Topic 2 - Part 2: Exchange rates Flashcards
What is an exchange rate?
The price of a country’s currency in terms of another country’s currency
How are exchange rates determined in Aus?
Forces of supply or demand
What rank is Aus in terms of the most traded currency?
5th most traded currency
What % of currency trades is AUD used in
Used in 6.8% of all currency trades
What is the significance of exchange rates?
Enables trade and financial flows (as firms and consumers want to be paid in their own currency) - thus, significant impacts on international competitiveness, trade flows, investment decisions, inflation, and other factors.
What is the difference between a bilateral exchange rate and a trade weighted index
Bilateral exchange rate: Measures the value of a unit of domestic currency relative to another currency
Trade weighted index: Measures the movements in a nation’s currency against a basket of currencies of the nation’s trading partners, weighted according to their importance to the nations trade
This means that the TWI is a more accurate measure of the worth of the AUD
What is the weighting of the Japanese Yen in the TWI from 2017-2022
10.7 (2017) –> 12.5 (2022)
What is the weighting of the USD in the TWI from 2017-2022
10.3 (2017) –> 8.2 (2022)
What is the weighting of the Chinese RMB from 2017 - 2022
27.46 (2017) –> 30.7 (2022)
What is the weighting of the European Euro from 2017-2022?
Stagnated at around 9.7
What is the importance of the TWI?
More accurate and important measure of AUD purchasing power than bilateral rates (which only measure changes against one currency, whereas the TWI measures a whole basket of currencies (that Aus is actually important to) and thus shows the overall value of the AUD). Shows upward and downward movements in the overall value. It is related to changes in Aus BOPs performance over time
What are the limitations of the TWI?
Can be misleading. Weighted according to volumes of trade, regardless of which currencies the contracts are invoiced in. All the currencies are denominated in $US and so the exchange rate of US is the main factor that changes and not the currency of Aus and trading partners. ⅔ of Australian exports and ½ of imports are denominated in $US currency, reflecting that the $US/$AUD exchange rate is far more important than its weight in TWI calculation.
When did Aus shift from a managed flexible peg to a floating exchange rate?
December 1983
What is a floating exchange rate system?
Under this system, the exchange rate is determined by free market forces and not gov intervention. Here, supply and demand establish an equilibrium price for the AUD in terms of another country’s currency
What are the 3 main reasons for switching to a floating ER system?
Most efficient exchange rate mechanism for determining value of currency
Expose the Aus economy to international competitive market pressures → ↑innovation
Pursue more independent and effective monetary policy (to control inflation) in a deregulated financial environment
What is demand for AUD represented by?
Represented by the people who wish to buy the currency
What are the 3 factors affecting demand for AUD?
Size of financial flows into Aus from foreign investors
Expectations of future movements of the AUD
Demand for Aus exports
Explain how size of financial flows into Aus from foreign investors affects demand for AUD
This is because foreign investors wanting to invest into Aus will have to convert their currency into AUD –> increasing demand for AUD. This is further influenced by the level of Aus i/r relative to overseas i/r, where higher i/r is more attractive for foreign savings –> increased demand for AUD
How do expectations of future movements of the AUD influence demand for AUD?
Speculation that the AUD will appreciate will result in increased investors wanting to invest into Aus –> increased demand for AUD due to having to change currencies.
On the flip side, expectations for a depreciation in the AUD will instead reduce demand for AUD as its deemed unprofitable
How do demands for Aus exports influence demand for AUD?
This is because foreigners who buy Aus exports need to convert their currency into AUD to pay Aus exporters. This in turn is affected by changes in commodity prices and terms of trade, in which their increase will lead to the increased value of Aus exports –> increased demand for AUD
It is also influenced by the degree of international competitiveness (IC) and Aus inflation rate compared to overseas markets. If IC is high and inflation is low, Aus X will be cheaper and more attractive to foreign buyers –> increased demand for AUD
Also affected by changes in global eco conditions. Demand for Aus commodity exports is dependent on the growth rates of Aus trading partners. When global EG is ↑, then demand and prices for Aus X ↑, same vice versa
What is supply of AUD represented by?
