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Exchange Rate Essay - Grade: A
BUSS1000 (University of Sydney)
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EXCHANGE RATE ESSAY
PAST QUESTIONS
Discuss the impact of changes in the domestic and global economy on Australia’s
exchange rate.
INTRODUCTION
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Define exchange rate: price of one currency expressed in terms of another in order
to give a measure of its purchasing power
The exchange rate can be measured bilaterally, for example the US$ to the AU$ or
against the trade weighted index
The Australian currency operates under a floating exchange rate system, whereby
the forces of demand and supply for a currency determine its value; increasing the
volatility of the dollar.
Background information: financial deregulation in 1983 has led to floating exchange
rate meaning that the $A is determined by market forces of supply and demand
o Changes in the domestic and global economy influence demand and supply
thus result in either an appreciation or depreciation of the exchange rate
Sustained Appreciation:
o Before 2008: sustained appreciation = almost parity with the $US by 2008
o 2009-11, with a post-float high of US$1.10 and TWI of 79 in May 2011
Depreciation since 2011
o As a result of the negative implications of the appreciation, loose monetary
policy and other factors
o At a post-GFC low of 70c in October 2015
Current trends of AUD: Sinking commodity prices - driven the Australian dollar to
new six-year lows this week, as the $A US74¢ for the first time since May 2009 in
overnight international trade in July
Factors that affect Aust. exchange rate:
o Domestic:
 Changes in economic growth (affects demands for exports/imports)
 Changes to Aust. interest rates (affects investors decisions)
 Changes to competitiveness of domestic firms (affects prices of
exports = international demand)
 Availability of investment opportunities
o International:
 Fluctuations in the International Business Cycle
 Economic growth of trading partners
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THEORY
Appreciation:
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Define: increase in the relative purchasing power of a currency
A appreciation refers to the value of the exchange rate decreasing in relation to it’s
main trading partners and is measured most commonly through the trade weighted
index, an average of the exchange rates of a country's currency with the currencies
of its most important trading partners
An Appreciation in the Australian currency may be caused by a either an decrease in
supply or increase in demand, and may result in a range of positive and negative
effects on the Australian economy.
The AUD has recorded a trend appreciation or increase in value against the
currencies of its major trading partners between 2009 and 2011 and reached a post
float high of US$1.10 (TWI of 79) in 2011.
The appreciation of the AUD increased its purchasing power relative to other
currencies such as the US dollar, particularly between 2009-11
Depreciation:
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Define: loss of purchasing power of the exchange rate which may lead to higher
import prices and inflation
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As a result of the negative implications of the appreciation, loose monetary policy in
culmination with other factors has lead to a depreciation of the dollar
Now reaching record lows below 74 c in mid July for the first time since 2009 GFC
conditions
Demand: Factors affecting demand for the Australian dollar, come out of speculation,
demand for Australia’s exports, financial inflow and income payments from overseas income
payments.
Supply: The facts that influence the supply of the Australian dollar are represented by all
those people willing to sell Australian dollars, and is affected by speculation, demand for
imports and financial income and outflows
BODY
CHANGES IN ECONOMIC GROWTH OF DOMESTIC ECONOMY
AFFECTS AUD
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TS: Australia is a commodity-dependent currency (21.4% of exports of G&S as a
percentage of GDP in 2014), thus our economic growth is seen in our ToT
EXPLANATION:
o Economic growth affects demand for exports and imports which then
influence the demand and supply of AUD
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o
Higher economic growth generally leads to higher demand for imports and
vice versa
o
Discussion of how it is positive/negative
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Depreciation: A depreciation of the exchange rates raises the domestic prince of
imports and reduces the foreign price of exports
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In the long run, a D of the ER enhances the competiveness of the tradable goods
sectors (i.e. export and import competing industries) by making Aust. goods and
services more rice competitive, relative to foreign producers
