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Economics ATAR > Exchange rates > Flashcards

Exchange rates Flashcards

1
Q

What is a trade weighted index?

A

A basket of currencies weighted according to their importance in trade flows with Australia. It accurately reflects changes in the value of the currency.

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2
Q

What is an exchange rate?

A

The price of one country’s currency in terms of another country’s currency

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3
Q

What is the foreign exchange market?

A

The market in which currencies of different countries are bought and sold

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4
Q

What is foreign exchange?

A

The currency of another county needed to carry out international transactions

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5
Q

What would happen if Australia increased imports from the US?

A
  • Increased supply of $AUST
  • Value of the $AUST will depreciate
  • Increased demand for $US
  • $US will appreciate
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6
Q

When is the Australian dollar said to have depreciated?

A

If one unit buys less units of another currency

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7
Q

When is the Australian dollar said to have appreciated?

A

If one unit buys more units of another currency

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8
Q

What is the link between a nation’s balance of payments and the value of its currency?

A
  • 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
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9
Q

What is a fixed exchange rate?

A

Implies that the value of the currency is maintained at the same rate for a long period of time

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10
Q

What is a floating exchange rate?

A

The market forces of supply and demand led to the fluctuations in the exchange rate

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11
Q

What is a hybrid exchange rate?

A

The value of the currency is tied to the certain groups or baskets of currencies

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12
Q

What is the demand for a currency is determined by?

A
  • Exports of goods and services
  • Receipts of income from overseas
  • Capital inflow (foreign investment)
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13
Q

What is the supply of a currency is determined by?

A
  • Imports of goods and services
  • Payments of income to overseas
  • Capital outflow (investment abroad)
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14
Q

What happens when demand for $AUST increases?

A
  • Due to an increased demand for Australian exports

- The value of the Australian dollar will appreciate

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15
Q

What happens when the supply of the $AUST increases?

A
  • Due to an increase in imports or increased income payments to overseas investors
  • The value of the Australian dollar will then depreciate
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16
Q

Why does a floating exchange rate means that the total balance of payments will always balance?

A
  • 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)
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17
Q

What is a clean float?

A

Currency floats free from the interference of the central bank

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18
Q

What is a managed exchange rate?

A

Occurs when there is official intervention in the foreign exchange market by the Reserve Bank

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19
Q

What are the 2 ways the central bank can influence exchange rates?

A
  1. 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
  2. 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
20
Q

What happens when a rise in the CAD causes the exchange rate to depreciate?

A
  • 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
21
Q

What happens when there is an excess supply of $AUD?

A
  • 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
22
Q

What is the J Curve effect?

A
  • 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
23
Q

Why is elasticity an important factor to consider when looking at the relationship between the exchange rate and the balance of payments?

A
  • Price changes on imports and exports that are inelastic hive little effect on quantities traded
  • A depreciation may not initially reduce a trade deficit
24
Q

What is the major disadvantage of free exchange rates?

A

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)
25
Q

Advantages to a free exchange rate?

A
  • 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
26
Q

How can a currency appreciation can help to shield the economy from a positive external shock?

A
  • 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
27
Q

Exchange rates between 2002-20014?

A
  • Fluctuated between $US0.51 and $US1.10

- Average value was $US0.83

28
Q

Exchange rates between 2002-2008?

A
  • Strong appreciation of the $AUD
    Marked the start of the mining boom
  • Fuelled by the strong demand from China
  • $US0.51 to $US0.96
29
Q

Exchange rates between 2008-2009?

A
  • 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

30
Q

Exchange rates between 2009-2011?

A
  • $AUD recovered by 2011

- $US1.10

31
Q

Exchange rates at the end of 2011?

A
  • $AUD fell to $US0.84

- Commodity prices, especially iron ore and coal took a tumble which decreased the demand for the $AUD

32
Q

What are the main factors that effect movements in the exchange rate?

A
  • Relative inflation rates
  • Movements in the terms of trade
  • Domestic economic growth
  • World economic growth
  • Relative interest rate
  • International capital flows
33
Q

How do relative interest rates effect the exchange rate?

A
  • 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
34
Q

How do movements in the terms of trade effect the exchange rate?

A
  • When the terms of trade become more favourable, the currency appreciates and vice versa due to the increase in demand for our currency
35
Q

How does domestic economic growth effect the movements in the exchange rate?

A
  • 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
36
Q

How does world economic growth effect the movements in the exchange rate?

A
  • 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
37
Q

How do relative interest rates effect the exchange rate?

A
  • 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
38
Q

How do international capital flows effect the exchange rate?

A
  • If investors found Australia to be a relatively more attractive destination for their funds compared to other economies, then the Australian dollar would appreciate
39
Q

What are the two key factors that influence the exchange rate?

A
  • Commodity prices

- Interest rate differentials

40
Q

Explain how commodity prices influence the exchange rate

A
  • 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
41
Q

Explain how Australia’s interest rate differentials with the United States effect the exchange rate?

A
  • 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
42
Q

What are the advantages to a depreciation of the exchange rate?

A
  • 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
43
Q

What are the disadvantages to a depreciation?

A
  • 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
44
Q

What are the advantages to an appreciation?

A
  • 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
45
Q

What are the disadvantages to an appreciation?

A
  • 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

Economics ATAR (12 decks)

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