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EXCHANGE RATES ESSAY

The value of one nations currency, expressed in terms of another, is known as the exchange
rate. In Australia we have had a floating exchange rate since December 1983. A floating
exchange rate is one whose value is determined by the forces of demand and supply in the
FOREX market. The dollars value changes over time. It appreciates (gains value) or depreciates
(loses value) as market conditions change.
Australias Floating Exchange Rate System
The decentralisation of the financial markets opened up the Australian economy to global
financial flows. With no government intervention, the exchange rate is determined by the forces
of demand and supply of the AUD. This deregulation reflected the fundamentals of the
Australian economy, where it would lead to a more realistic market price for the currency.
One advantage of a floating exchange rate is that it transmits changes in market conditions
quickly & this encourages producers & consumers to adjust their behaviour accordingly. This
promotes continual structural adjustment within the economy. However, the main disadvantage
of adapting to the changes of the business cycle is the increase in volatility over time caused by
speculation from foreign investors.
RBA Intervention
Although the exchange rate is determined primarily by market forces, the RBA can smooth out
short term fluctuations in the currencys value. They do this by dirtying the float. If they feel that
a short term change caused by excessive speculation will harm the domestic economy, the RBA
can step in either as a buyer or a seller of $A.
Currently, the AUD is above parity with the US, reflecting the enormous surge of Australias TOT
due to the commodities boom. Thus in such a situation if the appreciated AUD is harmful to the
domestic economy, the RBA will sell AUD, reducing the pressure on the exchange rate,
containing the appreciation. Likewise, in situations of rapid depreciation, the RBA will buy AUD
to put upward pressure on the exchange rate
However, the RBAs ability to directly intervene through buying and selling AUD is limited by
the size of its foreign currency holdings. Thus they can opt to indirectly affect the AUD by
dirtying the float changing the level of interest rates through its open market operations
(OMO). This in turn will alter the interest rate differential between Australia and the rest of the
world.
- IR encourage capital inflow and Demand for AUD prevent excessive
depreciation of the AUD
- IR encourage capital outflow and Supply for AUD prevent excessive
appreciation of the AUD
- May change stance of macroeconomics policies to / rate of economic growth in
Australia relative to the world
o CONTRACTIONARY: reduce AD D for M eco growth raise XR by
causing appreciation
o EXPANSIONARY: boost AD D for M eco growth lowering XR and
causing depreciation
PRE-GFC
Over the past decade, the AUD has been growing in strength, where between 2004 and 2008 the
increased demand for AUD reflected:
- Rising global commodities prices and Australias terms of trade.
o As a large commodity exporter, the boom in export prices for coal and minerals
complemented with China and Indias need for commodities
- Weakness in the US Dollar
o The US Dollar depreciated by about 30% against other major currencies due to
its large current account and budget deficits. This is due to the faltering economy
caused by the sub-prime mortgage crisis and the credit crunch in 2007 2008
One of the first indicators of the GFC characterised by a rise in
subprime mortgage delinquencies and foreclosures and the resulting
decline of securities backed by said mortgages
Credit Crunch: reduction in the general availability of loans (credits) or a
sudden tightening of conditions in the US
- Sustained capital inflow into Australia
o By foreign investors reflected positive investor sentiment about Australias
export boom in the mining sector and the potential for rising returns and profits
in this sector
In 2005 2008 the RBA raised the cash rate from 5.25% to 7.25% - maintaining the positive
interest differential with the rest of the world encouraged portfolio and direct investment
GFC
However, despite this sustained appreciation, the collapse of the Global Financial Crisis (GFC)
had increased the volatility in the financial markets with commodities prices falling rapidly. The
AUD depreciated against all major currencies, with TWI terms falling by 20% between August
and November 2008, the AUD remaining around $US0.65. This was due to:
- Rapid deterioration in global economic outlook
- Sharp fall in commodities
- Narrowing of interest rate differential between Australia and the rest of the world
- General scaling back of international investments
- Widespread selling of commodity driven currencies such as the AUD
This volatility prompted the RBA to increase its purchases of AUDs to support the exchange rate.
EFFECTS
- Increased the prices of imported goods and services putting upward pressure on
consumer price inflation
- Effected businesses with foreign currency denominated assets and liabilities
o Depreciation increase in AUD value of foreign debt denominated in foreign
currencies in interest payments valuation effect
- Improvement in international competitiveness
- Stimulatory for economic growth however, this occurred during the GFC where the
environment consisted of slower economic growth, lower commodities prices, and
reduction in Australias income and growth prospects
POST-GFC
Prior to the GFC, where the AUD was as low as $0.62USc, the AUD experienced a relatively
sustained appreciation, besides the slight fall-back in May 2010. In NOV 2010, the AUD
appreciated past parity for the first time since being floated.
