Chapter five summary – Exchange Rates

8/7/2019 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

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Chapter five summary – Exchange Rates

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