australia’s place in the global economy exchange rates an overview
TRANSCRIPT
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.
S of A$ Price of A$ in US$ US.60
D for A$ 0 Q1 Qty of A$
S of A$ Price of A$ in US$ US.60 D for $A 0 Q1 Qty of A$
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
Q2Q3
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.
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.50
An increase in the supplyof 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$
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.50
Higher interest ratesoverseas 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$
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.70
Higher interest rates inAustralia 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$
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.50
Higher economic growth inAustralia will depreciate A$
SUPPLY
DEMAND
D1 for A$
Q2 Q3
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$
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.65
Lower economic growth inAustralia will appreciate A$
SUPPLY
DEMAND
D1 for A$
Q2 Q3
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$, which will further depreciate A$
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.50
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
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of A$
S1 of A$ US.65
Lower inflation rate inAustralia may appreciate A$
SUPPLY
DEMAND
D1 for A$
Q2 Q3
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$
Priceof A$in US$
0
Imports -15S of A$
15
Balance of Merchandise Trade 5 Favourable
Goods
Services Credits Debits Net Services
6 D for A$
26
-9
24S of A$
1
2
Bal. of Goods & Services 2
Income Transfers Into Aust. Out of Aust. Net Income Overseas
-3
3
293 -14
-11
38
-9Current Transfers Into Aust. Out of Aust. Net Transfers Overseas
41
30
-2-1
40
-10 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$
Priceof A$in US$
0
Capital Outflow -1S of A$
41
Net Capital Inflow 1
Financial Account Direct Invest. into Aust. Direct invest. overseas Net Direct. Investment
6 D for A$
-2
43S of A$
Portfolio Invest. in Aust. Portfolio Invest. overseas Net Income Overseas
4
5 -2
3
45
Portfolio borrowing Portfolio lending overseas Net Transfers Overseas
2-1
1
46
10 Capital & Financial Account Surplus (K&FAS)
Other investments & Reserve Assets 1
3238 434546
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$.50
A balance of payments surplus is created by the amount the RBA sells A$.
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of 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$.70.
A balance of payments deficit is created by the amount the RBA buys A$.
S of A$ Price of A$ in US$ US.60 D for A$ 0 Q1 Qty of 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?