Currently, the AUD is slightly above parity at $1.04 US, an exponential increase from 83c US in
April 2007. Following the release of CPI figures in June 2011, the AUD had appreciated to a
record high of 110.6 USc, where the CPI had rose by 0.9% for an annual inflation rate of 3.6%,
the fastest rate of inflation since 2008 this had automatically increased the AUD.
However, the aftermath of natural disasters and fuel volatility was the major contribution to the
high CPI WRITE MORE.
This increase of the AUD, however, impacts the manufacturing sector of the economy
dramatically. The already suffering book retailers must compete against this high AUD
EFFECTS:






Economic Effects of Exchange Rate Movements
One of the most important influences on the exchange rate is the performance of the BOP
Under the floating exchange rate, AUD supplied must be equal to the AUD demanded
An appreciation of exchange rate
Negative
Aus X more expensive, CAD
M less expensive, CAD
economic growth
financial flows
value of foreign assets in AUD Valuation Effect
Positive
Aus consumers enjoy purchasing power
Decreases interest servicing cost on foreign debt outflow of
net income, CAD
$A of foreign debt valuation Effect
Inflationary pressures as imports become cheaper
A depreciation of the exchange rate domestic price of M reduces foreign price of X
Negative
In the long run, depreciation enhances competitiveness of the
tradeable goods sector help to raise X Y and reduce M
expenditure, improving the CAD J CURVE
Imports more expensive
Increase the value of foreign assets in Australian dollar terms
Valuation Effect
Positive
Aus X , CAD
M, CAD
Aus Growth
value of foreign assets in AUD valuation effect
Less expensive to invest in aus greater financial flows ,
however will stop once foreign investors expect currency to
continue to fall
When the value of the currency falls it has a valuation effect on our foreign debt as around 40%
of the debt has to be repaid in other currencies. Between September 2000 and September 2001
there was a 10% increase in our foreign debt and 1/3 of that was due to the fall in the value of
the $A. In 2004 for every $2 generated in the economy, $1 was already owed to foreigners. Our
foreign debt reached $406 bn in the 3 months to September 2004 and by the Dec quarter 2005
it had risen to $473 bn (net foreign debt).
As the value of our currency fluctuates it impacts on the price of our exports and imports. This
has implications for inflationary pressures within the domestic economy and for the level of
demand for our exports and imports. If demand for exports and imports is price elastic the
volume of these will vary and this could impact on the balance on goods and services. Variations
in the exchange rate also have a valuation effect on our foreign debt and this could affect the net
income component of our CAD. A fall in the price of exports and a rise in the price of imports
will result in a deterioration of Australias terms of trade.
The depreciation of the $A and the subsequent increase in the price of imported goods will lead
to a contraction in demand for imported goods, reducing the volume of imports. The decrease in
imports essentially translates to a reduction in competition for some goods and services. For
example a possible depreciation of the $A could lead to the fall of imported textiles and clothing
from overseas economies such as China. Thus Australian clothing manufacturers will face less
competition in the market, and the reduction in supply will increase the prices of those goods.
Furthermore, if the depreciation is sustained over a long period of time, the quantity and variety
of consumable goods and services available in the Australian economy will decrease, leading to
a gradual fall in our standard of living.
In addition, the depreciation of the Australian exchange rate relative to overseas rates will make
Australian financial assets cheaper for overseas buyers. Hence it will encourage foreign
investment. Though increased foreign investment means increased capital inflow, it will also
result in greater foreign ownership. Moreover, depreciation in our currency will make it more
expensive for Australians to purchase foreign assets in foreign currencies, decreasing capital
outflow as overseas investment becomes more expensive. This will have a detrimental impact
on our CAD as money flows out of Australia.
However, increased capital inflows could be a beneficial if our economy requires foreign
investment. For example, in time of recession, investment is needed to stimulate the economy,
and if the government is unable to stimulate the economy through fiscal policy, foreign
investment is a welcome alternative. The deterioration in our CAD caused by the costs of the
Australian Dollars depreciation may be countered by the benefit of cheaper Australian exports,
which would lead to an increase in the volume of our exports.
Another benefit of depreciation of our $A relative to other currencies is that the fall in the price
of Australian exports on the world market shall increase the international competitiveness of
Australia industries. This will increase the volume of exports if demand is price elastic,
therefore increasing our export receipts, thus boosting employment in the export sector of the
domestic economy.