Chapter 5 - Exchange Rates Flashcards
Define exchange rate.
Price of Australia’s currency in terms of another country’s currency. Currency conversion occurs in the foreign exchange market.
What is a floating XR?
When the value of an economy’s currency is determined by forces of demand and supply in foreign exchange markets.
What is the TWI?
Measures the value of Aus dollar against a basket of foreign currencies of major trading partners. Currencies are weighted according to significance to Aus trade flows.
What are the pros and cons of the TWI compared to a bilateral exchange rate?
Pros: gives a better representation of how the AUD is performing in the global economy and the importance of different currencies for trade.
Cons: Measurement is weighted only based on volumes of regardless of the currency in which X and M are invoiced. For example, around 2/3 of Aus X and ½ of M are priced in US dollars which is far more important than the TWI suggests weighted at 9.6%.
Outline 5 factors that affect the demand for the AUD.
Possible answers:
- Size of financial flows into Aus from foreign investors who need to convert their currency to invest.
- Aus i/r compared to overseas, higher i/r makes us more attractive for saving.
- Availability of investment opportunities into Aus.
- Expectations of future movements of the $AUD. e.g future appreciation expectation will increase demand.
- Demand for Aus X as currency conversion is needed for this.
- Change of commodity prices and terms of trade. Improvement and rise will increase $AUD.
- International competitiveness and inflation rate. Higher int. competitiveness and low inflation - greater X.
- Global economic conditions - growth rates of Aus partners.
Outline 5 factors that affect supply for the $AUD.
Possible answers:
- Level of financial flows out of Aus by Aus investors who need to convert their currency.
- Aus i/r relative to overseas. Lower Aus i/r increase overseas investment.
- Availability of overseas I opportunities.
- Expectations of future movements of $AUD. If expected depreciation Aus investors will sell and increase supply.
- Domestic demand for M as Aus importers will need to sell $AUD to convert currency.
- Level of domestic Y affects demand for M into Aus.
- Domestic inflation rate and int. competitiveness.
- Tastes and preferences of Aus consumers.
What is the affect of an increase in demand or decrease in supply for the $AUD on the XR?
Appreciation
What is the affect of an increase in supply or decrease in the demand for the $AUD on the XR?
Depreciation
How can the RBA “dirty the float”?
When RB feels a large short-term change in the exchange rate will be harmful to domestic economy, it may intervene in foreign exchange market.
To curb rapid depreciation RBA will buy A$, putting upward pressure on the exchange rate. By selling A$, RBA may prevent a rapid appreciation.
RBA’s ability to intervene through buying A$ is limited by the size of its foreign currency holdings.
Give an example when the RBA dirtied the float.
In the second half of 2008 when A$ lost one-third of its value against the US$, the RBA purchased $3.3 billion of A$ to moderate its depreciation and provide support in the forex market.
How can the RBA affect the XR through monetary policy decisions?
Why is this usually not the RBAs goal when conducting monetary policy?
If RBA wants to stop depreciation, it may increase demand for A$ by raising i/r. Higher i/r will attract more foreign savings, which must be converted into A$. This will increase D for A$ and put upward pressure on exchange rate.
It is unusual for RBA to change i/r in response to currency movements as the primary focus of monetary policy is usually to influence the domestic economy.
What are 3 positive effects of appreciation?
- Aus consumers enjoy increased purchasing power
- Decreases interest servicing cost on foreign debt because Aus can buy more foreign currency with AUD. This reduces outflow on NPY and helps CAD.
- Reduce A$ value of foreign debt that has been borrowed in foreign currency – valuation effect.
- Inflationary pressures in Australia will be reduced as imports become cheaper.
What are 3 negative effects of depreciation?
- Aus consumers suffer decreased purchasing power
- Increased interest servicing cost on foreign debt because Aus can buy less foreign currency with AUD. Increases outflow on NPY component of current account can increase CAD in future.
- Increase A$ value of foreign debt that has been borrowed in foreign currency – valuation effect.
- Inflationary pressures in Australia will be increased as M become more expensive.
What are 5 positive effects of depreciation?
- Aus X become cheaper leading to increase in X and improvement in Aus CAD in the medium term.
- M will be more expensive, discouraging M spending and improving Australia’s CAD. Domestic production of M substitutes is likely to rise.
- Lower M spending and increased X revenue will increase eco growth – won’t happen if Aus can’t replace M with domestically made products.
- Increases A$ value of foreign income earned on Aus I causing improvement in NPY of the CAD.
- Increased value of foreign assets in $AUD - valuation effect.
- Foreign investors will find it less expensive to invest in Aus, generally causing greater financial inflows unless expectation of future depreciation.
What are 5 negative effects of appreciation?
- Aus X become more expensive leading to decrease in X income and worsening of CAD in the medium term.
- Encouraging M spending leading to a worsening Australia’s CAD. Domestic production of M substitutes is likely to fall.
- Higher M spending and reduced X revenue will reduce eco growth.
- Foreign investors will find it more expensive to invest in Aus, leading to lower financial inflows unless expectation of future appreciation.
- Reduces $AUD value of foreign Y earned on Aus I causing deterioration in NPY in the CAD.
- Reduce value of foreign assets in $AUD - valuation effect.
