Exchange Rates

13.
Exchange Rates
Definition
The exchange rate is referred to as the Australian Dollar (AUD)
The exchange rate is the rate at which one countrys currency exchanges
for that of another country.
An exchange rate shows the value of one currency in terms of another
currency. ie how much foreign currency is paid for one AUD?
The Need for Exchange Rates
nternational !ayments" #verseas suppliers of goods and services want to
$e paid in their own currencies and not in Australian dollars. %ocal firms
deal in Australian dollars.
!urchasing !ower !arity" The exchange rate ad&usts for relative values in
the currencies of different countries. ie #ne AUD currently $uys a$out '(
)apanese *en. This would indicate that one )apanese *en is worth a lot
less than one AUD. +xchange rates ad&ust for these differences in
purchasing power. +xchange rates are usually near the purchasing power
parity $etween countries.
Automatic Ad&ustment ,echanism" -lexi$le exchange rates are an
automatic ad&ustment mechanism and .eep the $alance of payments in
e/uili$rium. The capital and financial accounts will always e/ual the
current account as a result of changes in the exchange rate.
Forex Market
A mar.et is an organised networ. of $uyers and sellers.
The foreign exchange mar.et (-orex) is a networ. of the $uyers and
sellers of Australian dollars AUDs.
0arious financial institutions in Australia have a foreign exchange license
which allows them to deal in foreign exchange.
Floating Exchange Rate
Australia adopted a floating exchange rate in Decem$er 1234.
The value of the AUD is determined $y the demand and supply for
Australian dollars.
The following diagram shows that the demand and supply of AUDs
determines the value of the exchange rate. The exchange rate in the
following diagram is 1 AUD 5 (.6( U7D.
1
Determinants of Demand for AUDs
The following factors affect the demand for the AUD.
+xport volumes and values.
8apital inflow from direct or portfolio investment.
7ervice incomes from tourism and overseas students in Australia.
nterest and dividends received from overseas.
9:A $uying of AUDs
Factors that nfl!ence the Demand for the AUD
8ommodity !rices" The prices paid for Australias .ey commodities will
affect the value of exports incomes and the demand for AUDs. The AUD
is regarded as a commodity driven currency.
Terms of Trade" The ratio of the export price index to the import price
index. f this improves it usually indicates higher export prices and
increased demand for AUDs. Deterioration in the terms of trade could
indicate lower export prices and lower demand for AUDs.
nterest 9ate Differentials" nterest rate differentials are calculated $y
comparing the interest rate in Australia for a particular security compared
to the interest rate offered on a similar security in another country.
Australian interest rates are usually higher than overseas. f interest
differentials widen this will encourage more capital inflow which will
increase the demand for AUDs. A narrowing of differentials would
reduce the demand for AUDs.
;
nflation 9ates 8ompared to #ther 8ountries" f Australias inflation rate
is higher than other export competitors then Australia will lose exports
mar.ets to these countries and the value of exports and hence the demand
for AUDs will fall. %ower inflation rates compared to competitor
countries would result in increased demand for AUDs.
<lo$al +conomic 8onditions" 8hanges in the international $usiness cycle
will affect the demand for Australias exports. During $oom periods when
commodity prices are strong the AUD tends to appreciate.
Tastes = !references" 8hanges to the pattern of world fashion may affect
the demand for Australias exports. Australia is the worlds largest
exporter of coal. f the greenhouse effect worsens coal may $ecome less
desira$le. This would have a ma&or impact on the demand for AUDs.
7peculation in AUDs" 7peculators $uy currencies to ma.e capital gains.
f the AUD is expected to increase in value then this will create more
$uying. 7peculators sell when a currency is falling.
7peculation in Australian +/uity ,ar.ets" f foreign investors increase
their purchases of Australian shares then this will increase the demand for
AUDs.
Determinants of "!##l$ of AUDs
The following factors affect the supply of the AUD.
mport prices and values.
8apital outflow > either direct or portfolio investment.
Australian tourism overseas or Australian students studying overseas.
nterest = dividends paid out overseas.
9:A selling of AUDs
Factors Affecting the "!##l$ of the AUD
mport !rices" mport prices and the terms of trade? determines the
amount of AUDs needed to pay trade de$ts. Deterioration in the terms of
trade could $e caused $y higher import prices. This could result in higher
import values and increased supply of AUDs.
nflation" @igher domestic inflation will mean that local goods are una$le
to compete with imports. @igher import levels will result in more supply
of AUDs.
mport 0olumes" Tastes and preferences of Australian consumers for
imported goods could change resulting in higher import volumes. @igher
import volumes would increase the supply of AUDs.
