Exchange Rates Flashcards
Define the exchange rate. Why is it important?
The exchange rate is the price of Australia’s currency in terms of another country’s currency.
Important as it has significant impacts on international competitiveness, trade flows, investment decisions, inflation, etc.
How can the exchange rate be measured?
Bilateral Exchange Rates - measure the value of a unit of domestic currency relative to another current
Trade Weighted Index (TWI) - measures the movements in the AUD against a basket of currencies of Australia’s trading partners (weighted according to their importance in Australia’s trade)
What are the factors affecting the SUPPLY for $A?
Acronym: LAST DLD
- Level of financial outflows (Aus investors looking to sell $A to invest OS)
- Level of Aus IR relative to OS IR (higher IR - larger returns on investments)
- Availability of investment opportunities OS
- Speculators in foreign exchange markets expecting the value of the $A to fall
- Domestic demand for M, which is affected by…
- Domestic inflation rate and competitiveness of domestic m-competing firms
- Tastes and preferences of domestic consumers
What are the factors affecting the DEMAND for $A?
Acronym: CLASS CDDT
- Size of financial inflows (Foreign investors looking to buy $A to invest in Australia)
- Level of Aus IR relative to OS IR
- Availability of investment opportunities in Aus
- Speculators expecting the value of the $A to rise
- Demand for Aus X, which is affected by…
- Changes in commodity prices and TOT
- Degree of IC of domestic X-ers and Aus inflation rate relative to foreign
- Changes in global eco conditions
- Tastes and preferences
What are the factors causing an appreciation or depreciation of the AUD?
Acronym: CALL CED
- Changes in Aus IR or OS IR
- Availability of investment opportunities in Australia or OS
- Changes in commodity prices and TOT
- Level of international competitiveness
- Level of inflation
- Demand for Aus g/s and OS g/s
- Expectations for future movements
Identify the types of exchange rate systems
- Floating or Flexible exchange rate system
- Fixed exchange rate system
- Managed exchange rate system
What is the floating exchange rate system?
What is the fixed exchange rate system?
What is the managed exchange rate system?
Floating: When the value of an economy’s currency is determined by the forces of demand and supply in foreign exchange markets
Fixed: A country’s exchange rate is fixed by the Central Bank, usually on a daily basis to another currency
Managed: currency is pegged or adjusted daily to variations in major trading partners’ currency
What are the benefits of the floating exchange rate system?
Acronym: MDCPC
- More market-determined price for the currency that reflected the fundamentals of the Australian economy
- Discourages destabilising speculation about the future value of the currency
- Can pursue a more independent and effective monetary policy as BOP surpluses and deficits don’t impact money supply
- Provides some insulation properties for the Australian economy from external real and financial shocks by moving to new equilibrium ER positions
- Consistent with the systems used by major trading partners in 1970s, allowing for global capital integration
What are the disadvantages of the floating exchange rate system?
- Can be an increase in volatility over time (caused by changes in ER expectations)
- May lead to ER ‘overshooting’ - leads to misalignment of the ER in relation to the TWI basket
What are the benefits of the fixed exchange rate system?
- Certainty about the immediate short term value of the exchange rate - assists exporters and importers in their decision making - allows RBA to conduct a MP similar to the country it has pegged its currency to
What are the disadvantages of the fixed exchange rate system?
Acronym: RSBC
- Speculation increases - destabilises ER, causing RBA to eventually revalue the AUD
- RBA must hold large foreign exchange reserves to keep ER at its pre-determined level
- BOP outcomes impact the money supply
- Currency crises lead to devaluations/revaluations of the currency and adjustments in economic policy
Define ‘dirtying the float’
Occurs when the RBA feels that a large ST change in the ER will be harmful to the domestic economy and decides to step into the foreign exchange market as a buyer/seller in order to stabilise the $A
- buying - upward pressure on the ER - curb rapid depreciation
- selling - prevent rapid appreciation
What is the importance of monetary policy decisions in terms of exchange rates?
- Indirect way of influencing the exchange rate and are rarely used for this purpose
e. g. curb rapid depreciation by increasing IR and increasing the demand for $A
How does the balance of payments influence the exchange rate?
Under a floating ER system, the quantity of $A supplied must always equal the quantity of $A demanded - if there is disequilibrium, it is temporary and automatically corrected by a movement in ER
e.g. if value of M increased, while X were unchanged, there would be a deterioration in the CAD
How does the RBA influence exchange rates?
Acronym: JIST
- Targeting: when RBA aims for a precise currency value - undermines the floating ER
- Smoothing and testing: RBA intervenes to make sure the currency doesn’t fluctuate too dramatically (smooths out large fluctuations in the value of AUD)
- Interest rates
- Jawboning: influencing forex market through public statements
