CHAPTER FIVE
SUMMARY –
EXCHANGE RATES
Tahni Valentine
HSC SYLLABUS EXTRACT:
EXCHANGE RATES
The mechanism that allows people and firms
to ‘convert’ one currency to another
Currencies are traded – or ‘bought and sold’
Allowing people to buy goods from around
the world and invest in foreign countries
The price of one currency in terms of
another currency
Australian dollar worth 78 US cents – one
Australian dollar costs 78 US cents
FOREX MARKET
Where currencies are bought and sold
Rarely a physical market, technology &
cyberspace
MEASUREMENT OF EXCHANGE
RATES
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 tell whether
or not the overall value of the $A has fallen or risen
TWI (Trade Weighted Index):
Most accurate measure
Measures the $A against a basket of 23 currencies of
Australia’s main trading partners
Reflects changes in global economic conditions
DEMAND FOR $A
The demand to convert other currencies into
Australian dollars
Demand rises exchange rate appreciates
Demand falls exchange rate depreciates
INCREASE IN DEMAND FOR $A
DECREASE IN DEMAND FOR $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
Exports:
Australian firms sell more exports
exchange the earned foreign currency for $A
increased demand for $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
Investments (capital inflows):
Foreign companies invest money into
Australia foreign currency must be
exchanged for $A increased demand for $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
Reserve Bank:
Reserve bank aims to raise price of $A RBA
buys $A on FOREX $A appreciates
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
Speculation:
Speculators expect $A to appreciate
purchase more $A (hoping to make a profit
when selling them) in itself causing a
higher demand for $A
SUPPLY FOR $A
Australian dollars being converted into other
currencies
Dollars are put on the market to be sold in
return for other currencies
Supply rises $A depreciates
Supply falls $A appreciates
INCREASE IN SUPPLY OF $A
DECREASE IN SUPPLY OF $A
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
Imports:
Australian’s buy more imports exchange
$A for foreign currency supply of $A
increases
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
Investment (capital outflow):
Australian’s invest more overseas (e.g.
purchase of shares) $A exchanged for
foreign currency supply of $A increases
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
Reserve Bank:
Reserve bank aims to lower $A RBA sells
$A on FOREX market supply of $A
increases depreciation of $A
CHANGES IN EXCHANGE RATES
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
CHANGES IN EXCHANGE RATES
Revaluation:
An appreciation which occurs in a fixed
exchange rate system
Devaluation:
A depreciation which occurs in a fixed
exchange rate system
FIXED EXCHANGE RATE SYSTEM
The value of the currency is set and
converted 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) the
currency changes when the US currency
changes
FIXED EXCHANGE RATE SYSTEM
FIXED EXCHANGE RATE SYSTEM
Forces of supply and demand do not play a
role in determining the exchange rate
Supply and demand are counteracted by
either buying or selling foreign currency in
exchange for $A
Previous slide: the government has bought
the excess supply of $A (Q1 Q2) at a price
of US 90c in order to lift the exchange rate
to US 90c from the naturally occurring US 80c
FLEXIBLE EXCHANGE RATE
SYSTEM
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 free
market
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 market
forces of supply and demand determine the
value of the currency
MANAGED EXCHANGE RATE
SYSTEM
Exhibits elements of both a floating and
fixed exchange 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 fluctuate
China’s Yuan is allowed to float either 0.5%
above or below a value determined by the
central bank
RESERVE BANK OF AUSTRALIA
Holds foreign currency reserves
May intervene in the FOREX market either
directly or indirectly
Directly:
To prevent a depreciation in currency the RBA
may exchange its foreign currency for $A thus
increasing demand for $A – causing an
appreciation of the $A
To prevent an appreciation in currency the RBA
may sell $A and buy more foreign currency
which will increase supply for $A – thus causing a
depreciation of the $A
RESERVE BANK OF AUSTRALIA
Indirectly:
The RBA may intervene indirectly through the
use of monetary policy, specifically interest
rates
To prevent a rapid depreciation in the $A the
RBA may set interest rates higher this will
increase capital inflows since Australia will
become an attractive investment opportunity
due to higher interest rates increasing
demand for $A (foreign investors must
exchange foreign currency for $A) – thus
causing an appreciation of the $A
FACTORS CAUSING AN
APPRECIATION OF $A
Increase in Australian interest rates or
decrease in overseas interest rates
Improved investment opportunities in
Australia or deterioration in foreign
investment opportunities
A rise in commodity prices and an
improvement in Australia’s terms of trade
Improvement in Australia's international
competitiveness
Lower inflation in Australia
Increased demand for Australia’s exports
Speculation of a currency appreciation
FACTORS CAUSING A
DEPRECIATION OF $A
Decrease in Australian interest rates/increase in
overseas interest rates
Deterioration in investment opportunities in
Australia/improvement in foreign investment
opportunities
Fall in commodity prices & deterioration in
Australia’s terms of trade
Deterioration in Australia’s international
competitiveness
Higher inflation in Australia
Increased demand for imports
Speculation of a currency depreciation
POSITIVE EFFECTS OF AN
APPRECIATION
Increased purchasing power for Australian
consumers
Decrease in interest servicing cost on
Australia’s foreign debt – Australians can buy
more foreign currency with $A reducing
outflow on the net income component of the
current account reducing the CAD
Reduction in the $A value of foreign debt
Imports become cheaper – reduced inflationary
pressures reducing pressure on the RBA to
raise interest rates to defend its inflation
target
NEGATIVE EFFECTS OF AN
APPRECIATION
Australian exports more expensive on world markets,
difficult to sell decrease in export income
deterioration in Australia’s CAD in medium term
Imports less expensive encouraging import spending
worsening Australia’s CAD
Higher import spending & reduced export revenue
reduce Australia’s economic growth rate
More expensive for foreign investors lower capital
inflows (if foreign investors expect currency to continue
rising financial inflows may continue)
Reduces $A value of foreign income earned on Australia’s
investments causing a deterioration in the net income
component of the CAD
Value of foreign assets reduced in $A terms
POSITIVE EFFECTS OF A
DEPRECIATION
Australian exports cheaper on world markets, easier
to sell – increase in export income – improvement in
Australia’s CAD
Imports more expensive – discouraging import
spending potentially improving Australia’s CAD
Lower import spending – increased export revenue
increasing Australia’s growth rate
Increase in $A value of foreign income earned on
Australia’s investments abroad causing an
improvement in the net income component of the
CAD
Increase in value of foreign assets in $A terms
Greater capital inflows – foreign investors find it
cheaper to invest in Australia
NEGATIVE EFFECTS OF A
DEPRECIATION
Reduced purchasing power for Australian
consumers
Australia can buy less foreign currency with
its domestic currency – increased interest
servicing cost on Australia’s foreign debt
Higher $A level of foreign debt which has
been borrowed in foreign currency as
expressed in $A terms
Imports more expensive – increased
inflationary pressures in Australia may
increase pressure on the RBA to raise interest
rates to defend its inflation target