Represented by all those people who wish to sell the currency
What is supply of AUD affected by? (5)
Level of financial flows
Availability of investment opportunities overseas
Speculators in the forex markets
Domestic demand for imports
Tastes and preferences of domestic consumers
How does level of financial flows affect the supply of the AUD?
Financial flows out of Aus by AUs investors wanting to invest overseas will need to sell A$ –> Increasing supply for AUD
Meanwhile, if there are low financial flows out of Aus by investors trying to invest overseas, there will be less supply of AUD
What is the level of financial flows affected by?
Influenced by the level of Aus i/r relative to overseas i/r. This is because investing overseas will be more worthwhile than in Aus. It is also influenced by the number of actual investment opportunities overseas there are
How does availability of investment opportunities overseas impact supply of the AUD
Greater opportunities of investment → ↑ financial flows out of Aus → ↑ Supply of A$
How does speculation in the forex markets impact supply of AUD
Speculators in the forex market who expect value of the A$ to go down → sell A$ → Increasing supply of A$, which ultimately contributes to the anticipated depreciation
How does the domestic demand for imports affect supply of AUD?
because Aus importers who buy from overseas will sell A$ to obtain foreign currencies to make import payments.
What is demand for imports determined by?
Level of domestic income. Strong EG and rising incomes and employment → Demand for imports rising → ↑Supply of A$
The domestic inflation rate and competitiveness of domestic firms that compete with imports. If Aus inflation is higher and import-competing firms are relatively uncompetitive, imports will be cheaper than domestic products → demand for imports ↑ → ↑Supply of A$
How do tastes and preferences of domestic consumers affect supply of the AUD?
An increasing preference for g+s from overseas → ↑supply of A$ on the forex market
How do RBA policy measures affect the value of the currency? (example)
In 2020, when RBA purchased bonds in the bond market to increase liquidity and put downward pressure on i/r, it ↑supply of A$ → 1-2% depreciation of exchange rate in Nov 2020.
What is a depreciation?
a fall in the value or purchasing power of the exchange rate relative to other currencies.
What is an appreciation?
a rise in the value or purchasing power of the exchange rate relative to other currencies.
What is a summary of 6 reasons for appreciations?
An increase in Aus i/r or decrease in overseas interest rate
Improved investment opportunities in Aus or deterioration in foreign investment opportunities
A rise in commodity prices and an improvement in Aus TOT
An improvement in Aus international competitiveness
Lower inflation in Aus
Increased demand for Aus exported g+s
What is a summary of 6 reasons as for a depreciation?
A decrease in Aus i/r or increase in overseas i/r
Deterioration in investment opportunities in Aus or improvement in foreign investment opportunities
A fall in commodity prices and a deterioration in Australia’s TOT
Deterioration in Australia’s international competitiveness
Higher inflation in Australia
↑Demand for imported g+s
What are the 3 main types of exchange rates?
Floating exchange rate
Fixed exchange rate
Managed exchanged rate
What is a floating exchange rate?
This is where the exchange rate is determined by market forces. Here, there is no government intervention in the forex markets. This is considered a clean float, as there is no gov intervention.
What are the advantages of the floating exchange rate? (3)
Shock absorber/automatic stabiliser. When the currency appreciates, exports become less competitive –> automatically depreciates as it is less IC, and continues in cycle.
Prevents destabilising speculation on the value of the currency
Due to currency being market price, it will represent the fundamental stat of the Aus economy
What are the disadvantages of the floating exchange rate? (1)
There is an increased exchange rate volatility. This is because uncertainty can lead to a reduced level of investment, due to unpredictable exchange rate movements affecting the security of the investments
What is a fixed exchange rate system?
It is where the exchange rate is determined by the central bank (the RBA)
What is it called when the RBA lowers the exchange rate?
It is called a devaluation
What is it called when the RBA increases the exchange rate?
