Chapter 5: Exchange rates Flashcards
what is the ER
the ER is the price of domectic currency in terms of another country’s currency, or the price at which tarders and investors can swap AUD for another currency
what are bilateral or cross rates
bilateral or cross rates measure the ERs relative to individual currencies (ie refers to the value of one currency against another)
Why are ERs necessary for exporting firms
exporting firms usually want to be paid in their own currency so importers need a mechanism to convert their own currency into the exporter’s currency in order to make payments
what takes place in the forex market (foreign exchange makret)
- currency converisons
- where the forces of supply and demand determine the price of one country’s currency in term of another
what was one of the most improtant structural changes in AUS’ eco history
AUS switch from managed flexible peg to a floaitng ER bcos it opened up the eco to global financial flows
what are the factors affecting demand for AUD
- the size of financial flows into AUS from foreign investors who wish to invest in AUS assets and need to convert their currency to AUDs
- expectations of a future appreciation of the AUD will be increase current D by speculators, who purchase AUD at a lower ER to profit from AUD appreciating
- the D for AUS exports, since foreigners importing need to convert their currency into AUS
what is the size of financial flows into AUS from foreign investors influenced by
- interest rate differentials: the level of AUS interest rates relative to overseas interest rates is a cirtical influence on demand for the AUD
- investment opportunities: if there are more enticing opportunities for overseas investors to buy AUS real estate
what are foreign importers of AUS exports infleunced by
- changes in commodity prices and the terms of trade: a rise in commodity prices and an improvement in the TOT means AUS exports are more valuable, causing an increase in D for the AUD
- the degree of international compeitiveness of domestic exporters and AUS’ inflation rate relative to other countries: if AUS competitive and inflation rate low, AUS’ exports will be cheaper –> increase D for AUD
- changes in global eco conditions: the D for AUS’ exports highly dependent on the growth rate of AUS’ trade partners; ie when world eco in an upturn, D and pirces for AUS’ exports rise increasing D for the AUD
- tastes and preferences of overseas consumers change over time, affecting the D for AUS exports and thus D for the AUD
what is the supply of AUD determined by
- the level of financial flows out of AUS by AUS investors who wish to invest in overseas assets and need to convert their AUDs into foreign currency
- exoectations of a future depreciation of the AUD will prompt speculators to sell AUDs, thus contributing to the anticipated depreciation
- domestic D for imports need to sell AUDs in order to obtain foreign currencies to pay foreign exporting firms
what is the level of financial flows out of AUS by AUS investors influenced by
- interest rate differentials: lower interest rates in AUD making investing savings overseas more attractive and thus increasing S
- investment opps: greater opps for AUS investors to buy foreign real eststae to start bus overseas or purchase of shares from overseas will increase financial flows out of AUS –> increasing S
what influences domestic D for imports
- the level of domestic income: rising incomes and employment results in an increase in D for imports, causing an increase in supply for AUD
- domestic inflation and the competitiveness of domestic firms that compete with imports: if AUS’ inflation is relatively high and import-competing firms uncompeititve, imports will be cheaper
- tastes and preferences of domestic consumers change over time, with an increasing preference for overseas products raising the S of AUD
how does the ER of AUS against the USD appreciate due to change in supply nd demand (how does AUD appreciate)
- rightward shift from D1 to D2 would cause an appreciation (more demand, more exp)
- leftward shift from S1 to S2 would cause an appreciation (less supply, more exp)
how does ER of AUS depreciate due to changes in supply and demand (ie how does AUD depreciate)
- leftward shift from D1 to D2 will decrease the price of the AUD (less D, lower price)
- rightward shift from S1 to S2 would also cause depreciation (more supply, lower price)
why can comparing the AUD against a single currency create misleading impression of trends
there are unique factors influencing the currency
what does the TWI measure
provides a broader measure of the value of the AUD than bilateral or cross ER, as it is calculated by measuring the value of the AUD against a basket of currencies of AUS’ major trading partners
(more significant trading partners have a gerater influence on TWI)
what does the TWI consist of
- TWI must cover 90% of AUD trade
- 17 countries included in the TWI calculations in 2024
what are the recent trends in teh AUD
- AUD experienced a sustained appreciation form 2001-2011 as commodity prices increased during the global resources boom and strong demand from AUS’ tarding partners for resources exports
- and a trend depreciation since 2011 peak - slower world grwoth drove commodity prices down and the end of the mining investment boom saw a contraction in foreign capital inflows and successive cuts to the cash rate
