increase ER volatility
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Economic effects of exchange rate movements
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| depreciationraises domestic prices of importsreduces foreign prices of exportseffects can be ST or LToverall, a depreciation has an expansionary effect on EG by stimulating domestic output and employment | |
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| positive | negative |
| LT - enhances competitiveness of the tradable goods sector (export and import competing industries)AU g/s are more price competitive, relative to foreign produced g/s 10% real depreciation can lead to a 4% increase in exports in the LT → help reduce CAD \n may induce higher levels of capital inflows into AU economy as domestic assets become cheaper than relative foreign assetsmay help reduce level of foreign debt (less debt borrowings), and increase foreign direct and portfolio investment into AU \n may lead to structural adjustment and greater competitiveness in industry eg. depreciation of AUD in early 1990s assisted the growth of manufactured and service exports (eg. financial and business services) → rose by 25% between 1987 and 1993, particularly to fast growing Asian region | ST - depreciation raises the price of imports and reduces price of exports lead to lower export income from the sale of a given volume of X, but raise cost of given volume of Mlower X revenue and higher M expenditure om the ST will worsen goods balance and increase size of CAD (‘J-curve’) \n may lead to higher domestic inflation through higher import priceschanges to operation of monetary policy by using inflation target of 2-3% helped to contain ‘depreciation-induced’ imported inflation microeconomic policies eg. enterprise bargaining, has made the economy more flexible in dealing with currency shocks and ST price effects \n increases the value of net foreign debt denominated in foreign currencies about 60% of AU net foreign debt is denominated in foreign currencies, but most is hedged back into AUD \n \n \n \n depreciation will raise the debt servicing ratio (interest repayments on foreign debt as percentage of X income)↑ interest repayments overseas could lead to ↑ NPY deficit and CAD \n a large depreciation could lead to RBA indirect intervention to support the ER through ↑ IRs to reduce demand for imports and encourage capital inflow this could lead to lower EG and levels of private investment spending, causing ↑ UE |
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| appreciationlowers domestic prices of imports raised foreign prices of exports appreciation of ER has a contractionary effect on the economy reducing IC, domestic output, employment, and EG | |
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| positive | negative |
| ST - lowers price of imports and increases price of exports higher export income from a sale of a given volume of exports + lower import expenditure from a given volume of imports → in the short run will improve goods balance (X-M) and reduce the CAD \n may lead to lower domestic inflation through lower import prices raise the real incomes of consumers → can improve living standards through access to greater volume and variety of cheaper imports - compared to domestic products \n \n \n reduces value of the net foriegn debt denominated in foreign currencies against which the AUD has appreciated \n reduce debt servicing ratio → lower interest repayments could lead to lower NPY deficit + reduce the size of CAD | LT - reduces the competitiveness of tradable goods sector, by making AU g/s less price competitive relative to foreign g/scould reduce export income and increase import expenditure in the LT, worsening CAD \n lead to higher levels of capital outflow from AU as domestic assets are more expensive and less attractive relative to foreign assetsmay decrease FDI or portfolio investment in AU, reducing rate of EG \n appreciation may lead to higher UE in export and import competing industries - restructuring economy to become more internationally competitive \n \n large appreciation may lead to RBA intervening to reduce ER by lowering IRs + reduce demand of AUD lower IR structure could lead do higher EG and investment - also could cause inflation to rise |
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| appreciation | individuals | businesses | government |
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| good | costs of imports reduce in AUD terms → more importers bring more and different products into the economy → ↑ choice and utility \n costs of items with global prices eg. electronics will reduce, ↑ purchasing power for domestic consumers \n enables cheaper overseas travel | intermediate goods are cheaper to use in production → assist IC for those industries \n cheaper inputs for machinery and technology capital goods eg. mining companies purchasing equipment for less | CAD improves as a result of valuation effect and downwards pressure on inflation |
| bad | if individuals are employed in import-competing businesses, or exporting businesses, the reduction in IC arising from appreciation may lead to ↑ UE eg. domestic manufacturing, | decreased IC for import competing and exporting businesses → reducing profits | GDP slows (M increases, X decreases) \n UE increases, social welfare increase, tax receipts decrease |
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effect of exchange rate movements on domestic macroeconomic goals and the current account balance
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| exchange rate can act as an aggregate demand factor, affecting levels of net export spending (X-M) and economic activityexchange rate can act as an aggregate supply factor, affecting international competitiveness | |
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| inflation | RBA and gov try to pursue the goal of low inflation - keeping inflation rate between 2-3% annually over the business cycle exchange rate fluctuations can affect the rate of demand inflation and/or cost inflation \n demand-pull inflationoccurs when there is excessive and strongly rising spending in an economy → boom conditions with widespread shortages of g/sa falling A$ can further stimulate exports while depressing imports when value of net exports rises, and there is already low UE, stocks fall and firms cannot readily replace them → leading to shortages and hence demand inflationa rising A$ tends to reduce net exports, slow AD, and cause unplanned rise in stocks → widespread price discounting will slow inflation \n cost-push inflationoccurs when production costs rise, eroding business profitsfirms are forced to pass on higher costs to consumers, so prices risea falling A$ can add to cost inflation, because many local firms need to purchase imported equipment and materials a rising A$ will make costs for some local producers cheaper, allowing firms to cut prices to compete, and easing cost inflation \n |