It is called a revaluation
What does it mean if a fixed exchange rate is pegged to another currency?
Meaning that there is a fixed exchange rate for its currency with a foreign currency or basket of currencies
Did Aus peg their currency to a different currency? If so when and who
In 1976 with the AUD pegged to the UK
What are the advantages of utilising a fixed exchange rate? (2)
Allows for certainty about the immediate ST value of the E/R which helps businesses make decisions
If central bank chooses to undervalue or overvalue their E/R, it will allow for them to constantly receive the benefits respective to each
What is an example of a fixed exchange rate and it’s benefits?
China intentionally undervalues their currency to receive a competitive advantage to the global export market leading to no appreciation of their currency even despite the massive demand from the global economy
What are the disadvantages of having a fixed exchange rate? (2)
Can cause destabilising speculation as speculators bet on the future value of the currency . If speculators buy AUD, it is harder for the central bank to keep currency at its set level. Making people want to sell more AUD. If speculators sell AUD, the central bank has to buy foreign currency to stabilise the AUD which depletes foreign reserves, making people want to buy more AUD
No shock absorber unlike a floating exchange rate
What is a managed exchange rate system?
Attempts to combine fixed and floating E/r systems, involving the central bank fixing the rate daily and then allowing it to float within a predetermined zone above and below the fixed rate, if it moves out of the zone, then the central bank will intervene to buy or sell currency
What are the 3 forms of the RBA influencing the e/r? and what type are they (direct vs indirect)
Dirtying the float (direct)
Monetary policy decisions (Indirect)
Jawboning (indirect)
What is dirtying the float as a form of influencing the exchange rate?
This is where the RBA feels that a ST change in the e/r will be harmful to the domestic economy (i.e. excessive speculation), and steps into the forex market as either a buyer or seller to stabilise the A$
How does selling or buying A$ as part of dirtying the float affect the e/r?
To prevent a depreciation of the currency, the RBA will buy AUD, which will put upward pressure on the ER due to increased demand
Selling the AUD will result in an increase in supply as opposed to less demand, which can be used to prevent rapid appreciation
How does the RBA buying or selling the RBA influence the exchange rate?
This can be explained through the supply and demand curves. In which the purchase of A$ will lead to increased demand, whilst supply remains constant, thus price decreases, and vice versa
What is the RBA’s limitation to buying A$?
Limitation is that it depends on the size of the foreign currency holdings (reserves of foreign currency and gold that can be used to fund such purchases)
How do monetary policy decisions affect the e/r?
Indirect way of influencing the ER. If the RBA wants to slow down depreciation, they may increase demand for A$ through increasing i/r –> more foreign investment
Normally, this is quite unusual as the RBA only changes the i/r to influence the domestic economy and the inflation rate
How does a depreciation result in an increase in inflation and what are the stats
However, RBA research shows that a 10% depreciation → 0.5% increase in inflation, and a 10% appreciation → 0.3% decline in inflation. These large currency movements are a concern for the RBA
Depreciation –> more expensive to buy foreign g+s –> suppliers in Aus who buy from foreign and sell to Aus have to pass on th increased price (imported inflation) Also there is an increased demand for Aus goods and services from overseas and not enough supply –> increased inflation. Same vice versa
What is jawboning (indirect) and how does it affect the e/r?
The practice where officials try to affect forex market outcomes through public statements. Predictions of strong EG can encourage foreign investment and speculation
What is an example of jawboning?
Phillip Lowe during the covid pandemic stated that interest rates wont increase until 2024, which was eventually unable to be followed due to high inflation rates
What is the general effect of an appreciation?
Generally contractionary effect
What is the general effect of a depreciation?
Generally expansionary effect
What are 6 negative effects of appreciation?
Lower IC (X more expensive) –> decreased X revenue –> Increased CAD
Imports will be less expensive, encouraging import spending and worsening Australia’s CAD. Domestic production of import substitutes falls → unemployment.
