EXCHANGE RATES Flashcards
What is an exchange rate
An exchange rate is the value of one countries currency expressed in terms of another
-if the value increases - APPRECIATION
-if the value decreases - DEPRECIATION
What is the TWI
-TRADE WEIGHTED INDEX
-the TWI is a measure of a currencies value, by tracking the exchange rates of a ‘basket’ of currencies that are weighted according to their importance to Aus trade
-best indicator we have of value of currency overall
-last 10 yrs according to TWI, Aus dollar depreciated
Current weightings
1) Chinese renminbi
2) USD
3) Japanese yen
4) Euro
5) South Korean won
Appreciation occurs when
Increase in demand OR decrease in supply
Depreciation occurs when
Decrease in demand OR increase in supply
Floating exchange rates
Currencies value is set in accordance with S+D in the market
-1983 Aus moved to floating
-gov prefers it as monetary policy is more effective
-economists prefer it- prices/trade automatically adjust to ER increasing stability
One benefit of floating ER
-FREE ER REDUCES SWINGS IN THE CA (LONG TERM)
-aus trade balance deficit - depreciation of AUD
-more supply (increased M) and less demand (decreased X) for AUD
-short term: depreciation - increased M prices and decreased X prices, trade balance DECREASE
-long term: markets adjust behaviour to the prices, volume M decrease and X increase (competitive) so trade balance increase
-J CURVE
Second benefit of floating ER
-FREE ER INSULATES ECONOMY FROM EXTERNAL SHOCKS
-POSITIVE SHOCKS: e.g 2001-2011 mining boom
-growth in chin increase commodity prices
-large upswing in business cycle led to inflation
-free ER led to record high (1 AUD+ 1.1 USD)
-increased X prices an decreased M prices slowing economy
-NEGATIVE SHOCK: e.g. COVID global recession 2020
-recession for trading partners could have led to severe us recession
-AUD depreciated decreased X profits in short term but quick recovery
Drawback of floating ER
-UNCERTAINTY FOR BUYERS + SELLERS OF AUD
-gov + businesses are unsure about the future value of AUD, can cause big loss for investments in AUS
-THIS MAKES AUD MORE VOLATILE
-because it is floating, the D/S of AUD is heavily influenced by uncertainty and speculators
-speculators = investors in the forex market and futures market, betting on future ER and trading currencies to make profit
Key determinants ER - high commodity prices last 10 yrs
-AUD viewed as a commodity currency (75%)
-global commodity prices remained high + demand is inelastic
-therefore high demand for AUD or buy our commodities
APPRECIATION
Key determinant ER- global econ growth (last 10yrs )
-the world esp. China has experienced strong growth
-this growth increases demand for commodities
-therefore high demand for AUD to buy our commodities
APPRECIATION
Key determinants ER- relative interest rates (last 10 yrs)
-Aus has had a low interest rate relative to the rest of the world
-this differential has caused increased investment outflows
-so decreased demand and increased supply for AUD to invest abroad
DEPRECIATION
Key determinants ER- relative inflation rates (last 2 years)
-Aus has had high inflation but low relative to OECD countries
-this means Aus export prices have stayed competitive
-so high demand for AUD to buy our imports
APPRECIATION
Effect of depreciation on INTERNATIONAL TRADE
-SHORT RUN: domestic firms that import/ export are worse off
-because X prices decrease and M prices = decreased profits
-many domestic firms import capital goods needed for production
-LONG RUN: domestic firms are overall better off
-exports are more competitive so quantity of exports increase
-import competing domestic firms benefit because local consumers substitute away form imports
Effects of depreciation - MACRO ECONOMY
-LONG RUN ONLY
-depreciation has an expansionary effect on the economy
-increased X and decreased M leads to greater profits, allowing businesses to expand
-leads to increased production and increased econ growth (GDP)
-UNEMPLOYMENT decrease as businesses hire more workers to expand production (cyclical)
ST INFLATION: increases because M = more expensive (M IN CPI) COST PUSH
-LT INFLATION: increases because increased consumer spending (increased income) DEMAND PULL
Effects of depreciation- BALANCE OF PAYMENTS (TRADE BALANCE)
-SHORT TERM: decrease in TB sub account form CA
-decreased credits from lower export prices (Aus exporters receive less foreign currency per AUD)
-increased supply from higher import prices (AUS importers need more AUD to get required foreign currency)
-LONGTERM: increases in TB sub account of CA
-increased credits from higher export quantity
-decreased debts from lower import quantity
Trends in Aus ER 2015-2025\
-TWI and AUD/USD rates show depreciation over last decade
-bottom in AUD value in 2020- COVID recession and appreciated since supply chain issues e.g. Ukraine war leading to increased commodity prices
AUD depreciation driven by:
-end of mining boom, less foreign investment and demand for AUD
-IR differential declines= increased supply and decreased demand AUD
-TOT deteriorated meaning decrease demand for AUD because exports cheaper and increased supply of AUD because imports are more expensive
-from 2015-2025 RBAs TWI recorded AUD falling from 75-roughy 70
