1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-1 The Exchange Rate

2. Today we are going to look at the exchange rate as it is an interesting example of demand and supply analysis with different non-price determinants of demand and supply. It is a useful example as we are all very familiar with it. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-2

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 3 Foreign Exchange Market The exchange rate is the rate at which a unit of a country’s currency is exchanged for currency of another nation Under floating exchange rate, the equilibrium exchange rate is determined by forces of supply and demand for a country’s currency

4. The exchange rate Two approaches. The direct quote, when the price of one unit of forex is quoted in terms of the local currency, this is the usual method. For example. We might like to know what US dollar is worth in terms of Aussie dollars. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-4

5. The indirect quote, when the price of one unit of local currency is quoted in terms of forex, this is the Australian method. For example Australians usually want to know what one Aussie dollar is worth in terms of US dollar or pounds sterling This approach is our focus Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-5

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 6 Equilibrium Exchange Rate Demand for the Aussie dollar – Australian exporters and investors need to be paid in Aussie dollars as they need to pay their employees and suppliers in AUD, other currencies are worthless in Australia. – Demand is driven by Exports and Capital Inflows, – If exports and capital inflows increase the supply of Forex to the Forex market increase and the demand for the AUD increases. – That is, people sell forex, eg USD, to buy AUD – The exchange rate appreciates

7. And visa versa. When the demand for Australian exports or investment opportunities, either portfolio investment or direct foreign investment, falls the demand for the Aussie dollar falls and the exchange rate falls or depreciates. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-7

8. Equilibrium Exchange Rate Supply of the Aussie dollar – Foreign exporters and investors need to be paid in Forex as they need to pay their employees and suppliers in forex not AUD. – Aussie dollars are essentially worthless overseas. – Supply is driven by Imports and Capital outflows – If imports rise or capital outflows increase the supply of the AUD to the forex market increases in order to buy more AUD – The supply curve shifts to the right – The exchange rate depreciates 18-8

9. And visa versa So, if the amount of imports rise, or the outflows of capital rises, e.g. overseas firms repatriate profits or Australian firms decided to “invest” overseas, Then the supply of the Aussie dollar rises, and the exchagne rate depreciates Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-9

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 10 Equilibrium Exchange Rate P Q The price of one AUD in terms of USD Aussie Dollars (AUD) 321321 S1S1 D0D0 D1D1 D0D0 D1D1 S1S1 S1S1 QoQo Q1Q1

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 11 Equilibrium Exchange Rate P Q The price of one AUD in terms of USD Aussie Dollars (AUD) S1S1 D0D0 D0D0 S1S1 S2S2

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 12 Determinants of Exchange Rates Changes in exports and imports – Relative income changes – Relative price changes Relative real interest rates, the interest rate differential. – When Australian interest rates are higher than American rates, there are string capital inflows to Australia leading to an appreciation – When Australian interest rates are lower than American rates, there are string capital outflows to Australia leading to a depreciation

13. Determinants of Exchange Rates Why has the Aussie dollar surged? Over the past year the Aussie dollar has appreciated from AUD 1 being worth USD 67 cents, to parity, to USD1.07. Most commentators blame the mineral boom, the massive inflow of forex resulting from the export of millions of tonnes of commodities. But that is nonsense Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-13

14. The amount of money flowing through the current account (i.e. exports and imports) is dwarfed by the amount of money flowing through the capital account ( i.e. Capital inflows and outflows) The movement of money through the capital account explains the recent surge in Aussie dollar, and not the minerals boom. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-14

15. The interest differential between the USA and Australia should be about 200 basis points. That is, Wall St analysts say that America is the safest place to invest in the world, so US interest rates should be the world’s lowest. Australia is a bit more risky place to invest, so investors need a risk adjusted premium of about 2 per cent, or 200 basis points. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-15

16. That is, the Australian cash rate, the interest rate paid by the Commonwealth Government on its debt should be 2 percentage points higher than the US Bond rate. So, with the bond rate in the USA being 0.25 per cent, the cash rate in Australia should be 2.25 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-16

17. But it is not it 4.5 per cent. So, it is 425 basis point higher than the Fed’s bond rate not, 200 points higher, which is what the markets expect. So, this has increased the inflow of capital from overseas, which has increased the demand for the AUD. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-17

18. On the other hand “investment opportunities” in Australia are more profitable than overseas opportunities, so Australian fund managers are investing at home rather then “investing” overseas. This has reduced the supply of the AUD leading to a massive appreciation. Many people argue that the AUD is as much as 20 per cent over valued because out interest rates are too high. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-18

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 19 Equilibrium Exchange Rate P Q The price of one AUD in terms of USD Aussie Dollars (AUD) S1S1 D0D0 D1D1 D0D0 D1D1 S1S1 S2S2