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This can help to raise export income and reduce import expenditure, thereby
improving the CAD in the balance of payments
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In the short run however, this can raise prices of imports and reduce the prices of
exports, leading to a lower export income
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This is known as the theory of the J Curve
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EXAMPLE:
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International trade data shows Australia's terms of trade fell 5.8 per cent in the June
quarter (2015), the largest quarterly decline since 2009, when export prices crashed
in the midst of the GFC
Australian GDP expanded 0.2% in the June quarter of 2015, slowing from 0.9%
growth in the previous quarter and missing market forecasts. It is the weakest
growth since the first quarter of 2013, as positive contributions from final
consumption expenditure and investment were unable to offset a decline in net
exports
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Appreciation: In the short run, an appreciation of the exchange rate lowers the price
of imports and increase price of exports
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However in the long run reduces the competitiveness of tradable goods
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EXAMPLE:
o JUL 2011: AUD peaked at 1.10 following 0.2% rise in GDP in June 2011
o Based on Australia’s terms of trade averaging 50%-60% above the long-term
average
o As a result of the high demand for our commodity exports, Australia has
experienced favourable terms of trade, being lifted 20% between 2010-11
(95% higher on average than 1990’s)
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HOWEVER: Changes to the competitiveness of domestic firms and thus Aust. exports
may lead to Dutch Disease
Dutch disease is the apparent causal relationship between the increase in the
economic development of a specific sector (for example natural resources) and a
decline in other sectors (like the manufacturing sector or agriculture)
The putative mechanism is that as revenues increase in the growing sector (or
inflows of foreign aid), the given nation's currency appreciates compared to
currencies of other nations This results in the nation's other exports becoming more
expensive for other countries to buy, and imports becoming cheaper, making those
sectors less competitive
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Although a simple trade models suggest that a country should specialize in industries
in which it has a comparative advantage; so a country rich in some natural resources
would be better off specializing in the extraction of those natural resources
However this can be detrimental when the natural resources deplete
*Break up into three paragraphs
DOMESTIC INTEREST RATES
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TS: A change in Aust. interest rate differentials can greatly affect the value of the
AUD
EXPLANATION:
o The RBA may intervene directly in the foreign exchange markets periodically
in an attempt to influence the value of the exchange rates and in doing so
‘dirty’ the float
o A serious misalignment of the exchange rate, as it deviates from its long run
equilibrium path, may have adverse effects on macroeconomic variables of
inflation, employment and EG
o Higher interest rates will encourage capital inflow, increasing the demand
for AUD for foreign investors, however it has a contractionary effect on Aust.
consumers (they will spend less in the economy)
o Lower interest = vice versa (DO NOT SAY THIS IN ESSAY)
o A depreciation of the exchange rate will increase competitiveness by
reducing the price of exports and raising price of imports
o An appreciation of the exchange rate will increase competiveness by
reducing the price of exports and raising the price of imports
o Lower interest rates will therefore have an expansionary effect on T and EG
EXAMPLE
o Interest rate in 2010 was at 4.75% which coincided with a 30% rise in the
value of the AUD
o Sustained investment due to the fact hat interest rate differentials between
Australia and the rest of the world are relatively high
o RBA has lowered our cash rate to 2% (makes investment less attractive but is
still above US 0.25%)
o Part of the RBA rationale was to dampen demand for $A
o Incentive to hold Australian assets has diminished
o The fact that we had a sustained appreciation was impacting on
international competitiveness in other areas — hollowing out our export
base (e.g. manufacturing areas found it increasingly difficult to compete)
FLUCTUATIONS IN THE IBC
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EXPLANATION:
o The main disadvantage of a floating exchange rate system is that there can
be an increase in volatility over time, caused by changes in the international
business cycle
o Boom in international business cycle leads to higher AUD due to economic
prosperity, higher demand for Aus. exports etc.
