Unit 3.C - Exchange rates and BoP Flashcards
What are exchange rates?
An exchange rate is the price of one currency in terms of another.
These two currencies are called a currency pair.
What is the relationship between currencies in a currency pair?
Inverse: they move in opposite directions: if one goes up in value (appreciates) the other goes down in value relative to it (depreciates).
This means they can also be calculated as inverses:
if 1 Aussie dollar buys 0.73 US dollars, if we want to know how many Aussie dollars 1 US dollar can buy, we divide 1/0.73, which = 1.37. Thus, 1 $USD buys 1.37 $A.
Can we determine the value of a currency from looking at a single currency pair?
Not really.
$A might be doing really well relative to the yen, but poorly relative to the pound. $A might appreciate against the NZ dollar due to a spike in inflation in NZ: basically, the change in our currency isn’t because Australia has done something to merit a higher currency value, but because the other member of the pairing has become worse off.
What is an appreciation?
An appreciation is a relative increase in a currency’s value.
This means that residents have increased purchasing power overseas.
Foreign goods become relatively cheaper.
72 Aussie cents - 80 Aussie cents per $USD.
What is a depreciation?
A depreciation is a relative decrease in a currency’s value.
This means that residents have decreased purchasing power overseas.
Foreign goods become relatively more expensive.
0.8 $A - 0.72 $A per $USD.
What is the relationship between a currency’s value and the spending power holders have overseas?
If the Australian dollar appreciates in value, holders have increased spending power overseas: the $A buys you more pounds than it did before. Hence foreign goods become relatively cheaper.
How can changes in exchange rates be modelled graphically?
Appreciations and depreciations of a currency can be shown as changes in the price of a currency (in terms of another) in a market diagram (see unit 1). For example, in the market for $A price would be shown as $US (or any other currency we might like to contrast with) and quantity would be given in $A. Thus, value of the $A changes with changes in market equilibrium, due to changes in supply or demand factors.
Apprecation: when the price of $A in $US rises:
- Increase in demand
- Decrease in supply
Depreciation: when the price of $A in $US falls:
- Decrease in demand
- Increase in supply
Can we have a dollar that’s appreciating against one currency but depreciating against another?
Yes!
Consider the following scenario. Australia is printing a little money, China is printing none, but the USA is printing A LOT… thus, relative to Chinese currency $A is depreciating (as supply is increasing) yet relative to the $US, $A is actually appreciating, just because they are essentially depreciating MORE.
How are importers and exporters affected by changing exchange rates?
- If you import a good, you need to pay in that good’s home currency. If you export a good, you receive payment in your own currency, so the importing country must demand $A so that they can pay Aussie exporters.
- When we import, we need to pay in foreign currencies, so in order to buy foreign currency we must sell/supply $A which can be bought then by people who buy our exports (an exchange, see?)… we must give up our currency to buy another.
- People who buy our exports must pay in A$ (a demand for $A, if exports increases demand for our currency increases may cause appreciation) and so the more able to purchase A$ they are the better our exporters will fare: if our currency depreciates they experience a relative increase in purchasing power, meaning that they will be able to buy more $A than before, opposite true for an appreciation.
Thus an appreciation is bad for our exporters and good for our importers, and a depreciation is good for our exporters and bad for our importers.
Who benefits from a currency’s depreciation? (Say of $A against $USD).
- Exporters (by decreasing value of $A in terms of other currencies, our exports become cheaper on world markets and thus easier to sell.
- Aussies holding $US
- Import-competing businesses
- Aussies with shares in US companies
- Increases value of foreign assets in $A terms
- Entities with foreign assets: their value increases in $A terms (the valuation effect).
- Cheaper for foreign investors to invest in Australia: may increase financial flows.
Who is disadvantaged from a currency’s depreciation? (Say of $A against $USD).
- Imports (become more expensive with a reduction in our purchasing power; discourages import spending).
- Disadvantages Australian consumers who want to buy overseas goods.
- Americans holding $A
- Aussies with debts to Americans in $US
- Australia’s foreign debt (borrowed in $US; increased the interest servicing cost bc we can buy less foreign currency with our domestic currency with which to pay this interest, increasing income outflow).
- -> Smaller, developing countries are often severely set back when their currencies depreciate for the reason that their debt essentially grows).
Also rise in cost of imports may be an inflationary pressure.
How does a change in a currency’s value affect AD?
Usually a depcreciating currency has an expansionary effect (discourages imports, encourages exports), boosting GDP, while an appreciating currency has a contractionary effect (encourages imports, discourages exports) potentially reducing GDP.
What are some of the negative effects of an appreciation?
- Our exports become more expensive to the rest of the world: decreases export volume.
- Increase in our purchasing power of other currencies means imports become relatively cheaper,
- More negative balance of net exports reduces GDP.
- Foreign investors will find it relatively more expensive to invest in Australia: lower financial inflows
- Reduces the A$ of foreign income earned on Australia’s investments abroad, deterioriation in CAD.
- Reduce the value of foreign assets in $A terms: valuation effect.
Factors that affect the supply of a currency?
- Our demand for imports
- Availability of overseas investment opportunities
Factors that affect the demand for a currency?
- Demand for our exports
- Aussie competitiveness
- Investment opportunities (increase in foreign investment increases demand for Aussie dollar: appreciation).
- Tastes and preferences of overseas consumers
Factors that may affect supply OR demand of a currency? (Or that affect BOTH)
- Speculators (supply currency when they sell as a result of expecting a depreciation, demand when the value is low and they expect an appreciation).
- Expectations (related to speculators): if currency has low value and is expected to rise, speculators buy it up as not to miss out on an appreciation, and this increased demand itself may cause said appreciation. If currency is of really high value and there is some risk of it losing value, then speculators will quit while they’re ahead and sell it off, both decreasing demand and increasing supply: double-barrel depreciation risk.
- Inflation (inflation is a domestic reduction in purchasing power; makes the currency less attractive to speculators as it implies a reduction in the economy’s stability, so decreases demand which results in a depreciation. As these speculators sell off the currency, this increases supply, which further reinforces the depreciation. Thus high inflation causes a depreciation, reduced inflation causes an appreciation.
- Our interest rates: if our interest rates are higher that makes Australia a more attractive place to leave your savings, hence increasing demand and causing an appreciation. On the other hand, if we have relatively low interest rates, then overseas locations with higher interest rates make more attractive places for Aussies to leave their savings: increases financial flows out of Australia.