- brief depreciation during pandemic and recovered and continued depreciating from 2021-2024
how have commodity prices played a role in the volatility of the ER
- AUS’ TOT and long term export performance strongly influenced by the prices of commodities (eg during resources boom, commodity prices tripled their pre-2003 lvls, fuelling D for the AUD from trade and investment by currency speculators
- more recently, due to Russia’s invasion of Ukrained, AUS experienced increase in demand for commodity exports such as coal, gas and iron ore
- however, the influence of other factors on the AUD can outweigh the impact of commodity prices at times
how has the cash rate played a role in the volatility of AUD
- when AUS’ cash rate is higher than other adv ecos, foreign investors become more likely to invest their savings in AUS (aka carry trade)
- AUS’ official cash rate have historically been higher than other adv ecos however, RBA was slow to start increasing cash rate again –> AUS interest rates have remained lower than other ecos, putting downward pressure on the AUD - one of the most significant factors contributing to the weaker AUD
what has been a significant factor to the recent depreciation of AUD
interest rate expectations have been a significant factor behind this recent depreciation, with markets anticipating the RBA will begin cutting its official cash rate in 2025
what are factors which may apply downward pressure on the AUD in 2025
- china’s weaker growth prospects (tned to reduce D for AUDs)
- commodity prices remaining below the highs of 2022 - reducing export revenue and D for AUDs
- increased global economic uncertainty due to geopolitical and the re-election of Trump - heightened risk leads to investors seeking ‘safe haven’ assets such as bonds, gold and the USD but AUS seen as a ‘risky currency’
what has been the trend in govs and central banks role in the forex makret
- govs and central banks have genrally played a much smaller role in global foreign exchange markets
- as forex developed, ER volatility reduced, market participants have become better equipped to manage currency fluctuations and the benefits of a freely floating ER have been seen weakening the justification for intervention
- the power of govs to influence ER has also been reduced as priv sector participants - esp currency speculators with large holdings of finance - have become more dominant
- ie the RBA cannot change the value of the AUD in the long term but may intervene periodically to smooth out fluctuations relating to short term factors
for what three main reasons would the reserve bank intervene in the forex makret
- a serious misalignment of the ER and economic fundamentals - deviation of the ER from its long run equilibrium path may have adverse impacts on macroeconomic variables such as GDP
- excessive speculation - which may lead to greater ER volatility and the ER overshooting and undershooting its equilibrium path
- to prevent an excessive depreciation or appreciation of the ER - sharp currency fluctuations have adverse eco impacts (depreciation raises import prices and inflation, appreciation reduces international competitiveness)
what are the two main ways that the RBA may try to influence the value of the AUD
- ‘dirtying the float’ (direct intervention)
- monetary policy (indirect intervention)
what are the other two indirect methods of influencing the value of the AUD
- ‘jawboning’
- quantitative easing
what is dirtying the float
- in order to curb a rapid depreciation of the currency, the RBA will buy AUDs, putting upwards pressure on the ER through an increase in D
- by selling AUDs, the RBA may prevent a rapid appreciation thrpough an increase in S
how is dirtying the float limited in its ability
RBA’s ability to intervene thru buying AUDs is limited by the size of its foreign currency holdings (reserves of foreign currnecy and gold that can be used to fund such purchases)
how can the RBA influence the ER through monetary policy
- RBA may raise the cash rate to attract more foreign investment, increasing D for the AUD and putting downward pressure on the ER (and vice versa)
what has been a factor to the RBAs decision to hold back on cutting rates
- interest rates overseas were generally higher, putting downward pressure on the AUD and thus adding to inflationary pressures by making imports (and domestic goods made using some imported inputs) mroe expensive
- easing monetary policy too soon would thus threatne the progress made in bringing inflation down since cutting interest rates would depreciate AUD (downward pressure) leading to increased inflation
what does ‘jawboning’ refer to
refers to persuasive tactics such as public staements used by central banks to influence market participants to change their behaviour
- eg if RBA were concerned with impacts of appreciating AUD, they would indicate on public statements that the board are considering future cuts to the cash rate –> cause speculators to anticipate a fall in the value of the AUD, decreasing D for AUD
- such tactics can erode confidence in the credibility and transparency of the RBA
what is quantitative easing
- ## an unconventional monetary policy strategy used to stimulate an economy - involving central banks to increase money supply (printing money but no cash created) to purchase second hand gov bonds from banks –> market interest rate is lowered encouraging ppl to invest their money into riskier assets aka shares to gain more profit, stimulating eco activity