Reduces A$ value of returns from investments overseas, worsening NPY, as well as decreasing $A value of foreign assets. (valuation effect)
Higher M spending and reduced X revenue will reduce Australia’s EG rate
U/E in X and M competing industries
Increase in Inflationary pressures
What are 6 negative effects of a depreciation?
Increased debt servicing ratio and interest repayments, higher NPY deficit, therefore, increases Australia’s CAD
Higher Inflation present as imports are expensive and therefore slows economic activity –> decreased living standards
Reduced Purchasing Power
A depreciation will raise the $A level of foreign debt that has been borrowed in foreign currency as expressed in AUD (valuation effect)
Depreciation will raise the price of overseas assets that are being purchased by Aus investors
The J curve effect
What is the J curve effect?
It represents the ST and LT effects of a depreciation. Involves a curve that initially falls, then steeply rises above the starting point
In the short run, a depreciation increases import prices and decreases export prices
At a fixed volume, this worsens the BOGS as it decreases X revenue and increases X expenditure
In the long term, it increases Export competitiveness which increases export volumes and decreases Import volume
What are the 4 benefits of having an appreciation?
Increased purchasing power for consumers
Lower $A value of foreign debt that has been borrowed in foreign currency. This will ↓outflow on the NPY component of the current account in future years and help reduce Aus CAD (valuation effect)
Inflationary pressures will be reduced as imports become cheaper and will also reduce pressure on the RBA to raise interest rates to defend its inflation target
For Aus investors wanting to purchase overseas assets, an appreciation will reduce the price of those assets
What are the 6 benefits of having a depreciation?
Higher IC, therefore, ↑export income and ↑CAD in the medium term. This is due to Aus X becoming cheaper.
Increasing employment
A depreciation increases $A value of foreign income earned on Australia’s investment abroad, improve NPY of the CAD
Imports are more expensive → discouraging import spending → improving AUstralia’s CAD. Domestic production of import substitutes will rise
Greater financial inflows as domestic assets become cheaper to purchase → an increase in FDI and FPI(Foreign Portfolio investment)
A depreciation also increases the value of foreign assets in Australian dollar terms (valuation effect). (Worth more than we bought them at a higher ER) (Because the investment will be considered more expensive) (Overseas assets will have appreciated in value)
What are the effects of a depreciation of the AUD on the CA balance and why?
A depreciation of $A makes exports and services relatively cheaper to overseas buyers in terms of their currency. Therefore, the value of our export sales typically rises, causing the CAD to shrink. Also imports and services are dearer, and this tends to slow purchases of imports, Debits, CAD
A depreciation tends to make purchase of shares and property, denominated in Australian dollars, cheaper and more attractive for investors. By increasing net capital inflow and foreign liabilities, this could ultimately add to NPY debits involving the payment of dividends, rent and profits abroad and deteriorate the CAD
What are the effects of an appreciation of the AUD on the CA balance and why?
An appreciation leads to more imports than exports causing a higher CAD. Our exports become dearer, reducing value of sales, less debits and so CAD increases
An appreciation can encourage capital outflow associated with the purchase of overseas assets by residents, these assets could become cheaper and more attractive if denominated in foreign currencies. in the LT, this will lead to higher NPY credits while discouraging foreign capital inflow and NPY debits. Therefore, there is a reduction in CAD
How does the RBA overvaluing the AUD work? Using an example of the market value of 0.8 USD
RBA chooses to overvalue the AUD, fixing it at 0.9 USD. This means that there is an excess supply and the RBA will buy AUD and sell foreign currency to keep 1 AUD - 0.9 USD. (utilises a demand curve)
How does the RBA undervaluing the AUD work? Using an example of the market value of 0.8 USD
The RBA may choose to undervalue the AUD, fixing it at 0.7 USD. This means that there is excess demand, thus the RBA will need to sell AUD and buy foreign currency to keep 1 AUD = 0.7 USD
What are the important periods of time for Aus exchange rates, with their relevant events? (8)
2003-08: MIB I (Mining Investment boom)
2008-09: GFC
2010-13 MIB II (Mining Investment Boom 2)
2013-16: End of mining investment phase, enter mining production phase
2016-17
2019:
2020:
2022:
What was the appreciation/depreciation in 2003-08: MIB I
Appreciation:
$A rose from $US 0.47 (2001) to $0.94 peak in 2008
What was the appreciation/depreciation in 2008-09: GFC
Rapid depreciation: $A fell to $US0.62 March 09 (7 year low)
What was the appreciation/depreciation in 2010-13 MIB II?