| economic growth | gov. seeks to promote the macro goals of a strong and sustainable rate of economic growth keeping the GDP increasing at the fastest rate that is economically and environmentally sustainable (around 3%)fluctuations in the ER can influence EG by affecting the level of AD and/or AS \n changes in A$ can alter AD by affecting net export spending, and hence the level of economic activity a weaker A$ will tend to boost overseas spending on exports, while slowing spending on imports → firms will lift production as AD increases, accelerating the rate of EG a stronger A$ will slow net exports and weaken AD, causing stocks to rise and output to be cut \n changes in the A$ can make conditions for local businesses either more or less favourable, affecting productive capacity and the potential rate of economic growth a lower A$ will be less favourable for those firms importing materials and equipment as they face higher productive costs and lower profits → possibly leading to business closures → reduced capacity and slowed EGthese may be offset since a weaker ER also makes some businesses more competitive in domestic and global markets \n stronger A$ - goods for firms importing materials and equipment as it reduces costs and stimulates growth makes local businesses that do not import less competitive → lower rate of EG |
| employment and UE | changes in the ER can affect rates of cyclical and structural unemployment ER can affect net exports, production, the demand for resources and unemploymentby boosting exports and slowing imports, a weaker A$ helps to accelerate AD → causing firms to lift production and employ more labour → decreasing cyclical UErising A$ slows net exports and AD, leading to firms cutting output and employment \n A$ can alter production costs and our international competitiveness lower A$ means dearer imports and higher production costs for some firms → reducing their profits and possible leading to closures and structural UEthis may be offset by improved competitiveness for other local businesses, leading to fewer closures and less UE \n \n |
| current account balance | Australia’s current account records transactions between Australia and the rest of the world - BOGS, NPY, NSYAU typically runs a CADfluctuations in A$ can affect the size of our CAD through value of imports/exports, and through value of primary income credits or debits \n value of exports and imports of g/schanges in the A$ affect price, attractiveness, and value of AU’s exports and imports \n a fall in A$ makes exports of goods and services (eg. minerals, tourism) relatively cheaper to overseas buyers in terms of their currency → value of our export sales rise, causing CAD to shrink makes imports of goods and services (eg. oil, cars, electronics) more expensive in terms of our currency → tends to slow purchases of imports, reducing debits and decreasing CADST - depreciation raises the price of imports and reduces price of exports lead to lower export income from the sale of a given volume of X, but raise cost of given volume of Mlower X revenue and higher M expenditure om the ST will worsen goods balance and increase size of CAD (‘J-curve’)LT - enhances competitiveness of the tradable goods sector (export and import competing industries)AU g/s are more price competitive, relative to foreign produced g/s 10% real depreciation can lead to a 4% increase in exports in the LT → help reduce CAD \n \n a rise in A$ exports of g/s become dearer, reducing the value of sales, while imports become cheaper, increasing purchases → increasing the CAD ST - lowers price of imports and increases price of exports higher export income from a sale of a given volume of exports + lower import expenditure from a given volume of imports → in the short run will improve goods balance (X-M) and reduce the CAD \n may lead to lower domestic inflation through lower import prices raise the real incomes of consumers → can improve living standards through access to greater volume and variety of cheaper imports - compared to domestic products LT - reduces the competitiveness of tradable goods sector, by making AU g/s less price competitive relative to foreign g/scould reduce export income and increase import expenditure in the LT, worsening CAD \n \n value of primary income credits and debits changes in the A$ alter the cost and attractiveness of overseas capital inflow and outflow associated with buying and selling assets o/s \n fall in A$makes purchase of shares and property, denominated in AUD, cheaper and more attractive for non-residents may induce higher levels of capital inflows into AU economy as domestic assets become cheaper than relative foreign assetsmay help reduce level of foreign debt (less debt borrowings), and increase foreign direct and portfolio investment into AU \n increases the value of net foreign debt denominated in foreign currencies about 60% of AU net foreign debt is denominated in foreign currencies, but most is hedged back into AUD \n depreciation will raise the debt servicing ratio (interest repayments on foreign debt as percentage of X income)↑ interest repayments overseas could lead to ↑ NPY deficit and CAD \n \n increasing net capital inflow and foreign liabilities → adds to primary income debits involving dividends, rent, and profit abroad → widening the CAD dearer and less attractive for AU investors to purchase foreign assets (denominated in foreign currencies) → in the LT, this may add to our CAD by slowing down primary income credits \n rise in A$encourage capital outflow associated with purchase of o/s assets by AU residents reduces value of the net foreign debt denominated in foreign currencies against which the AUD has appreciated \n reduce debt servicing ratio → lower interest repayments could lead to lower NPY deficit + reduce the size of CADlead to higher levels of capital outflow from AU as domestic assets are more expensive and less attractive relative to foreign assetsmay decrease FDI or portfolio investment in AU, reducing rate of EGassets become relatively cheaper if denominated in foreign currencies in LT, this could lead to higher primary income credits, while discouraging foreign capital inflow and primary income debits → reduction in CAD |
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