Exchange Rates (Ch 6)

Question 0

What is the FOREX market?

Answer 0

The market in which currencies are traded

Question 1

Define exchange rate

Answer 1

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

Question 2

Define appreciation

Answer 2

The increasing value of one currency against another.

Question 3

Define depreciation

Answer 3

The decreasing value of one currency against another.

Question 4

What is a “fixed exchange rate”?

Answer 4

When a country’s currency is determined by the government authorities and is adjusted periodically to reflect the changes in the value of other currencies and trade.

Question 5

What is a “floating exchange rate”?

Answer 5

When the price of currency is determined by the forces of supply and demand.

(Aus since 1983)

Question 6

What is a “managed/ dirty float exchange rate”?

Answer 6

When the monetary authority of the country (i.e. RBA) intervenes in the foreign exchange market to influence the value of the currency.

This is done by influencing monetary policy or buying and selling the AUD.

An example of this in Australia’s context is in 2001 when the exchange rate

Question 7

Under floating exchange rate regimes, what factors influence the DEMAND for $AU?

Answer 7

The DEMAND for AUD is determined by the spending and investment patterns of OVERSEAS residents in Australia.

These are shown as CREDIT transactions in the BOP
(E.g. Payments for exports, tourists spending in Australia, foreign investment)

Question 8

Under the floating exchange rate regime, what factors influence the SUPPLY of $AU?

Answer 8

The SUPPLY of AUD is determined by the spending and investment patterns of AUSTRALIAN residents overseas.

These are shown as DEBIT transactions in the BOP
(E.g. Payments for imports, freight payments to overseas shipping lines and interest payments)

Question 9

What are the causes of an APPRECIATION in a freely floating market?

Answer 9

INCREASE IN DEMAND

• increased demand for exports
• increased capital inflow
• increased TOT
• increased international competitiveness

DECREASED SUPPLY

• decreased demand for imports
• decreased capital outflow
• increased TOT
• increased international competitiveness

Question 10

What are the causes of a DEPRECIATION in a free floating market?

Answer 10

Basically, a decrease in credits in the BOP and an increase in debits in the BOP.

DECREASED DEMAND

• decrease in demand for exports
• decrease in capital inflows
• fall in TOT
• fall in international competitiveness

INCREASED SUPPLY

• increased demand for imports
• increased capital outflow
• fall in TOT
• fall in international competitiveness

Question 11

What are the main factors affecting exchange rates?

Answer 11

1) Relative inflation rates
2) Domestic economic growth
3) Worth economic growth
4) Relative interest rates
5) TOT
6) International investment

Question 12

How is “relative inflation rates” a factor that influences exchange rates?

Answer 12

EXPORTS:
Higher inflation rates means our goods and services are less competitive on the global market leading to a decrease in demand for AUD as less people are changing into AUD.

IMPORTS:
Lower prices of domestic and import-competing goods mean less need for imports which decreases the supply of AUD and thus appreciates the AUD.

Question 13

How is “world economic growth” a factor that influences exchange rates?

Answer 13

As the economic conditions of our trading partners improve, it will generally result in a greater demand for our commodities, and thus the AUD.

This is the main reason for the appreciation of the AUD in recent years: thanks to the rapidly growing economies of China and India who need our raw materials for investment in infrastructure and export production.

This is also seen by the fact that even following the GFC, where there was a DECREASE IN COMMODITY PRICES and a steep DECLINE IN THE AUD, China’s quick recovery from the GFC meant we rebounded into appreciation also.

Question 14

How is “domestic economic conditionsa” a factor that influences exchange rates?

Answer 14

Australia has a high marginal propensity to import.
When the domestic economy is growing strongly,
FIRMS sector take in more investment in capital equipment which is predominantly sourced from overseas.
CONSUMERS experiencing higher employment conditions and income respond by increasing spending in consumer durables which are imported.

ALL OF WHICH INCREASE IN SUPPLY OF AUD!

Question 15

How is “international investment” a factor that influences exchange rates?

Answer 15

Increased foreign investment results in an increase in demand for AUD as currency must be converted to AUD in order to invest in Australia.

Australia, as of late, has been seen as a popular investment opportunity due to our higher interest rates compared to countries like the US, political stability, strong credit rating and strong domestic growth.

Question 16

How is “relative interest rates” a factor that influences exchange rates?

Answer 16

Higher interest rates are offer better financial returns on foreign savings, thus attracting investment into Australia, leading to an appreciation.

Over the past decade or so, Australia’s interest rates have remained above major industrialised countries such as the US. In late 2004, for example, the cash rate was 4.7% while the US was at 1%, meaning investors would gain 3.75% more returns when investing in Australia, thus increasing investment.

Question 17

What are the positive effects of the APPRECIATION in the AUD?

Answer 17

SHORT TERM BENEFITS

1) Decrease in the price of imports and increase in the price of exports
2) Lower inflation
3) Decreases foreign debt

Question 18

What are the negative effects of the APPRECIATION of the AUD?

Answer 18

1) Reduced competitiveness of Aus G&S
2) Higher investment overseas
3) Shifts towards narrow export base

Question 19

How is a “decrease in the P(M) and increase in P(X)” a benefit of the APPRECIATION of the AUD?

Answer 19

• Our major exports are relatively inelastic, therefore an appreciation would have a small effect on the demand of our goods.
• The decrease in the P(M) reduces the cost of inputs
• Higher export and import expenditure will help improve CAD

Question 20

How is a “Lower inflation” a benefit of the APPRECIATION of the AUD?

Answer 20

Because lower import prices would mean a reduction in the cost of production. This would be reflected onto almost all businesses in Australia as the majority of capital goods are imported goods.

Question 21

How is a “reduced competitiveness” a cost of the APPRECIATION of the AUD?

Answer 21

• There will be a dramatic increase in prices of Australian goods and services in the long term, ESPECIALLY elastic goods such as tourism and manufacturing.
• This reduces export income relative to import expenditure, thereby worsening CAD.

Question 22

How is “higher investment overseas” a cost of the APPRECIATION of the AUD?

Answer 22

Domestic assets are too expensive, therefore shift overseas.

This decreases direct and portfolio investment.

Question 23

How is “shifts towards narrow export base” a cost of the APPRECIATION of the AUD?

Answer 23

• Already mining commodity exports take up the highest percentage, with chine being our highest buyers.

• Makes Australia VULNERABLE to external shocks
(E.g. Recent dampening of the Chinese ECON)