Exchange Rates

Question 1

Define trade-weighted index.

Answer 1

Trade weighted index is a ‘basket’ of currencies weighted according to their importance in trade flows with Australia.

Question 2

Define an exchange rate.

Answer 2

An exchange rate is simply the price of one country’s currency.

Question 3

Define the foreign exchange market.

Answer 3

The foreign exchange market is the market in which the currencies of different countries are bought and sold.
I.e. An Australian farmer selling wool wants to be paid in Australian dollars, while an American IPhone producer wants US dollars.

Question 4

With the aid of a diagram, explain how the value of the Australian dollar will be impacted if Australia increases its imports from the US.

Answer 4

If Australia increases its imports from the US, there will be an increase in the supply of AUD, and an increase in the demand for USD, The AUD will depreciate, the USD will appreciate.

Question 5

How are a country’s balance of payments and the value of its currency linked?

Answer 5

A country’s balance of payments and the value of its currency are closely linked. The exchange rate is the means by which all transactions in the balance of payments are facilitated.

Question 6

When is the AUD have said to have appreciated?

Answer 6

The Australian dollar is said to have appreciated if one unit buys less units of another currency.

Question 7

When is the AUD have said to have depreciated?

Answer 7

The Australian dollar is said to have depreciated if one unit buys more units of another currency.

Question 8

What is a fixed exchange rate?

Answer 8

Artificially setting the price of the exchange rate.

Question 9

What is a floating exchange rate?

Answer 9

Allowing the market forces of supply and demand to freely set the value of the currency.
Australia adopted a floating exchange rate in 1983.

With a floating exchange rate, the value of the currency is determined by the forces of supply and demand.

Question 10

What is a hybrid exchange rate?

Answer 10

This is where the value of the currency is tied to a specific group or ‘basket’ of currencies, but its value is reset by the central bank (Reserve Bank).
Also known as the ‘crawling peg’ system.

Question 11

In terms of the supply/demand of a country’s currency, what is the impact of credits and debits? Use examples.

Answer 11

Credits in the balance of payments represent the demand for a country’s currency. Examples include the export of goods and services, the receipt of income from overseas, and the inflow of capital (foreign investment).
Debits in the balance of payments represent the supply of a country’s currency. Examples include the import of goods and services, the payment of income overseas, and the outflow of capital (investment overseas).

Question 12

What will happen to the AUD if the demand for Australian exports increases? What about if the demand for American imports increases?

Answer 12

If the demand for Australian exports increases, it means the demand for AUD increases and the value of the AUD will rise/appreciate.
If the demand for American imports increases, it means the supply of AUD increases and the value of the AUD will fall/depreciate.

Question 13

With the aid of a diagram, explain what will occur if the demand for AUD increases, and reasons why this could occur.

Answer 13

If the demand for AUD increases, then the demand curve shifts to the right, resulting in an appreciation of the currency. The AUD increases its value.
An increase in demand could occur if there was:
-An increase in the demand for Australian exports.
-Increase in foreign investment into Australia.
-Increase in income receipts from overseas.

Question 14

With the aid of a diagram, explain what will occur if the supply of AUD increases, and reasons why this could occur.

Answer 14

If the supply of the AUD increases then the supply curve shifts to the right, resulting in a depreciation of the currency. The AUD decreases in value.
An increase in supply could occur if there was:
-An increase in spending on imports.
-Increase in foreign investment to foreign countries.
-Increase in income payments to overseas residents.

Question 15

Why must the CAD balance with the KAS under a floating exchange rate system?

Answer 15

Under a floating exchange rate system, the CAD must balance with the KAS. This is because the sum of all the credit transactions (demand for AUD) will equal the sum of all debit transactions (supply of AUD). A floating exchange rate means that the total balance of payments will always balance. If there is a deficit in the current account a matching surplus will occur in the capital and financial account.

Question 16

When is currency referred to as a clean float?

Answer 16

When the currency is allowed to float free from the interference of the central bank (Reserve Bank) then it is referred to as a ‘clean float’.

Question 17

When does a managed exchange rate occur?

When will the reserve bank intervene?

Answer 17

A managed exchange rate occurs whenever there is official intervention in a foreign exchange market by the reserve bank.
The reserve bank can act as either a buyer or seller of currency. Intervention will usually occur if the exchange rate gets too high or too low.8

Question 18

What are the two methods by which the reserve bank can influence the rate of the AUD?

Answer 18

1) The reserve bank can act as a buyer or seller of currency, indirectly influencing its rate through the market system. For example, if the reserve bank wanted to prevent the exchange rate from falling too low, it would enter the market as a buyer of Australian dollars -increasing demand.
Conversely, if the bank wished to stop the currency from appreciating, it would sell AUD, increasing the supply and hence reducing any upward pressure on the exchange rate.