o Trough leads to lower AUD …
EXAMPLE:
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GFC: The Australian dollar depreciated rapidly and sizeably as the crisis
intensified, declining by over 30 per cent from its July 2008 peak
By July 2008, when Australia was on the brink of the global financial crisis
(GFC), the dollar had surged to US 98c. However, Australia was soon caught
up in the midst of a collapsing world economy, and the exchange rate
plummeted to US 64c in March 2009. Unpredictably, the dollar made a
relatively quick recovery; within seven months it had risen again to US90c
China’s rapid recovery from the GFC was the main cause, as its government
successfully substituted export demand for domestic demand as their main
source of economic growth
CHANGES IN ECONOMIC GROWTH OF MAJOR TRADING PARTNERS
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EXPLANATION
o Higher economic growth in global economy leads to increased consumer
spending; greater expectations etc. higher AUD
o Lower economic growth leads to less demand
o The near 23% fall in the index over the past seven days is the biggest weekly
fall since 1996
o And as often happens, the rest of the world’s stock exchanges followed The
London stock exchange fell 7.4% in two days before slightly recovering, the
Dow Jones index in New York fell 9.7% on four days, before recovering 4%
today
o Here in Australia, the All Ordinaries index fell 4% on Monday before
recovering 2.6% on Tuesday and a further 0.6% on Wednesday
o The value of the AUD fell to its lowest since the GFC of 0.69, but has
recovered to $US0.718
CONCLUSION:
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In conclusion, it is evident that domestic changes in the economy such as blah blah
blah and international changes such as blah blah blah have had both positive and
negative impacts on the AUD
Recap some of your arguments..
From the analysis of these impacts it is evident that the consequences of changes in
both domestic and international economies on the AUD can lead to either an
appreciation/depreciation of the AUD
INSIGHTFUL COMMENT: In the long term, the main implication of an appreciating
exchange rate is structural change within the Australian economy, in broadening its
export base; the AUD may be less volatile etc. etc.
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PAST QUESTIONS
Explain how movements in the Australian dollar can affect the performance of the
Australian economy.
INTRODUCTION
-
-
-
-
-
-
Define exchange rate: price of one currency expressed in terms of another in order
to give a measure of its purchasing power
The exchange rate can be measured bilaterally, for example the US$ to the AU$ or
against the trade weighted index
The Australian currency operates under a floating exchange rate system, whereby
the forces of demand and supply for a currency determine its value; increasing the
volatility of the dollar.
Background information: financial deregulation in 1983 has led to floating exchange
rate meaning that the $A is determined by market forces of supply and demand
o Changes in the domestic and global economy influence demand and supply
thus result in either an appreciation or depreciation of the exchange rate
Sustained Appreciation:
o Before 2008: sustained appreciation = almost parity with the $US by 2008
o 2009-11, with a post-float high of US$1.10 and TWI of 79 in May 2011
Depreciation since 2011
o As a result of the negative implications of the appreciation, loose monetary
policy and other factors
o At a post-GFC low of 70c in October 2015
Current trends of AUD: Sinking commodity prices - driven the Australian dollar to
new six-year lows this week, as the $A US74¢ for the first time since May 2009 in
overnight international trade in July
The demand for Australian dollars is equal to the sum of receipts associated with
exports, net income credits and capital outflow in the balance of payments
A persistent CAD has seen a currency depreciation in Aust.
THEORY
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A change in a country's balance of payments can cause fluctuations in the exchange
rate between its currency and foreign currencies
The reverse is also true where a fluctuation in relative currency strength can alter
the balance of payments
There are two different and interrelated markets at work: the market for all financial
transactions on the international market (balance of payments) and the supply and
demand for a specific currency (exchange rate)
These conditions only exist under a free or floating exchange rate regime.
The balance of payments does not impact the exchange rate in a fixed-rate system
because central banks adjust currency flows to offset the international exchange of
funds
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Floating Exchange Rate System
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The Aust. government floated the AUD in 1983, as it was the most efficient exchange
rate mechanism for determining the value of the currency
It exposed the Aust. economy to international competitive market pressures and it
allows for a more independent and effective MP
The demand for AUD is derived from the demand for Aust. goods, services and
assets by foreigners, whereas the supply of AUD’s is derived form the domestic or
Australian demand for foreign goods, services and assets
Demand for AUD
1. SPECULATION referring to the short term, future movements in the exchange rate. - If
there is expectation that the Australian dollar will appreciate, then speculators will buy the
currency and vice versa
2. DEMAND FOR EXPORTS effects the demand for our currency since foreigners whom
purchase them need to convert there currency
o
This is influenced by a range of factors, including the international competitiveness
of our exports i.e. price, quality, as well as the level of inflation. + changes in
economic growth of trading partners
3. FINANCIAL INFLOW into the economy requires foreign investors to convert their foreign
currency into Australian dollars -affected by several factors, including domestic interest rates
relative to overseas interest rates, level of confidence in the Australian economy i.e. a low
credit rating and changes in EG
4. INCOME PAYMENTS from overseas to Australian residents; and/or returns from
investment from overseas to Australian residents.