4
nterest 9ate Differentials" A narrowing of interest rate differentials
would cause capital outflow from Australia and this would increase the
supply of AUDs.
7peculation in -oreign 8urrency" f Australian investors increase their
speculation in foreign currencies this will increase the supply of AUDs.
7peculation in -oreign 7hare ,ar.ets" f Australian investors increase
their purchase of international shares then this will increase the supply of
AUDs.
%hanges in the exchange rate
An increase in the value of the exchange rate is called an appreciation.
An appreciation will occur if the demand for AUDs increases or if the
supply of AUDs decreases. This is shown in the diagrams $elow.
A decrease in the value of the exchange rate is called a depreciation.
A depreciation will occur if the demand for AUDs decreases or the
supply of AUDs increases. This is shown in the diagrams $elow.
Australia has an exchange rate with all the currencies of the world and
each exchange rate will vary according to economic conditions in any of
the countries or with any change to economic conditions in Australia.
8hanges in economic conditions in Australia and overseas will affect the
demand and supply of AUDs.
The Trade Aeighted ndex shows the average change in the value of the
exchange rates of Australias trading partners. t is the $est indicator of
the trend or direction of the AUD. The exchange rate with any one
country can $e affected $y economic conditions within that country and
may not $e indicative of changes to conditions in Australia.
B
An appreciation will occur if the demand for AUDs increases.
An appreciation in the AUD will occur if the supply of Australian dollars
decreases.
C
A depreciation of the exchange rate will occur if the demand for AUDs
decreases.
A depreciation of the exchange rate will occur if the supply of AUDs
increases.
R&A inter'ention in the Forex Market
The 9:A does not influence the longDterm trends in the exchange rate.
These trends are due to changing economic conditions. The exchange rate
is an ad&ustment mechanism and changes accordingly.
The 9:A influences short term fluctuations in the exchange rate?
particularly where there is any panic or insta$ility.
6
Dirt$ing the float
f the 9:A is of the opinion that shortDterm fluctuations of the AUD are
due to speculation and are harmful to the economy then it will start
$uying or selling AUDs.
This is called dirtying the float $ecause the value of the exchange rate is
no longer purely determined $y mar.et forces.
The 9:A has limited funds and is una$le to halt a ma&or trend.
The 9:A can see. the help of the other central $an.s.
Monetar$ (olic$ ) m#act on the Exchange Rate
8hanges to monetary policy do affect the value of the AUD.
,onetary !olicy affects the level of interest rates which affects
international movements of money which affects the demand for AUDs
which affects the value of the AUD.
,onetary !olicy is usually changed to control inflation and other
domestic indicators and is rarely used to influence the exchange rate.
The Relationshi# *et+een the Exchange Rate and the &alance of
(a$ments
Under a flexi$le exchange rate the /uantity supplied of AUDs must
always e/ual the /uantity demanded of AUDs.
The net outflow of funds on the 8urrent Account (supply of AUDs) is
e/ual to the net inflow of funds on the 8apital = -inancial Account
(demand for AUDs).
To pay for our 8AD we always have capital inflow on $oth the -inancial
= 8apital Accounts.
The value of the AUD changes automatically to .eep the net outflows
e/ual to net inflows.
An increase in outflows on the 8urrent Account would result in an
increased supply of AUDs and a lower exchange rate. The lower
exchange rate would increase the level of capital inflow $ecause
investment in Australia would $e cheaper.
An increase in incomes on the 8urrent Account would increase the
demand for AUDs and this would cause a higher exchange rate. A higher
exchange rate would ma.e it more expensive to invest in Australia and
this would reduce the capital inflow on the 8apital and -inancial
Accounts.
'
The Effects of a %hange in the Exchange Rate
A##reciation ) Negati'e Effects
%ower +xport 0olumes" +xports $ecome more expensive and less are
sold. +xport services li.e tourism and education will decline.
%ess Direct nvestment" A higher AUD will mean that it costs more in
foreign currency to purchase capital goods in Australia. This will
discourage direct investment and any possi$le stimulus from overseas.
@igher mport 0olumes" Australians will find it cheaper to $uy overseas
goods which will increase imports.
Deterioration in Eet <oods :alance" %ower exports and higher imports
will cause the trade $alance to deteriorate.
%ower %evels of +conomic Activity" %ower export volumes and
increased import penetration will result in lower levels of economic
growth.
