Exchange rates Flashcards
What is a trade weighted index?
A basket of currencies weighted according to their importance in trade flows with Australia. It accurately reflects changes in the value of the currency.
What is an exchange rate?
The price of one country’s currency in terms of another country’s currency
What is the foreign exchange market?
The market in which currencies of different countries are bought and sold
What is foreign exchange?
The currency of another county needed to carry out international transactions
What would happen if Australia increased imports from the US?
- Increased supply of $AUST
- Value of the $AUST will depreciate
- Increased demand for $US
- $US will appreciate
When is the Australian dollar said to have depreciated?
If one unit buys less units of another currency
When is the Australian dollar said to have appreciated?
If one unit buys more units of another currency
What is the link between a nation’s balance of payments and the value of its currency?
- The balance of payments records all the international transactions in goods, services, income, financial assets and liabilities
- The exchange rate is the means by which these transactions are facilitated
What is a fixed exchange rate?
Implies that the value of the currency is maintained at the same rate for a long period of time
What is a floating exchange rate?
The market forces of supply and demand led to the fluctuations in the exchange rate
What is a hybrid exchange rate?
The value of the currency is tied to the certain groups or baskets of currencies
What is the demand for a currency is determined by?
- Exports of goods and services
- Receipts of income from overseas
- Capital inflow (foreign investment)
What is the supply of a currency is determined by?
- Imports of goods and services
- Payments of income to overseas
- Capital outflow (investment abroad)
What happens when demand for $AUST increases?
- Due to an increased demand for Australian exports
- The value of the Australian dollar will appreciate
What happens when the supply of the $AUST increases?
- Due to an increase in imports or increased income payments to overseas investors
- The value of the Australian dollar will then depreciate
Why does a floating exchange rate means that the total balance of payments will always balance?
- If there is a deficit on the current account, then under a free exchange rate, a matching surplus will occur on the capital and financial account
- The balance of payments must balance because with a free exchange rate, the demand of the currency (the sum of all credits) equals the supply of the currency (the sum of all debits)
What is a clean float?
Currency floats free from the interference of the central bank
What is a managed exchange rate?
Occurs when there is official intervention in the foreign exchange market by the Reserve Bank
What are the 2 ways the central bank can influence exchange rates?
- Can act as a buyer or seller of currency
o Indirectly influencing its rate through the market system
o EG. To prevent the exchange rate from falling too low, it would enter the market as a buyer of $AUST and use its reserves of foreign exchange to bid up the price - Monetary policy
o Used to set short term interest rates
o If interest rates are increased, then foreign investment will be attracted to the Australian economy increasing the demand for the Australian dollars and appreciating the currency
What happens when a rise in the CAD causes the exchange rate to depreciate?
- This then increases the price of imported goods and services and decreases the price of exports
- Demand for imports should fall
- Demand for exports should rise
What happens when there is an excess supply of $AUD?
- Cause a depreciation
- There will be a rise in the prices of imported goods and services in domestic currency
- There will be a decrease in the price of exported goods and services in foreign currency
- There will be an automatic clearance of excess supply
What is the J Curve effect?
- If demand is relatively inelastic, higher import prices may lead to an increase in import payments
- Similarly, if exports are relatively inelastic, then lower prices may initially lead to lower export receipts
- The result is that a depreciation may actually increase the current account deficit
Why is elasticity an important factor to consider when looking at the relationship between the exchange rate and the balance of payments?
- Price changes on imports and exports that are inelastic hive little effect on quantities traded
- A depreciation may not initially reduce a trade deficit
What is the major disadvantage of free exchange rates?
They increase the degree of uncertainty for the buyers and sellers which increases the cost of international transactions
- If trade occurs under a free exchange, there may be uncertainty about whether or not that rate will change in the future
- This problem can be avoided by the buying of currencies in the ‘forward’ or future market at a set price (forward contract)
Advantages to a free exchange rate?
- Can help to insulate the domestic economy from external shocks
- 2008-09, when the GFC caused a major depreciation of the Australian dollar, the price of Australian exports dropped, providing Australia with a competitive advantage in overseas markets, thereby insulating the economy from the overseas recession
- The $A fell from $US0.96in June 2008 to $US0.64 in January 2009
How can a currency appreciation can help to shield the economy from a positive external shock?
- Australia’s mining boom occurred as a result of the increased economic growth in China and India, which boosted world commodity prices
- Caused Australia’s exchange rate and terms of trade to more than double
- Rose from around $US0.50 in early 2001 to $US1.10 in July 2011
Exchange rates between 2002-20014?