Supply for AUD
1. SPECULATION- if confidence is weak they will try and sell as much stock of Australian
dollars as possible, thus raising the supply of such in the economy
2. DEMAND FOR IMPORTS, requires a conversion of Australian dollars into foreign currency
when buying imports.
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Factors affecting this include competiveness of domestically produced goods, in
terms of there price and quality; and further changes in domestic economic growth.
3. FINANCIAL OUTFLOW, i.e. investment abroad by Australians further affects the supply of
Australian dollars, with factors including level of domestic interest rates, level of foreign
interest rates, confidence in foreign economies, and economic growth
BOGS - CONSUMERS
Balance of Goods and Services: The sum of the goods balance (exports, rural and non rural
and imports, consumption, capital and intermediate goods) ad net services (exports of
services and imports of services including tourism, travel, education, insurance, transport,
and finance)
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Appreciation
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An appreciation leads to Australia’s exports become more expensive on world
markets and thus, are harder to sell as Australian firms become less competitive
This decrease in exports provides Australia with less export capital and deterioration
in Australia’s CAD
This concept is reflected in Australia’s recent poor trade performance and its
worsening of the CAD
However, Australia’s imports would become less expensive, encouraging firms to
import rather then to export; leading to a worsening of the CAD and a reduction in
Australia’s economic growth rate as there is a reduction in export revenue and a
possible unemployment increase as domestic workers are laid off
A raise in export prices would have a negative affect on aggregate demand as net
trading decreases
It was estimated that a “1 percent rise in the dollar, $190 million is wiped from the
value of the farm sector”
Depreciation
A depreciation of the AUD can impact heavily on the BOP and the CAD
As Australia is a trading nation, a depreciation in exchange rates can have several
impacts on the balance of goods and services (BOGS) component of the current
account
A depreciation of the AUD would result in an increase in the price of imports for
Australian consumers and a decrease in prices of exports to overseas buyers
The increase in import price discourages domestic buyers from purchasing imports
whilst enabling domestic producers to compete with imports resulting in lower
import spending
Furthermore the decrease in export prices will make them easier to sell to foreign
buyers, resulting in greater export revenue
This is beneficial to the BOP as it will lead to an improvement in the BOGS, and a
reduction of the CAD and overall economic growth of the Australian economy as
exports consist of 21.42% of Australia’s GDP
The negative effect of a depreciating AUD on the BOGS is that the increased import
costs would lead to an increase in imported inflation
This will result in the RBA increasing interest rates if inflation rises above the 2-3%
target the RBA has set
EXAMPLE:
International trade data shows Australia's terms of trade fell 5.8 per cent in the June
quarter (2015), the largest quarterly decline since 2009, when export prices crashed
in the midst of the GFC
Australian GDP expanded 0.2% in the June quarter of 2015, slowing from 0.9%
growth in the previous quarter and missing market forecasts. It is the weakest
growth since the first quarter of 2013, as positive contributions from final
consumption expenditure and investment were unable to offset a decline in net
exports
-
Appreciation: In the short run, an appreciation of the exchange rate lowers the price
of imports and increase price of exports
-
However in the long run reduces the competitiveness of tradable goods
-
EXAMPLE:
o JUL 2011: AUD peaked at 1.10 following 0.2% rise in GDP in June 2011
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o
o
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Based on Australia’s terms of trade averaging 50%-60% above the long-term
average
As a result of the high demand for our commodity exports, Australia has
experienced favourable terms of trade, being lifted 20% between 2010-11
(95% higher on average than 1990’s)
HOWEVER: Changes to the competitiveness of domestic firms and thus Aust. exports
may lead to Dutch Disease
Dutch disease is the apparent causal relationship between the increase in the
economic development of a specific sector (for example natural resources) and a
decline in other sectors (like the manufacturing sector or agriculture)
The putative mechanism is that as revenues increase in the growing sector (or
inflows of foreign aid), the given nation's currency appreciates compared to
currencies of other nations This results in the nation's other exports becoming more
