Exchange Rates: Concepts Flashcards
How could the AUD appreciate against the Chinese Yuan and depreciate in terms of its TWI at the same time?
If the AUS depreciated against many other major trading partners’ currencies, this would outweigh the appreciation against the Yuan.
OR
If the AUD depreciated against another major trading partner’s currency significantly (e.g. Japan) but only appreciated against the Yuan slightly, then the depreciation would outweigh the change against the Yuan and the TWI would decrease
How can a government peg its currency?
- Buying and selling the currency: If the exchange rate starts to rise, the gov can sell the currency to increase supply and push it back down. And if the exchange rate starts to fall the gov can sell foreign reserves to demand the currency to push it back up.
- Monetary policy: If the exchange rate starts to rise, the gov can cut the cash rate (or vice versa if the exchange rate starts to fall)
How does a floating exchange rate act as a shock absorber for cyclical changes in the global economy?
a significant decrease in aggregate demand due to low exports or foreign investment could lead to a downturn in the domestic business cycle. However in this situation, a floating exchange rate would also depreciate due to the decrease in demand for the currency. As a result, the lower exchange rate would make it cheaper for foreigners to purchase exports or invest into the country, causing a recovery in aggregate demand and thus stabilising the business cycle.
The opposite would happen if there was an increase in exports or foreign investment - and the appreciation would counteract the risk of rising inflation.
Why does a floating exchange rate reduce the central bank’s need for foreign reserves?
If the central bank is not trying to control the exchange rate, it does not need to have foreign reserves to sell in order to buy the currency in the event that the exchange rate starts to fall
Why does a floating exchange rate allow the central bank to focus monetary policy on managing inflation?
If the central bank is not trying to control the exchange rate, it does not need to increase the cash rate in the event that the exchange rate starts to fall. Instead, it only needs to consider what inflation is like when setting the cash rate.
Why has the terms of trade increased over the past 7 years?
- Reductions in global production, due to floods in Brazil and covid disruption
- Increased global demand due to (i) covid impact of macro stimulus on construction; (ii) increased spending on goods rather than services
- Russian sanctions increasing commodity prices
But the ToT has fallen recently due to slowing growth in China
Why does the terms of trade affect the value of the AUD?
If the ToT increases, it usually means the price of exports have increased. This means that foreigners demand more dollars every time they buy exports, increasing demand and the AUD
Why does speculation affect the value of the AUD?
If speculators believe the currency will rise, they will demand more of it - causing their prediction to come true.
If speculators believe the currency will fall, they will sell it off (increasing supply) - causing their prediction to come true.
How does the level of domestic and global growth affect the value of the AUD?
If global growth is higher than domestic growth, exports will usually grow more than imports. This means that demand for the AUD will increase more than supply, causing the AUD to appreciate.
Why does the inflation rate affect the value of the AUD?
If the price of Australian products rises, foreigners no longer want to buy them - so demand for the AUD decreases.
Likewise, Australians now want to buy imports instead of locally made goods - so supply of the AUD increases.
Why has the Australian dollar fallen over the past 10 years?
The mining investment boom ended in 2013 (once mine expansions and infrastructure construction was completed), meaning there was less foreign investment and therefore less demand for the AUD
List 4 current factors affecting the value of the AUD, and identify for each whether it is putting upward or downward pressure on the value of the AUD.
- The decline in foreign investment since the end of the mining boom - pushing the AUD down
- The ToT spike over the past 5 years - pushing the AUD up (and recent ToT decline, pushing the AUD down)
- Australia raised interest rates, which should push the AUD up (but other countries raised their even more, which pushes the AUD down)
- In 2020, speculators predicted the AUD would fall due to lockdown - this caused a temporary depreciation
How does a depreciation of the AUD affect imports and exports?
J-curve:
In the short-term, import spending increases (still buy things, but they’re more expensive). In the long-term, import spending falls (people import less).
In the short-term, export revenue is unchanged (foreigners take time to respond). In the long-term, exports rise.
So in the short-term, the trade balance worsens, but in the long-term the trade balance improves.
How does a depreciation of the AUD affect net foreign debt?
The value of debt owed to foreigners would increase, because it now costs more AUD to get the foreign currency to repay the debt.
But around 90% of Aus foreign debt is dollar denominated, so it usually is unaffected by changes in the AUD.
How does a depreciation of the AUD affect net foreign equity?
The value in AUD of assets owned overseas would increase, so net foreign equity would improve (meaning NFE would decrease)
