australia’s place in the global economy exchange rates an overview

AUSTRALIA’S PLACE IN THE GLOBAL ECONOMY

EXCHANGE RATES

AN OVERVIEW

EXCHANGE RATES An exchange rate is the price of one

currency in terms of another currency The exchange rate for A$ is most quoted

with the US dollar (US$) eg A$1 = US$.80 this is also A$1.25 = US$1

A$ can also be measured by the trade weighted index (TWI), which is a basket of currencies of our 26 biggest trading partners

INDIRECT QUOTE

DIRECT QUOTE

FLOATING EXCHANGE RATES

The value of A$ is determined by the forces of supply and demand in the ‘forex’ market

A$ fluctuates so as to maintain equilibrium between S and D.

Sole reliance on market forces without any govt intervention is a ‘clean’ float.

S of A$ Price of A$ in US$ US.60

D for A$ 0 Q1 Qty of A$

S of A$ Price of A$ in US$ US.60 D for $A 0 Q1 Qty of A$


Overseas residents Demand A$ in the foreign exchange market to: buy exports of goods

and services, such as tourism in Australia

transfer income and current/money transfers into Australia and

invest or lend in Australia, which are known as financial inflows.

An increase in demand for A$ will appreciate A$

DEMAND

Q2Q3

D1 for A$

US.70


Australian residents Supply A$ in the foreign exchange market to: buy imports of goods

and services, transfer income and

current/money transfers out of Australia and

invest or lend overseas, which are known as financial outflows.

S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$

S1 of A$ US.50

An increase in the supplyof A$ will depreciate A$

SUPPLY

Q2

OTHER INFLUENCES Other factors, besides the forces of supply

& demand, which impact on the ‘forex’ market include: interest rate differentials between the

Australian economy and overseas relative economic growth rates between

Australia and its trading partners relative inflation rates between

Australia and its trading partners speculative factors that may or may not

have their origins in economics

INTEREST RATE DIFFERENTIALS

If Australia has interest rates lower than world interest rates then:

some Australians will supply A$ into the ‘forex’ market to get into deposits overseas with the higher rates

also residents from overseas may withdraw their Australian funds and transfer them out of the country i.e. supply A$

increased supply of A$ will depreciate A$


S1 of A$ US.50

Higher interest ratesoverseas will depreciate A$

SUPPLY

Q2

INTEREST RATE DIFFERENTIALS

If Australia has interest rates higher than world interest rates then:

Australians will not supply A$ into the ‘forex’ market

reduced supply of A$ will appreciate A$

also residents from overseas will increase their demand for A$ to get into Australian deposits with the higher rates

increased demand for A$ will appreciate A$


S1 of A$ US.70

Higher interest rates inAustralia will appreciate A$ SUPPLY

D1 for A$

DEMAND

Q2 Q3

RELATIVE ECONOMIC GROWTH RATES If Australia has an economic

growth rate greater than that of its trading partners then:

demand for imports, which is linked to the domestic economic growth rate, will increase the supply of A$


export growth, which is linked to world economic growth, will increase demand for A$

weaker world growth means demand for A$ will not offset the increased supply of A$


S1 of A$ US.50

Higher economic growth inAustralia will depreciate A$

SUPPLY

DEMAND

D1 for A$

Q2 Q3

RELATIVE ECONOMIC GROWTH RATES

If Australia has an economic growth rate less than that of its trading partners then:

demand for Australia’s exports, which is linked to the world ec. growth rate, will increase the demand A$


import growth, which is linked to domestic economic growth, will increase supply of A$

weaker domestic growth means supply of A$ will not offset the increased demand for A$


S1 of A$ US.65

Lower economic growth inAustralia will appreciate A$

SUPPLY

DEMAND

D1 for A$

Q2 Q3

RELATIVE INFLATION RATES If Australia has an inflation

rate greater than that of its trading partners then:

demand for imports, which appear cheaper than domestic goods, will increase the supply of A$


Exports are relatively more expensive and poor export sales may reduce the demand for A$

less demand for A$, which will further depreciate A$


S1 of A$ US.50

Higher inflation in Australia will depreciate A$

SUPPLY

DEMAND

D1 for A$Q2Q3

RELATIVE INFLATION RATES If Australia has an inflation

rate less than that of its trading partners then:

demand for Australia’s exports, which are now relatively cheaper, will increase the demand A$


imports, which are now relatively more expensive, will, if some import rigidity exists, still increase supply A$

increased supply of A$ may or may not offset the increased demand for A$ - here it doesn’t


S1 of A$ US.65

Lower inflation rate inAustralia may appreciate A$

SUPPLY

DEMAND

D1 for A$

Q2 Q3

SPECULATIVE FACTORS

This is a collection of rational and non-rational factors that influence the level of confidence in the ‘forex’ market and includes: the release of economic data, such

as the latest inflation rate other information that prima facie

should not influence the exchange rate, such as the illness of a political leader

Each of the previous factors influence some part of the balance of payments: economic growth & inflation influence real trade

flows (ie trade in goods & services) and these adjust fairly slowly

interest rates & speculative factors influence financial flows and these adjust fairly quickly (ie ‘hot money’ flows)

therefore, in the short-term, interest rates & speculation dominate exchange rate movements

SO, WHAT DRIVES THE EXCHANGE RATE?