$A peaked at $US 1.11 in 2011, 23% increase from US$0.87 in July 2010.
What was the appreciation/depreciation in 2013-16: End of mining investment phase
Depreciation:
June 2014 $0.93, $US0.73 in May 2016
What was the appreciation/depreciation in late 2016-17
Appreciation:
$A rose to US$ 0.80
What was the appreciation/depreciation in 2019?
Depreciation: $A fell to $US 0.69
What was the appreciation/depreciation in 2020-21: Covid
Appreciation: $A 0.62 in March 2020 –> $0.77 in 2021
What was the appreciation/depreciation in 2022?
Depreciation: Depreciation from $0.72 in Feb 2022 → low of $0.63 in Oct 2022
What caused the appreciation during MIB I (2003-2008) (3)
Demand > supply
Growth in emerging economies such as China increased demand for the relatively inelastic commodities such as iron ore. This, coupld with insufficient global supply leads to higher commodity prices –> increase in demand for AUD –> appreciation of the AUD
There was also increased foreign investment into Aus mining sector (where at it’s peak 80% of mining sector was foreign owned) –> increased demand for AUD
Increased imports of both capital goods and final g+s –> increased supply of AUD
What were the effects of the appreciation during MIB I? (3, 1 stat)
Significant damage to IC of manufacture exports such as PMV and service exports such as education and tourism (Known as Dutch Disease, where growth in one industry isn’t matched in others)
From 2003-2008, average growth in mining states was 4.7% compared to others which was 2.2%
Appreciation led to a relative decrease in import prices which contained imported inflation
What % of mining sector was foreign owned at its peak?
80% was foreign owned
How much did investment into the mining sector increase from 2003-2012
2% –> 8% of GDP between 2003-2012
What was the avg growth in mining industries from 2003-2008 compared to other industries? (example of Dutch Disease)
4.7% in 2003-08 compard to others which was 2.2%
What caused the rapid depreciation during the GFC? (2)
There was a global eco recession –> decreased D for Aus X –> decreased D for AUD
Financial outflows from Aus due to GFC caused a decline in the KFA surplus from $72.5bn to approx $40bn –> investors withdrawing funds due to uncertainty –> increased supply of AUD and Decreased demand for AUD
How much did the GFC change the KFA surplus?
$72.5bn to approx $40bn
What was the depreciation in the GFC slightly cushioned by? (2)
Increased IC of X –> increased demand for A –> Decreased demand for M –> small BOGS surplus
RBA intervention - purchased $3.3bn of $A in forex market –> Increased demand for AUD
What are the effects of the depression from the GFC?
Improved international competitiveness of Aus X and allowed for a two speed economy
Aus recorded a trade surplus of 6 million in 2008, the first in over a decade
Strong trade performance contained the fall in growth rate, allowing aus to avoid recession. AU growth rates dropped to 1.7% during GFC whilst global growth rates fell to negative growth (US: -8%)
Growth rates of Aus vs the US in GFC?
Aus dropped to 1.7% during GFC, whilst US fell to -8%
What should you discuss when talking about MIB I appreciation? (3)
Demand factors
Supply factors
Effects
What should you discuss when talking about GFC depreciation? (3)
Both increased supply and decreased demand for the AUD
What was the depreciation cushioned by?
Effects of the depreciation
What caused the appreciation during MIB II (2010-13)?