Unemployment" %ower export volumes and increased import penetration
will reduce employment in the export and import su$stitute industries.
A##reciation ) (ositi'e Effects
8heaper mported <oods = 7ervices" mported goods $ecome cheaper
for Australian consumers. #verseas travel and education will $ecome
cheaper for Australians. This will increase the standard of living for some
Australian consumers.
%ower -oreign De$t" -oreign de$t which is written in foreign currency
will decrease in Australian dollars. This is called a valuation effect.
9educed nterest !ayments" nterest payments on foreign de$t will
decrease in AUDs.
%ower nflation" mported goods and components will $ecome cheaper
and this will help reduce inflation.
De#reciation ) Negati'e Effects
@igher mport !rices" Australian consumers would have to pay more for
imported goods and this would reduce their standard of living.
nflation" @igher import prices could start cost push inflation if
Australian firms depend upon imported components.
@igher 8ost of #verseas 7ervices" Australian tourism and education
overseas would $ecome more expensive.
@igher nterest !ayments" ncreases the interest servicing cost on
Australias foreign de$t.
3
ncrease in 8AD" @igher interest payments will increase the net incomes
$alance of the current account.
ncreased -oreign De$t" Australias foreign de$t will increase in
Australian dollars. This is called a valuation effect.
De#reciation ) (ositi'e Effects
8heaper +xport !rices" +xport prices will fall in foreign currency and
this will increase export volumes.
%ower mport 0olumes" mport prices will increase in Australian dollars
and import volumes will fall which will $oost import su$stitute
industries.
@igher Direct nvestment" nvestment in Australia will increase $ecause
it will $e cheaper in foreign currency to $uy Australian capital goods.
+conomic <rowth" @igher investment? increased export volumes and
increased output from import su$stitute industries will result in higher
levels of economic growth.
@igher +mployment %evels" ncreased economic activity in the export
and import su$stitute sectors will result in higher employment levels.
A!stralias Recent Exchange Rate (erformance
+xchange rates are constantly changing and it is important for students to $e
aware of the latest tends. Fuestions on exchange rates may re/uire current
information. 9esearch into the latest data $y finding answers to the
following /uestions"
1. Ahat is the current value for the AUD in U7Ds?
;. @ow does this compare with recent values?
4. Ahat is the current value and trend for the TA?
B. 7uggest some reasons for the recent trends in the exchange rate?
C. @ave the recent changes in the value of the AUD had any impact on
the Australian economy? +xplainG
+xam Fuestions
,ultiple 8hoice Fuestions
1. An increase in foreign investment into Australia would"
a) ncrease the demand for AUDs.
$) ncrease the supply of AUDs
c) Decrease the demand for AUDs
d) Decrease the supply of AUDs
2
;. A depreciation of the AUD would"
a) ncrease the demand for imports from Australian consumers.
$) ,ore foreign travel cheaper for Australians.
c) ncrease direct investment in Australia.
d) ncrease speculation $uying of AUDs.
4. A higher interest rate differential $etween Australia and overseas would"
a) ncrease the demand for AUDs resulting in a depreciation.
$) Decrease the supply of AUDs resulting in a depreciation.
c) Decrease the demand of AUDs resulting in an appreciation.
d) ncrease the demand for AUDs resulting in an appreciation.
7hort Answer Fuestions
1. Define the following terms" -orex mar.et? floating exchange rate?
appreciation? depreciation? Trade Aeighted ndex? dirty float.
HHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHH
;. Ahy do we need an exchange rate?
4. +xplain the factors that affect the demand for AUDs?
1(
B. +xplain the factors that affect the supply of AUDs?
C. Ahy is a floating exchange rate an automatic ad&ustment mechanism?
11
6. Ahat is the impact of an appreciation in the value of the AUD?
'. Ahat is the impact of a depreciation in the value of the AUD?
+xtended response
Ex#lain the ca!ses and effects of a de#reciation of the A!stralian Dollar
against the c!rrencies of o!r ma,or trading #artners.
9ule 1" Define the terms in the /uestion" Australian dollar? depreciation?
currency? trading partner
9ule ;" dentify = define related concepts" capital outflow = inflow? import
= export volumes? commodity prices
9ule 4" %in. introduced terms to the /uestion" %ower commodity prices will
reduce the demand for AUDs and cause a depreciation.
9ule B" Draw logical conclusions" Anything that reduces the demand for
AUDs will cause a depreciation.
1;

Exchange Rates

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