Exchange Rates Flashcards
What is an exchange rate and why is it necessary?
An exchange rate is simply the price of one country’s currency in terms of another country’s currency
If AUD1 = USD0.80, how much would an American have to pay for an Australian good costing AUD60
USD48
What is the trade weighted index?
The trade weighted index is a basket of currencies weighted according to their importance in trade flows with Australia
What is the foreign exchange market? What would happen in the foreign exchange market if Australia sells more exports to the US?
The foreign exchange market is the market in which the currencies if different countries are bought and sold. If Australia exports more to the US, demand for AUD increases and the supply of USD increases. The AUD will appreciate and the USD will depreciate.
How is the balance of payments and the exchange rate linked?
All transactions that result in an inflow of money into the Australian economy, represent a demand for a country’s currency. Transactions that result in an outflow of money, on the other hand, represents the supply of a country’s currency. Changes in the balance of payments involving goods, services, income, or financial capital, will affect either the demand and/or supply of the currency and thus affect its value.
Distinguish between the demand for a currency and its supply
The demand of a currency is determined by: exports of goods and services, receipts of income from overseas and capital inflow
The supply of a currency is determined by: imports of goods and services, payment of income to overseas, and capital outflow
Explain how a freely floating exchange rate is determined
A floating or free exchange rate is one whose value is determined by the market forces of supply and demand
Explain how interest rates can affect the exchange rate?
The Reserve Bank could use monetary policy to affect the value of the exchange rate. If interest rates are increased, then foreign investment will be attracted to the AU economy increasing the demand for Australian dollars and appreciating the currency.
What are the advantages of a freely floating exchange rate?
Can provide automatic adjustment in the balance of payments - varies to change prices of traded goods, services and assets
A free exchange rate helps to reduce swings in the current account balance
A free exchange rate can help to insulate the domestic economy from external shocks - a currency appreciation can help to shield the economy from a positive external shock. A currency depreciation can help to shield the economy from a negative external shock
Explain how the uncertainty associated with a floating exchange rate can be reduced
By using a foreign exchange hedging strategy to avoid exchange rate fluctuation. This can insure against an adverse movement in the exchange rate over the period between the contract and delivery
Distinguish between a currency appreciation and depreciation
An exchange rate appreciation will occur when the demand for a currency increases or supply decreases. For example, if Australia’s exports and capital inflow increase then the demand for AUD will increase. The demand curve will shift to the right and appreciate the currency.
A currency depreciation will occur if there is an increase in supply and a decrease in demand for the currency. For example, if there is a decrease in Australia’s imports and capital outflow then the supply of AUD will increase, and the supply curve will shift to the left, depreciating the AUD.
What are the two most important factors driving the Australian dollar?
Commodity prices - Changes in the prices of commodities have a significant effect on export values and ultimately on Australia’s national income. A general increase in commodity prices, will result in an appreciation of the AUD
Interest rates differential with the US - affects the flow of foreign investment. If interest rates in AU fall relative to the US, the Australia’s interest rate differentials fall which will cause the AUD to depreciate. Less foreign investment will flow into the Australian economy, decreasing demand for the AUD and increasing supply as AU investors shift fund out of the AU economy.
Explain the effects of a currency depreciation on the balance of payments, GDP and the price level
Price level - A depreciating currency is potentially inflationary because the higher priced imports feed into the consumer price index (cost inflation). The increase in net exports will have an expansionary effect on the economy, increasing income and spending which may increase demand inflation.
Balance of Payments - an exchange rate depreciation would increase the price of imports relative to exports, which would decrease the value of net exports and widen the current account deficit. However, an exchange rate depreciation increase the volume of exports and reduce the volume of imports. This will increase net exports and diminish the current account deficit.
GDP - an increase in export volumes and decrease in import volumes will increase national income in Australia. This will increase demand for non-tradable goods and services produced in Australia. In order to meet the increased demand for their products, Australian firms will have to hire more workers, which will increase employment and lower the unemployment rate in Australia. An increase in GDP