- Fluctuated between $US0.51 and $US1.10
- Average value was $US0.83
Exchange rates between 2002-2008?
- Strong appreciation of the $AUD
Marked the start of the mining boom - Fuelled by the strong demand from China
- $US0.51 to $US0.96
Exchange rates between 2008-2009?
- Dramatic fall in the Australian dollar due to the GFC
- Declined by 33% from the $US0.96 in June 2008 to a low of $US0.64
Exchange rates between 2009-2011?
- $AUD recovered by 2011
- $US1.10
Exchange rates at the end of 2011?
- $AUD fell to $US0.84
- Commodity prices, especially iron ore and coal took a tumble which decreased the demand for the $AUD
What are the main factors that effect movements in the exchange rate?
- Relative inflation rates
- Movements in the terms of trade
- Domestic economic growth
- World economic growth
- Relative interest rate
- International capital flows
How do relative interest rates effect the exchange rate?
- Inflation reduces the competitiveness of industries in the traded goods sector
- Decrease in demand for our exports as they become more expensive
- Therefore, high inflation relative to other countries is likely to have a negative influence on the exchange rate
How do movements in the terms of trade effect the exchange rate?
- When the terms of trade become more favourable, the currency appreciates and vice versa due to the increase in demand for our currency
How does domestic economic growth effect the movements in the exchange rate?
- Strong economic growth in Australia will lead to an increase in the demand for imports (both consumption and investment)
- Leads to a depreciation in our currency
How does world economic growth effect the movements in the exchange rate?
- Australia is a major exporter of commodities such as minerals and energy resources
- Growth in the world economy will increase the demand for our commodities
- Increase commodity prices
- Increases the demand for the $A
- Results in a currency depreciation
How do relative interest rates effect the exchange rate?
- If interest rates in Australia are higher than elsewhere, especially in the US, then foreign investment will increase
- Increased demand for our currency
- Appreciate the currency
How do international capital flows effect the exchange rate?
- If investors found Australia to be a relatively more attractive destination for their funds compared to other economies, then the Australian dollar would appreciate
What are the two key factors that influence the exchange rate?
- Commodity prices
- Interest rate differentials
Explain how commodity prices influence the exchange rate
- Around 67% of Australia’s exports are made up of primary commodities (rural and resources)
- Commodities include wheat, wool, beef, iron ore, bauxite and natural gas
- Changes in the price of these commodities has a significant effect on export values and Australia’s national income
- Exports account for around 20% of GDP, therefore the $AUD is often referred to as a commodity currency
- This means that a general increase in commodity prices, ceteris paribus, will result in an appreciation of the Australian dollar and vice versa
Explain how Australia’s interest rate differentials with the United States effect the exchange rate?
- Can be measured by the difference in the official cash rate between the two countries
- An example would be in January 2016, where the cash rate in Australia was 2%, while in the US, the federal funds rate was only 0.36%
- This higher rate attracted investors who were seeking higher returns for their funds
- Therefore, an increase in interest rate differentials, ceteris parabus, will lead to an inflow of foreign investment into the economy, increasing the demand for the $AUD and appreciating the currency
What are the advantages to a depreciation of the exchange rate?
- It bestows a competitive advantage in our producers through the relative price effects on imports and exports
- The price of Australian goods and services in foreign currency (exports) fall, while the price of Australian imports, in Australian currency rise
- A depreciation encourages resources to flow into the traded goods industry (both export and import competing industries)
- Will increase exports and decrease imports which will increase aggregate demand in the economy
- A depreciation can deduce a trade deficit or increase a trade surplus in the CAD
What are the disadvantages to a depreciation?
- Hurts consumers since they must pay higher prices for imported goods such as cars, petrol, household appliances and overseas travel
- It is potentially inflationary, as the higher priced imports feed into the consumer price index
- The increase in the net exports will boost national income thereby increasing spending in the economy
What are the advantages to an appreciation?
- Reduces the prices of overseas goods (imports) to Australian producers and consumers
- Benefits travellers going overseas as it helps to reduce their travel costs
- Helps to reduce Australia’s inflations rate by reducing the price of imports
What are the disadvantages to an appreciation?
- Harms Australian exporters because exports become more expensive to overseas buyers, decreasing their competitiveness
- Domestic producers and retailers are disadvantaged as consumers are attracted to lower priced imports
- Will likely increase the trade deficit, or reduce a trade deficit and therefore increase the CAD
- Will have a contraction effect on the economy, as it reduces net exports and decreases aggregate demand