2) The second method is through monetary policy. Monetary policy is used to set short term interest rates. If interest rates are increased, then foreign investment will be attracted to the Australian economy -> increasing the demand for Australian dollars and appreciating the currency.

Question 19

What is a ‘dirty float’ or ‘lightly managed float’.

Answer 19

Whenever the central bank intervenes in the foreign exchange market to influence the movement of the currency, it is referred to as a ‘dirty float’ or ‘lightly managed float’.

Question 20

Which exchange rates do economists favour?

Answer 20

Economists favour free exchange rates.

Question 21

What is the advantage of a floating exchange rate regime? Explain using an example.

Answer 21

A floating exchange rate regime has the advantage of providing automatic adjustments in the balance of payments.
E.g. if there is excess supply of AUD, then a depreciation will raise the price of exported goods and services in domestic currency and lower the price of excess goods in foreign currencies. This will help to automatically remove the excess supply.

Under a floating exchange rate, the balance of payments does not effect the domestic money supply.

Question 22

What should happen to the AUD if the CAD increases?

Answer 22

Usually, a rise in the CAD will lead to an exchange rate depreciation (think there is a decrease in the demand for exports, less credits=increased deficit). This increases the price of imported goods and services and decreases the price of Australian exports. Demand for imports should fall while demand for exports will be increased, thus reducing a trade deficit.

Question 23

Explain the J curve effect.

Answer 23

Usually, a rise in the CAD will lead to an exchange rate depreciation, however, this assumes that the demand for both imports and exports is responsive/elastic to the change in price.
If the demand is relatively inelastic, then higher import prices may actually lead to an increase in import payments.
Similarly, if exports are relatively inelastic, then lower prices may initially lead to lower export receipts (lower prices won’t increase demand much).

The result is that a depreciation may actually increase a trade deficit -> this is known as the ‘J-Curve Effect’.
It all depends on elasticity- how responsive quantity is to a change in price.

If the demand for exports and imports was price inelastic (such as for commodity exports), then a change in price would have little effect on the quantities traded. The J curve effect is short term. Eventually, the change in exchange rate will have the expected effects on trade volumes.

Question 24

How can a floating exchange rate protect the economy from external shocks?

Answer 24

A depreciation has an expansionary effect on the economy which can help rebalance the economy after a negative shock.
An appreciation has a contractionary effect, which can help rebalance the economy after a positive shock (e.g. mining boom).

Question 25

What is the main disadvantage of a floating exchange rate?

Answer 25

The main disadvantage is that they increase degree of uncertainty for buyers and sellers and uncertainty effectively increases the cost of international transactions.

To overcome this problem a hedging strategy can be used to avoid any exchange rate fluctuation. A Forward Contract allows you to agree to an exchange rate today to buy or sell currency in the future.

Question 26

What impact does a depreciation have on the competitiveness of Australian exports?

Answer 26

A depreciation reduces the prices of Australia’s exports and provides Australian exporters with a competitive advantage in overseas markets.

Question 27

How does a depreciation help rebalance the economy?

Answer 27

A depreciation has an expansionary effect on the economy which can help rebalance the economy after a negative shock.

Question 28

What reduced inflationary pressure on the economy during the mining boom?

Answer 28

The mining boom increased mining investment and raided national income and wages. This would normally bring inflationary pressure, but the high Australian dollar helped to slow the economy by inducing higher export prices and lower import prices. The non-mining sector of the economy was weakened by the high dollar, and this reduced inflationary pressure on the economy.

Question 29

When will a depreciation in the AUD occur? An appreciation?

Answer 29

The exchange rate changes whenever demand or supply conditions change.

A depreciation occurs if the demand for the currency decreases or the supply of the currency increases.
An appreciation occurs if the demand for the currency increases or the supply of the currency decreases.

Question 30

What is the current value if the AUD?

Answer 30

0.77USD

Question 31

List the six factors affecting the exchange rate.

Answer 31

Anything that effects the demand for exports or foreign investment will effect the exchange rate

1) Relative inflation rates
2) Movements in the terms of trade
3) Domestic economic growth
4) World economic growth
5) Relative interest rates
6) International capital flows

Question 32

Explain how relative inflation rates effect the exchange rate.

Answer 32

Inflation reduces the competitiveness of industries in the traded goods sector. A high inflation rate relative to the other countries will have a negative influence on the exchange rate- the demand for AUD will decrease, the supply of AUD will increase.

Question 33

Explain how movements in the terms of trade effect the exchange rate.

Answer 33

Has a major influence.

When ToT increases (more exports) the demand for AUD increases and the currency appreciates.

Question 34

Explain how domestic economic growth effects the exchange rate.

Answer 34

Strong economic growth in Australia will increase the demand for imports (both consumer and investment goods).
Increases the supply of AUD causing a depreciation.