Increased demand for AUD
What should you discuss when talking about the appreciation during MIB II
Increased demand for AUD
Decreased demand for AUD in non-mining sectors (Dutch disease)
Decreased supply of AUD
What caused the rapid appreciation during MIB II (2010-2013) (2, 1 in detail (5 sub points))
Increased demand for AUD due to:
rising world commodity prices (iron ore prices rose to $US 180/ton –> increased TOT
Increased in investment in mining sectors –> KFA credits
Aus considered a safe haven with AAA credit rating as opposed to Euro.
I/r differential of Aus: 4.75% vs US 0% –> increased investment into Aus
DECREASED supply of AUD due to low global interest rates –> decreased debt servicing repayments with decreasing NPY debits –> decreasing supply of AUD
What did the price of iron ore rise to during MIB II?
Rose to $US 180/ton
What was the Aus and US I/R differential during MIB II?
4.75% (AUS) vs 0% (US)
Was there decreased demand for AUD during the MIB II? If so, explain
There was the ‘Dutch disease’, where there was a low IC in non-mining sectors –> decreased credits in BOGS from non-mining. This is seen in the closure of Holden, toyota, ford manufacturing plants due to removal of gov subsidies
What caused the depreciation during the end of mining investment phase; start of mining production phase? (2) (2013-16)
Decreased demand for AUD, decreased TOT
Decrease of iron ore prices from 180 USD per tonne in 2011 to 40 USD per tonne in 2016 (due to slow down in China’s EG 12% –> 6% from 2010-14)
What were the benefits of the end of mining investment phase depreciation (2013-16)? (2)
Depreciation improved IC of non-mining sectors –> increased demand for service exports and increased BOG credits –> increased demand for AUD
US fed reserve increased official interest rates 3 times below Dec 2016-17 –> decreased investment flows into AUs –> decreased KFA credits –> decreased demand for AUD –> Decreased value of AUD –> Increased IC
What are the two things to discuss in talking about e/r during 2013-16 (end of mining investment phase)?
The decreased demand for AUD
Benefits of the depreciation
How much did iron ore prices decrease from 2011 to 2016?
2011: 180 USD per tonne
2016: 40 USD pre tonne
What caused the appreciation in late 2016-17? (2)
Increased demand for AUD due to strong commodity prices (strong growth in China), rise in iron ore and coal prices. There is also an increase in investment flows into Aus KFA surplus –> increased demand for AUD –> appreciation
Decreased supply of AUD due to decreased import debits due to lower import prices –> decreased supply of AUD (?)
What caused the depreciation in the AUD in 2019? (3)
Decreased demand for AUD:
Global EG slowed to 3% with decreased commodities prices and a lower TOT
RBA cut interest rates from 2011-16 from 4.75% to 1.50% lowering the i/r differential between Aus and overseas –> downward pressure on the AUD
What caused the AUD appreciation in 2020/2021? (3)
Market sentiment; prior to covid-19, Aus already had good investability which may have led many to invest into Aus as it is perceived as a ‘safe’ investment
Net goods and services of 19.4bn demonstrates relatively strong demand for Aus X –> increased appreciation because more people overseas have to buy AUD to purchase Aus X. This was quite a significant increase in net g+s since 2018 7.1bn, 15.4bn in 2019
8 year high iron ore price of $160/ton
What was the net goods and services of Aus in 2020/2021 compared to the net g+s since 2018 and 2019?
It was $18.4bn in 2020/21,
2018: 7.1bn
2019: 15.4bn
What caused the depreciation in 2022?
Deteriorating risk sentiment; meaning that investors have less of an appetite for risk –> decreased demand for AUD –> worsening depreciation
What was the rise of the TWI during MIB I?
TWI rose from 50 to 75
What period was MIB I?
2003-2008
What was the TWI during the GFC?
TWI fell below 60
When was the GFC?
2008-2009
What was the TWI during MIB II?
TWI reached 87 in 2013
When was MIB II?
2010-2013
When was the end of mining investment phase?
2013-2016
What was the TWI at the end of mining investment phase?
71.3 to 60 (Jan 2016)
