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.

FLOATING EXCHANGE RATES 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 Q2 Q3 D1 for A$ US.70

FLOATING EXCHANGE RATES 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. An increase in the supply of 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$ Higher interest rates overseas 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$ Higher interest rates in Australia 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$ increased supply of A$ will depreciate 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$ Higher economic growth in Australia will depreciate A$ SUPPLY DEMAND D1 for A$ Q2Q3

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$ increased demand for A$ will appreciate 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$ Lower economic growth in Australia will appreciate A$ SUPPLY DEMAND D1 for A$ Q2Q3

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$ increased supply of A$ will depreciate A$ Exports are relatively more expensive and poor export sales may reduce the demand for A$ less demand for A$, which will further depreciate A$ 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$ increased demand for A$ will appreciate 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 Lower inflation rate in Australia may appreciate A$ SUPPLY DEMAND D1 for A$ Q2Q3

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$ Price of A$ in US$ 0 Imports -15 S of A$ 15 Balance of Merchandise Trade 5 Favourable Goods Services Credits Debits Net Services 6 D for A$ S of A$ 1 2 Bal. of Goods & Services 2 Income Transfers Into Aust. Out of Aust. Net Income Overseas Current Transfers Into Aust. Out of Aust. Net Transfers Overseas 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$ Price of A$ in US$ 0 Capital Outflow S of A$ 41 Net Capital Inflow 1 Financial Account Direct Invest. into Aust. Direct invest. overseas Net Direct. Investment 6 D for A$ S of A$ Portfolio Invest. in Aust. Portfolio Invest. overseas Net Income Overseas Portfolio borrowing Portfolio lending overseas Net Transfers Overseas Capital & Financial Account Surplus (K&FAS) Other investments & Reserve Assets

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?