how do ERs work under a fixed ER system
- a country’s ER is fixed by the central bank, usually on a daily basis to another currency
- since fixed rate will usually be either above or below what the equilibirum ER would be under free market conditions, the central bank has to buy or sell foreign currency to keep the ER at the pre-determined lvl
what are the two main adv to operating a fixed ER
- there is greater certainty about the immediate short term value of the ER
- countries susceptible to ER shocks can achieve increased currency and price stability by fixing their ER to a country which typically has a low rate of inflation
outline the relationship b/w ER and inflation
- high domestic inflation tends to cause currency depreciation - since exports become less competitive cos they are ore exp to make (lowering D for domestic currency cos ppl dont want to buy from us) and imports become more competitive cos they become cheaper to what we make domestically (increasing S of domestic currency to purchase more imports)
- currency depreciation tends to cause domestic inflation - since imports of finished goods and inputs become more expensive, and since imports more exp than domestic leading to greater aggregate demand driving prices up
- so it is both the case that domestic inflation can influence the value of the currency, and the value of the currency can influence domestic inflation
what disadvantages of the fixed ER system tend to outweigh the advnatages
- The ER does not respond directly and quickly to changes in market forces or external shocks
- limits ability of the central bank to influence interest rates through monetary policy
- large reserves of fforeign exchange must be held to be able to keep the ER at its pre-determined level
- increased speculation - currency speculators more likely to believe a currency has been overvalued or undervalued, making them more incline to buy/sell which can destabilise the ER causing the CB to revalue or devalue the currency
- currency crises (where serious doubt exists in the market as to whether a country has sufficient
reserves of FX to maintain its fixed exchange rate) may lead to forced devalutaions or revaluations of currency and adjustments in the eco policy
what is the managed flexible peg
rather than maintaining a specific ER, the central bank acts to keep the ER within a target band by buying or selling AUDs
why did AU decide to float the AUD in 1983
- a more makret determined price for currency would be more efficient and better reflect AUS’ eco fundamentals (ie eco growth, inflation)
- a floating ER would discourage destabilising speculation about the future value of the currency which undermined confidence in the AUD under prev fixed and managed ER regimes
- a floating ER gives RBA complete control over monetary policu and greater ability to control inflation and eco activity
- a floating ER would provide some insulation for the AUS economy from external shocks by moving new equilibrium positions
- the adoption of a floating ER was consistent with the trend among major trading partners (an eg of internatinal convergence), allowing for greater global capital market integration and capital mobility
what are the disadv of a floating ER
- there can be an increase in volatility over time caused by changes in ER expectations, based on foreigners’ perceptions of an eco’s fundamentals or their reaction to short term economic or political events
- sudden shifts in makret sentiment (market reactions): ppls opinions abt a country’s eco can cause currency values to jump or drop which ccan cause currnecy to move too far in one direction ie overshooting (goign too high) or undershooting (going too low)
what can overshooting or underhsooting be caused by
- ‘bandwagon effects’ - if speculators follow market trends causing the ER to lose or gain value very quickly
- or by ‘speculative bubbles’ - where currency traders expect the ER to continue recent movements
what si the influence of BOP on the ER
- under a floating ER system, the quantity of AUD supplied must alway equal the quantity of AUD demanded
- A net outflow (or inflow) of funds on the CA (comprised mostly of trade flows and income earned from financial flows) must be equal to a net inflow (or outflow) of funds on the KAFA
- Outflows represent S of AUD, while inflows represent D for AUD
how do net errors and omissions in the BOP affect the ER
If there’s an imbalance in the BOP, it will usually fix itself through changes in the exchange rate
how does CA affect the ER if value of imports increase but exports stay the same
the CA worsens meaning AUS needs more foreign currency to pay for imports –> increasing supply of AUD –> depreciating AUD –> increasing financial inflows into KAFA
how can the CA and KAFA affect the value of AUD
- CAD –> KAFA surplus –> depreciation (as more imports means more selling of AUD thus increasing supply and depreciaitng AUD)
- CAS –> KAFA deficit –> ER appreciation (more demand for AUS exoprts meaning more D for AUD thus appreciating)
how can the value of a currency balance BOP
- for countries with CAD, weaker currency helps limit the size of the deficit bcos then imports would be more exp for aussies, adn exports cheaper
- for countries with CAS, stronger currency helps limit the surplus bcos exports will be exp for foreigners and imports would be cheaper