Question 35

Explain how world economic growth effects the exchange rate.

Answer 35

Increases world economic activity increases world commodity prices which increases D(AUD) and appreciates the currency.

Question 36

Explain how relative interest rates effect the exchange rate.

Answer 36

If the interest rates in the US rise relative to Australia, there will be a decrease in capital inflow to Australia and an increase in capital outflow.
D(AUD) will decrease and S(AUD) will increase, causing a strong currency depreciation.

Question 37

Explain how international capital flows effect the exchange rate.

Answer 37

If investors found Australia to be a relatively more attractive destination for their funds, then D(AUD) will increase and the Australian dollar would appreciate.

Question 38

What value did the AUD fluctuate between from 2002 and 2014?

Answer 38

Between 2002 and 2014, the AUD fluctuated between USD0.51 and USD1.10, and between 50 and 79 on the traded weight index (TWI).
During this period, the average value for the AUD was US0.83, and the two exchange rates tracked each other very closely.

Question 39

What happened to the AUD from 2002-2008?

Answer 39

Between 2002 and June 2008, there was a strong appreciation of the AUD both against the USD and the TWI. This was the start of the commodity boom in Australia fuelled by the strong demand from China.

Question 40

What happened to the AUD from 2008-2009?

Answer 40

During 2008-2009, there was a dramatic fall in the Australian dollar due to the GFC.
The currency declined by 33% from USD0.96 in June 2008 to a low of USD0.64 in January 2009.

Question 41

What happened to the AUD following 2009?

Answer 41

During 2009, the AUD recovered and by July 2011 was USD1.10 -> its highest value since being floated in 1983.
Australia’s terms of trade also reached its highest level during 2011.

Question 42

What happened to the AUD following 2011?

Answer 42

By the end of 2011, the AUD had fallen back below parity with the USD and was equal to USD0.84.
Commodity prices, especially iron ore and coal, took a tumble which decreased the demand for the AUD.

Question 43

What are the two key factors that drive Australia’s exchange rate?

Answer 43

Commodity prices.

Australia’s interest rate differential with the United States.

Question 44

Explain how commodity prices are a key factor driving Australia’s exchange rate.

Answer 44

Around 65% of Australian exports are made up of primary commodities- rural goods and resources.
Changes in the prices of these commodities have a significant effect on export values and ultimately on Australia’s national income.
The Australian dollar is often referred to as a ‘commodity currency’.
There is a very strong positive correlation between movements in commodity prices and the Australian dollar.
A general increase in commodity prices, ceteris paribus, will result in an appreciation of the Australian dollar.

Question 45

Explain how Australia’s interest rate differential with the US is a key factor driving Australia’s exchange rate.

Answer 45

Australia’s interest rate differential with the US can be measured by the difference in the official cash rate between the two countries.
An increase in the interest rate differential, ceteris paribus, will lead to an inflow of foreign investment into the Australian economy, increasing the demand for AUD and appreciating the currency.

E.g.
In October 2014 where the cash rate in Australia was 2.5%, while in the US the federal funds rate was only 0.09%. Interest rates were also decreased in Japan and Europe which meant Australia’s rate was the highest in the developed world. This higher rate attracted foreign investors who were seeking higher returns for their funds.

Question 46

What is the effect of an appreciation of the AUD?

Answer 46

An appreciation harms Australian exporters because exports become more expensive to overseas buyers.
An appreciation also reduces the price of overseas goods (imports) to Australian producers and consumers.
Domestic producers and retailers are disadvantaged as consumers are attracted to lower priced imports.
An appreciation will likely increase a trade deficit, or reduce a trade surplus and therefore increase the current account deficit.
An appreciation will have a contractionary effect on the economy as it reduced net exports and decreases aggregate demand and will also reduce inflation.

Question 47

What is the effect of a depreciation of the AUD?

Answer 47

One advantage of a depreciation is that it bestows a competitive advantage through the relative price effects on exports and imports.
The prices of Australian goods and services in foreign currency (exports) fall while the prices of Australian imports, in Australian currency, rise.
A depreciation encourages resources to flow into the traded goods industry (both exports and imports competing industries).
A depreciation should increase exports and decrease imports which will increase aggregate demand in the economy.
A depreciation can reduce a trade deficit, or increase a trade surplus, in the current account deficit.
A depreciation hurts consumers as they pay higher prices for imported goods, and this may potentially be inflationary.
Tourists coming to Australia will increase.
Inflation will occur due to imports being more expensive.

Question 48

Is a higher exchange rate good?

Answer 48

Many people believe that a high exchange rate is good for an economy, and that a low exchange rate is bad. This is not necessarily true.
A high exchange rate is good for some groups in the economy, but bad for others.
There are costs and benefits associated with both a currency depreciation and a currency appreciation.