Questions Define the exchange rate. Explain what is meant by a ‘clean float’. Distinguish between A$ depreciation & A$

appreciation. Identify the sources of supply & demand for

the A$ in the ‘forex’ market. Describe the factors that influence the

exchange rate in the short-term. Explain what is meant by the ‘hot money’

theory of exchange rates.

WHAT DO YOU UNDERSTAND?

DIGRESSION: A BRIEF LOOK AT THE BALANCE OF PAYMENTS

The balance of payments is a record of transactions between Australia & the rest of the world. It is divided into TWO accounts: Current account, which records:

exports & imports of goods service transactions, such as tourism income transfers, such as dividends & interest current or money transfers, such as pensions &

migrant transfers Capital & Financial account, which records:

financial flows resulting from international borrowing & the buying and selling of assets

LINK BETWEEN EXCHANGE RATE & BALANCE OF PAYMENTS

• A CAD is when there is an excess of spending on imports, service debits, income & current transfers o/seas compared to corresponding receipts and inflows.

Exports

CURRENT ACCOUNT $billion

20

D for A$

20

D for A$

S of A$

Qty of A$

Priceof A$in US$

0

Imports -15S of A$

15

Balance of Merchandise Trade 5 Favourable

Goods

Services Credits Debits Net Services

6 D for A$

26

-9

24S of A$

1

2

Bal. of Goods & Services 2

Income Transfers Into Aust. Out of Aust. Net Income Overseas

-3

3

293 -14

-11

38

-9Current Transfers Into Aust. Out of Aust. Net Transfers Overseas

41

30

-2-1

40

-10 Current Account Deficit (CAD)

LINK BETWEEN EXCHANGE RATE & BALANCE OF PAYMENTS

• With a floating exchange rate the CAD = K&FAS

Capital Inflow

CAPITAL & FINANCIAL ACCOUNT Capital Account $billion

2

D for A$ 30

D for A$

S of A$ 40

Qty of A$

Priceof A$in US$

0

Capital Outflow -1S of A$

41

Net Capital Inflow 1

Financial Account Direct Invest. into Aust. Direct invest. overseas Net Direct. Investment

6 D for A$

-2

43S of A$

Portfolio Invest. in Aust. Portfolio Invest. overseas Net Income Overseas

4

5 -2

3

45

Portfolio borrowing Portfolio lending overseas Net Transfers Overseas

2-1

1

46

10 Capital & Financial Account Surplus (K&FAS)

Other investments & Reserve Assets 1

3238 434546

EFFECTS OF FLUCTUATIONS IN A$ ON AUSTRALIAN ECONOMY

Changes in A$ will impact both positively & negatively on the economy.

Positive effects of a A$ depreciation include: improved international competitiveness more expensive imports may see

development of import replacement industries

cheaper exports & increased foreign investment will increase economic growth

increased domestic employment improved CAD, in theory at least

EFFECTS OF FLUCTUATIONS IN A$ ON AUSTRALIAN ECONOMY

Negative effects of a A$ depreciation include: increased inflation as higher priced

imports feed into CPI increased foreign debt through a

‘valuation’ effect worsening CAD, if there is high import

‘rigidity’ reduced economic activity if RBA

raises interest rates to ‘prop up’ the A$

FIXED EXCHANGE RATES Fixed exchange rates involve

the exchange rate being set by a central bank (RBA).

RBA enters the ‘forex’ market as a buyer or seller to maintain the desired exchange rate.

If the A$ was set below the market exchange rate, the RBA would supply A$ to bring about equilibrium between demand for A$ & supply of A$ at US$.50

A balance of payments surplus is created by the amount the RBA sells A$.


A balance of payments surplus

occurs when the exchange rate is fixed below market

rate

Q2

US.50

Q3

RBA INCREASES SUPPLY OF A$ S1 of A$

BALANCE OF PAYMENTS SURPLUS

FIXED EXCHANGE RATES The exchange rate may be

fixed above the market rate If the A$ was set above the

market exchange rate, the RBA would enter the ‘forex’ market as a buyer of A$.

The RBA would demand A$ to bring about equilibrium between demand for A$ & supply of A$ at US$.70.

A balance of payments deficit is created by the amount the RBA buys A$.


A balance of payments deficit

occurs when the exchange rate is fixed above market

rate

Q2

US.70

Q3

RBA INCREASES DEMAND FOR A$

D1 of A$

BALANCE OF PAYMENTS DEFICIT

Questions Define the balance of payments. Identify the four components of the

current account. Explain what is meant by a current

account deficit (CAD). Identify the components of the capital &

financial account. Discuss the effects of A$ depreciation

on the Australian economy. Explain how an exchange rate is fixed.

WHAT DO YOU UNDERSTAND?

australia’s place in the global economy exchange rates an overview

Documents

higher rates

rates higher

supply demand d1

forces of supply demand

supply q2 slide

increased supply

supply d1

rates lower