expensive for other countries to buy, and imports becoming cheaper, making those
sectors less competitive
Although a simple trade models suggest that a country should specialize in industries
in which it has a comparative advantage; so a country rich in some natural resources
would be better off specializing in the extraction of those natural resources
However this can be detrimental when the natural resources deplete
NET PRIMARY INCOME ACCOUNT
Net Primary Income Account: refers to credits less debits in income received and paid,
mainly to service direct, portfolio and other investment and includes dividends, interest and
profits
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The primary income component of the current account is also affected by a
depreciation of the AUD
Domestically owned foreign assets as well as the returns on Australian investments
abroad will increase in value
This has several benefits to the BOP as there will be an increase in the net primary
income leading to a reduction of the CAD
This is known as the valuation effect
A depreciating AUD can also have a negative impact on the primary income of the
current account
As a lower exchange rate makes purchasing foreign currency more expensive, this
result in increased servicing costs on Australia’s foreign debt and the interest gained
on that debt
This increased income outflow out of the net income component will increase
Australia’s CAD as well as its passive accumulation of debt
EXAMPLE
The near 23% fall in the index over the past seven days is the biggest weekly fall
since 1996
And as often happens, the rest of the world’s stock exchanges followed The London
stock exchange fell 7.4% in two days before slightly recovering, the Dow Jones index
in New York fell 9.7% on four days, before recovering 4% today
Here in Australia, the All Ordinaries index fell 4% on Monday before recovering 2.6%
on Tuesday and a further 0.6% on Wednesday
The value of the AUD fell to its lowest since the GFC of 0.69, but has recovered to
$US0.718
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Have not seen the full affect on the CAD yet
CAPITAL AND FINANCIAL
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The financial account component of the BOP is also impacted by a depreciating AUD
Short term speculators as well as other foreign investors may lose investor
confidence resulting in them shorting our currency, leading to further depreciating
This will also make it more difficult to gain a surplus on the financial account to
balance the CAD as financial inflows dry up
Furthermore this increases the volatility of our currency, which will further decrease
investor confidence and discourages additional foreign investors
Investment dependent on speculation
95% of currency transactions are too do with investment
3rd most traded = volatile
EXAMPLE
o GFC: The Australian dollar depreciated rapidly and sizeably as the crisis
intensified, declining by over 30 per cent from its July 2008 peak
o By July 2008, when Australia was on the brink of the global financial crisis
(GFC), the dollar had surged to US 98c. However, Australia was soon caught
up in the midst of a collapsing world economy, and the exchange rate
plummeted to US 64c in March 2009. Unpredictably, the dollar made a
relatively quick recovery; within seven months it had risen again to US90c
o China’s rapid recovery from the GFC was the main cause, as its government
successfully substituted export demand for domestic demand as their main
source of economic growth
o The current account deficit improved from about -7% of GDP to -2.5%
between December 2007 and 2008
o The GFC caused a downturn in the international business cycle, thus world
growth contracted but more importantly consumer confidence declined
o As a result, foreign investment also declines, reducing the Australia's capital
inflows which in turn slows the CAD hence why it improved
o Consumer spending also diminishes reducing the expenditure on imports
o Additionally, emerging economies namely China, experienced slightly
slowed levels of growth but still positive growth, thus continuing to demand
Australian commodities, ultimately Australia's saving grace during the GFC
o As statistics indicate, Australia experienced a BOGS surplus during the GFC
as exports exceeded imports which is another contributing factor to the
improvement of the CAD in light of the GFC
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PAST QUESTIONS
Analyse the causes of an appreciation of the Australian dollar and the impact of a
sustained appreciation of the currency on the Australian economy.
Discuss the effects of an appreciation of the Australian dollar on Australia’s
internal and external stability
INTERNAL STABILITY
ECONOMIC GROWTH
UNEMPLOYMENT
INFLATION
EXTERNAL STABILITY
CAD- BOGS
CAD – NET INCOME
CAD- FOREIGN DEBT
PITCHFORD THESIS
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