Download - Chapter five summary – Exchange Rates
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Tahni Valentine
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The mechanism that allows people and firmsto convert one currency to another
Currencies are traded or bought and sold
Allowing people to buy goods from aroundthe world and invest in foreign countries
The price of one currency in terms ofanother currency
Australian dollar worth 78 US cents oneAustralian dollar costs 78 US cents
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Where currencies are bought and sold
Rarely a physical market, technology &cyberspace
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Two methods: Measurement against another currency- Not always accurate- E.g. $A may rise against the $US, but lose value
against the Yen making it difficult to tellwhether or not the overall value of the $A hasfallen or risen
TWI (Trade Weighted Index):- Most accurate measure- Measures the $A against a basket of 23
currencies of Australias main trading partners- Reflects changes in global economic conditions
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The demand to convert other currencies intoAustralian dollars
Demand rises exchange rate appreciates
Demand falls exchange rate depreciates
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Exports:
- Australian firms sell more exports exchangethe earned foreign currency for $A
increased demand for $A
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Investments (capital inflows):
- Foreign companies invest money intoAustralia foreign currency must be
exchanged for $A increased demand for $A
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Reserve Bank:
- Reserve bank aims to raise price of $A RBAbuys $A on FOREX $A appreciates
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Speculation:
- Speculators expect $A to appreciate purchase more $A (hoping to make a profit
when selling them) in itself causing ahigher demand for $A
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Australian dollars being converted into othercurrencies
Dollars are put on the market to be sold in
return for other currencies Supply rises $A depreciates
Supply falls $A appreciates
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Imports:
- Australians buy more imports exchange $Afor foreign currency supply of $A increases
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Investment (capital outflow):
- Australians invest more overseas (e.g.purchase of shares) $A exchanged for
foreign currency supply of $A increases
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Reserve Bank:
- Reserve bank aims to lower $A RBA sells $Aon FOREX market supply of $A increases
depreciation of $A
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Appreciation:- Increase in the relative value of a currency- A rise in the price of one currency in terms of
another
- A rise in the exchange rate- Occurs in a floating/flexible exchange rate
system Depreciation:- Decrease in the relative value of a currency- A fall in the price of one currency in terms of
another- A fall in the exchange rate- Occurs in a floating/flexible exchange rate
system
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Revaluation:
- An appreciation which occurs in a fixedexchange rate system
Devaluation:- A depreciation which occurs in a fixed
exchange rate system
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The value of the currency is set andconverted by the government or central bank
Value is maintained by buying or selling
currencies Sometimes it is made illegal to trade
currency at any other price
Usually pegged to the value of another
currency (e.g. 75% of the $US) @ thecurrency changes when the US currencychanges
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Forces of supply and demand do not play arole in determining the exchange rate
Supply and demand are counteracted by
either buying or selling foreign currency inexchange for $A
Previous slide: the government has boughtthe excess supply of $A (Q1 Q2) at a price
of US 90c in order to lift the exchange rateto US 90c from the naturally occurring US 80c
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Floating exchange rate Market forces of supply and demand determine
the value of the currency
Australian dollar was floated in December 1983
FOREX market operates like any other freemarket
Dirtying the float:- central bank (RBA)participates in the FOREX market as either a
buyer or a seller to influence the exchange rate Clean float:- an exchange rate system with no
central intervention at all i.e. only the marketforces of supply and demand determine thevalue of the currency
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Exhibits elements of both a floating and fixedexchange rate system
Often a step towards floating the exchange
rate Value of currency changes because of market
forces but only within a certain range
Central bank determines the upper and lower
limits of which the currency can fluctuateChinas Yuan is allowed to float either 0.5%
above or below a value determined by thecentral bank
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Holds foreign currency reserves
May intervene in the FOREX market eitherdirectly or indirectly
Directly:- To prevent a depreciation in currency the
RBA may exchange its foreign currency for $Athus increasing demand for $A causing anappreciation of the $A
- To prevent an appreciation in currency theRBA may sell $A and buy more foreigncurrency which will increase supply for $A thus causing a depreciation of the $A
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Indirectly:
- The RBA may intervene indirectly throughthe use of monetary policy, specifically
interest rates- To prevent a rapid depreciation in the $A theRBA may set interest rates higher this willincrease capital inflows since Australia willbecome an attractive investment opportunity
due to higher interest rates increasingdemand for $A (foreign investors mustexchange foreign currency for $A) thuscausing an appreciation of the $A
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Increase in Australian interest rates ordecrease in overseas interest rates
Improved investment opportunities inAustralia or deterioration in foreign
investment opportunities A rise in commodity prices and an
improvement in Australias terms of trade
Improvement in Australia's international
competitiveness Lower inflation in Australia
Increased demand for Australias exports
Speculation of a currency appreciation
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Decrease in Australian interestrates/increase in overseas interest rates
Deterioration in investment opportunities in
Australia/improvement in foreign investmentopportunities
Fall in commodity prices & deterioration inAustralias terms of trade
Deterioration in Australias international
competitivenessHigher inflation in Australia
Increased demand for imports
Speculation of a currency depreciation
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Increased purchasing power for Australianconsumers
Decrease in interest servicing cost on
Australias foreign debt Australians can buymore foreign currency with $A reducingoutflow on the net income component of thecurrent account reducing the CAD
Reduction in the $A value of foreign debt
Imports become cheaper reducedinflationary pressures reducing pressure onthe RBA to raise interest rates to defend itsinflation target
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Australian exports more expensive on worldmarkets, difficult to sell decrease in export income deterioration in Australias CAD in medium term
Imports less expensive encouraging import spending worsening Australias CAD
Higher import spending & reduced export revenue reduce Australias economic growth rate
More expensive for foreign investors lower capitalinflows (if foreign investors expect currency tocontinue rising financial inflows may continue)
Reduces $A value of foreign income earned onAustralias investments causing a deterioration in thenet income component of the CAD
Value of foreign assets reduced in $A terms
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Australian exports cheaper on world markets,easier to sell increase in export income improvement in Australias CAD
Imports more expensive discouraging importspending potentially improving Australias CAD
Lower import spending increased exportrevenue increasing Australias growth rate
Increase in $A value of foreign income earned onAustralias investments abroad causing an
improvement in the net income component ofthe CAD
Increase in value of foreign assets in $A terms
Greater capital inflows foreign investors find itcheaper to invest in Australia
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Reduced purchasing power for Australianconsumers
Australia can buy less foreign currency with
its domestic currency increased interestservicing cost on Australias foreign debt
Higher $A level of foreign debt which hasbeen borrowed in foreign currency as
expressed in $A terms Imports more expensive increased
inflationary pressures in Australia mayincrease pressure on the RBA to raise interest
rates to defend its inflation target