Exchange Rate Definition
The price of one currency in terms of another economy's currency, which facilitates economic transactions individuals, firms, and governments in different economies
- Currency conversion occurs in the foreign exchange market
Australia's floating exchange rate system
- Dec. 83, Australia switched from a managed flexible peg to a floating exchange rate system-one of most important structural changes Australia has implemented, opened up economy to global financial flows
- Under the floating system, the exchange rate is determined by the interaction of the market forces of demand and supply not govt, which establish an equilibrium price for the $A in terms of another country's currency
Demand for Australian Dollar
The Australian dollar demand is affected by:
- Size of financial flows into Australia from foreign investors wanting to invest in Australia and need to convert their currency into Australian dollar. The level of capital inflow is affected by Australia interest rate relative to overseas interest rates & the level of confidence in Australian economy (higher interest rate to overseas interest rate=encouraged capital inflow=increased demand for Australian dollar.
- Expectations of future appreciation of Australian dollar increase Demand for Australian dollar by speculators wanting to make a profit on short term money movements, thus contributing to the expected appreciation
- Demand for Australian exports (foreigners who imports Australian exports need to convert their currency into Australian dollar to pay Australian exporters)
- Historically, changes in dollar commodity price and terms of trade have had immediate effect on the dollar, rise in dollar price commodity & improvement in terms of trade expected engender improvement in CAD. Financial markets respond by increasing the value of the dollar
- Demand for Australian exports influenced by international competitiveness of domestic exporters and Australia inflation rate relative to overseas countries. If domestic firms are competitive overseas & inflation is low, dollar price of exports will generally be cheaper & more attractive to buyers
- Changes in global economic conditions-Demand for Australia commodity exports is highly dependant on the levels of national income of Australia trading partners (when global economy is on an upturn, demand for exports and dollar price of exports rise)
- Tastes & preference of overseas consumers for Australian exports
Supply of Australian Dollar
The supply is determined by:
- Level of financial flows out of Australia- This will be determined by domestic interest rate relative to overseas & international confidence in Australia & other economies. Low interest rate & deteriorated confidence in Australia economy will increase financial outflow=increased supply of Australian dollar.
- Speculators expecting Australian dollar to depreciate will sell Australian dollar and this will contribute to increased supply of Australian dollar contributing to the anticipated depreciation
- Domestic demand for imports- (Importers need to sell Australian dollar to obtain foreign currencies to make payments)- affected by:
- Level of domestic national Income-growing domestic economy, increased output, decreased unemployment tend to increased national income=increased supply of Australian dollar
- Domestic inflation rate & competitiveness of firms- high inflation rate & uncompetitive manufacturers leads to more competition for imports= cheaper imports, which leads to increased demand for imports and increase supply of Australian dollar
- Tastes & preferences- increased preference for overseas goods this tends to increased supply of Australian dollar
Appreciation
This is the increase in demand for Australian dollar or decrease in supply of Australian dollar.
Depreciation
This is the decrease in demand for Australian dollar or increase in supply of Australian dollar.
- Australia has several exchange rates (one for each country for which foreign transactions are required), rate can appreciate against one currency and deprecate against another simultaneously e.g. Asia financial crisis, depreciated against US, appreciated against Asian currencies
Trade Weighted Index
- Comparing the value of Australian dollar against one single currency can be misleading, TWI gives an indication of the movement in the value of Australian dollar against all currencies in general
- Calculated by measuring the value of Australian dollar against the currencies of Australia major trading partners compared with a base year. More prominent trading countries are given a higher weighting, having a greater influence on TWI
- The countries included in TWI (20-25) must comprise around 90% of Australia trading
- Significance of Yen and $US have declined, Chinese renminbi has become more important
- Limitation: TWI measure of exchange rate movements is weighted according to volumes of trade regardless of what currency exporters & importers contracts are voice in. 2/3 Australia exports, ½ imports are in $US, $A/$US is more important than the weight it receives in TWI calculation
After depreciating against most major currencies in 2000-01 (reflecting global downturn), Aus dollar has appreciated in recent years. Movements in TWI have been less severe in recent years because movements against $US have often been offset by opposite movements against yen & euro
Reserve bank intervention in the foreign exchange market
Dirtying the float
- Occurs when Reserve Bank of Australia enters foreign market as a buyer/seller to stabilise $A. happens when Reserve bank of Australia feels large short term change in the exchange rate (often due to excessive speculation) will be harmful to the economy
- Rapid depreciation: Reserve bank of Australia will buy $A, putting upward pressure on exchange rate (selling $A puts downward pressure on rate, curbing rapid appreciation)
- Reserve bank of Australia's ability to intervene limited by its foreign currency holdings, which is less than one day's total transactions in $A