how does market sentiment affect BOP and ER
- if investors think CAD isnt sustainable (AUS spends more than it earns), then investors less willing to buy AUS assets –> reduce demand for AUD –> depreciation
- if investors believe AUS’ eco in good shape then the CAD can be managed, as investors more willing to buy AUS assets –> increasing demand for AUD –> appreciation
give an eg of how does market sentiment affect BOP and ER
- 2008: AUS had large CAD but AUD appreciated cos investors believed AUS was in strong position cos of the high commodity prices
- 2020-23: AUS’ CA moved into surplus (more imports than exports) but AUD depcreiated cos global eco uncertainty and geopolitical concerns caused uncertainty
what are the positive effects of an appreciation in the AUD
- AUS consumers enjoy increased purchasing power
- decreasing the interest servicing cost of foreign debt given quantity of AUDs buy more foreign currency
- reducing the foreign debt aussies pay and adding value to foreign assets held by aussies
- reducing price of foreign assets
- inflationary pressures reduced as imports become cheaper
- the CAD may imporve in the short run due to price effects
what are the negative effects of an appreciation in AUD
- AUS’ exports become more expensive on world markets –> decrease in D and deterioration of CA
- imports become less expensive, encouraging import spending which reduces domestic production and worsens CA
- ‘dutch disease’ - decline in other sectors of the eco caused by development of specific sector which increases ER (eg decline in manu cos of coal industry decreasing competitiveness of manu)
- high import spending and reduced export revenue reduce AUS’ eco grwoth rate
- becomes more exp for foreigners to invest in AUS –> lower financial inflows
- the AUD value (but inflows may continue if expect AUD continue rising)
- the AUD value of foreign income earned on AUS investment abroad is reduced
- the AUD value of foreign assets owned by aussies is reduced (valuation effect)
what is the overall effect of appreciation of AUD on the eco
appreciation of the AUD tends to have a contractionary effect on the eco by reducing internaitonal competitiveness of the tradable goods sector, constraining domestic output and economic growth.
what are the positive effects of a depreciation in the AUD
- AUS’ exports become cheaper on world markets –> increase in export income –> imporve CA
- imports more exp, discouraging import spending which may imporve CA balance
- lower import spending and greater export revenue increase AUS’ eco grwoth rate
- the AUD value of foreign asstes owned by aussies is increased (valuation effect)
- less exp for foreigners to invest in AUS generally leadin to greater financial inflows (but may dry up if expcect currency to fall more)
what are the negative effects of a depreciation in the AUD
- AUS consumers exp reduced purchasing power
- increasing the interest servicing cost on foreign debt since a given quantity of AUDs buy less foreign currency
- raising the AUD value of foreign debt denominated in foreign currency (valuation effect)
- raising the price of overseas assets being purchased by AUS investors
- inflationary pressures in AUS increase as imports become more exp
- the CA may worsen in the short run due to price effects
what is the overall effect of depreciation of AUD on the eco
depreciation of the AUD tends to have an expansionary effect on the economy by boosting
the international competitiveness of the tradable goods sector, stimulating domestic output and economic growth
How does AUS’ floating ER act as a countercyclical stabiliser
by ocmbinging the contractionary effect of appreciation and the expansionary effect of depreciation, AUS’ floating ER acts as a countercyclical stabiliser which helps to insulate the economy from external booms or busts
How does the value of the AUD affect monetary policy and inflation?
A weaker AUD can raise inflation, making it harder for the RBA to cut interest rates. It can also limit government spending on household support due to higher inflation pressures
What impact does short-term exchange rate movement have on domestic prices?
Short-term exchange rate changes usually have a minor impact on domestic prices, though they can quickly affect specific items like petrol. A sustained depreciation would have a greater inflationary impact
How has the recent depreciation of the AUD helped the Australian federal budget?
The weaker AUD has boosted revenue from commodities exports (priced in USD), leading to higher company taxes and other revenues, helping reduce the budget deficit.
How does the depreciation of the AUD affect Australia’s foreign debt and assets?
Despite having foreign liabilities, a weaker AUD may reduce Australia’s net foreign liabilities because most of its liabilities are in AUD, while its foreign assets are in other currencies
Do the RBA and economists prefer a higher or lower AUD?
they prefer an exchange rate that reflects Australia’s economic fundamentals, not one influenced by speculative buying or selling of the AUD. Speculation can lead to excessive volatility and destabilize the economy
Why is the AUD vulnerable to speculators?
Australia is a small economy that relies on significant financial inflows, making the AUD a “hot money” currency. This makes it more vulnerable to speculative trading, which can cause large currency movements and instability
