Monetary Policy Decisions
- Indirectly influence exchange rate, rarely used
- To curb rapid depreciation, Govt can raise interest rate=increased demand for $A (higher interest rate attracts foreign savings which must be converted into $A) only effective for limited time
- Unusual, primary focus of Monetary policy is inflation, however exchange rate movements can sometimes affects economic stability/inflation
- April 2000, Reserve Bank of Australia raised interest rate partly in response to depreciation of $A, which was adding to inflationary pressures (first time Reserve Bank of Australia had done this since 86)
Fixed exchange rate systems
- Prior to 76, Australia had a fixed exchange rate system-$A was pegged, at different times, to the UK pound sterling, US dollar and TWI
- 76-83, Australia had a “managed flexible peg” system. 83-introduced floating exchange rate system
Fixed exchange rates
- Govt or RBA( Reserve Bank of Australia) would officially set the exchange rate (not left up to forces of demand & supply)
- Govt can attempt to maintain fixed exchange rate system by buying/selling foreign currency in exchange for $A (e.g. buying excess supply of $A to maintain it at a higher rate). To do so, govt needs reserves of foreign currency/gold
- Many argued Australia over valued exchange rate under managed flex peg early 80's
The relationship between the exchange rate and the Balance of payments
- One of most important influences on exchange rate-performance of balance of payments
- Dollar influences Balance of payments, Balance of payment influences dollar (cyclical relationship)
How the balance of payment influences the exchange rate
- Under floating exchange rate system, supply of $A= Demand for $A-i.e. Net outflow of funds on current Account. When Australia operated under fixed exchange rate system it obtained necessary foreign reserves by insisting that all foreign exchange holdings be lodged with them. Reserve Bank of Australia could exhaust their supply of holdings buying excess $A could if it is greater than the collapse of trade in the currency
- Govt could also change the exchange rate officially to match it's real market value (devalue/revalue rate)
The managed flexible peg
- Variation on fixed exchange rate, Australia 76-83
- Reserve Bank of Australia would “peg” value of $A at 9am everyday, that price would operate throughout that day
- Provides more flexibility than fully fixed rate, but can still allow fixed rate to deviate from rate determined by market
- (Supply of $A) = net inflow of funds on Capital account (Demand for $A) allowances are made through net errors and omissions on Balance of Payments
- Movement in exchange rate offsets Balance of Payments automatically and corrects any disequilibrium
- E.g. increased value of imports, while exports is unchanged= increase in CAD, increase supply of $A (importers selling $A to buy foreign currency)=depreciation of currency
- Because of depreciation, same inflow of foreign currency on Capital account buys more $Australian dollar positive balance on Capital account increases in terms of $A to match bigger current account deficit
- Increased outflow of funds on Current Account (e.g. income payments) greater than increase of current account deficit, depreciation $A, increase surplus on Capital account.
- Improvement in current account deficit greater than appreciation $A, decrease surplus on capital account
- Effect of Balance of Payment on exchange rate depends on perceptions of financial markets. Concern that current account deficit is not sustainable is greater than less willing to buy $A securities is greater likely depreciation (belief that rise in current account deficit is justified by other factors, high current account deficit may not have significant effect on currency
- E.g. Despite falling current account deficit in 2000, perceptions of financial markets more negative greater dollar fell throughout the year.
- $ Continued to fall 2001 to all time low of US47.8c, and $A depreciated, less severely against other currencies, reflecting declining confidence in $A
- 2003-04, $A appreciated to US70c despite large CAD reflecting belief that CAD was result of short term factor (drought in eastern Australia, weakness in global eco conditions which contributed to stagnant export growth)
- Recent years have indicated that the most significant effect on value of $A is how financial markets perceive developments in Balance of payments, not balance of payments figures themselves= greater instability in foreign exchange markets as depreciations have negative & positive effects
Appropriate value for $A is the point which true forces of S & D cause it to settle. These forces would result from exchange of goods & services and finance borrowing Australia and world, excluding changes due to speculation, which can distort the exchange rate, although as they compose a high proportion of foreign exchange transactions, they are crucial to shifts in exchange rate.
Australia has been "hot money" currency (subject to extensive speculation) since 80's b/c of high levels of financial flows. Speculative trade in $A is substantially lager than trade directly related to the exchange of goods & services. Excessive speculation=volatile currency (Asian crisis)
