Need to answer the question based on artcle “Australian dollar tipped to slide back to 70 US cents” (Sydney Morning Herald January 29, 2018, uploaded to Moodle),
Question : Using a Demand and Supply model of exchange rate determination, briefly explain how the exchange rate of the AUD is determined in the forex market, and what factors influence fluctuations of it.
Answer : The interaction of the forces of demand and supply determine price of any commodity in the market. If we take currency to be a commodity in the international market then forces of demand and supply determines its price in terms of another currency. This is what we call exchange rate – price of a currency in terms of another. So, it is basically the relative price that we are looking at. For instance, the AUD-USD exchange rate explains how many Australian Dollars need to be given away for buying 1 unit of the American Dollars. In simple terms it is the price of American dollar in terms of its Australian counterpart. USD-AUD would, therefore, mean the price of Australian dollar in terms of American dollars.
The demand for Australian dollar comes from the level of demand for exports and imports by the company. An increase in demand for the commodities exported by Australia increases its demand in the international market as Australian dollars will be needed to pay for the products exported by Australia. Similarly, the demand for imports will determine the supply of the currency as currency will be converted into US dollars to make payment for imports.
The demand and supply curves will be the following.
Figure 1: Determination of Exchange Rate through the Interaction of the forces of Demand and Supply
The exchange rate is determined by the intersection of the demand and supply curves for the currency.
Demand for export products, macro-economic conditions prevailing in both the countries and alterations thereof affect the exchange rates. If the demand for Australian goods jump the demand curve will move outwards and the exchange rate would rise. Australian dollar will become costlier in terms of US dollars.
Figure 2: How Exchange Rate Gets Affected
Inflation, interest rates, speculation and balance of payments are some of the crucial factors that determine the fluctuations in exchange rates. Higher inflation makes goods less competitive hence lowers demand for the product and in turn demand for the currency bringing down the exchange rate (Economics Help, 2016). High prevalent interest rate regime makes a country more attractive in terms of investment avenue raising the demand for its currency and affecting the exchange rate. Speculators affect exchange rate as their actions are guided by the outlook relating to the future exchange rate. If they expect future demand for AUD to be strong they will hoard AUD driving its price higher. Current account deficits caused by higher imports reduce the demand for AUD and hence the exchange rate. Government intervention can expand or constrict money supply thereby respectively reducing or increasing price for the currency and hence exchange rate.
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Question: Using nominal exchange rate data and trade weighted index data from the Reserve Bank of Australia website (use monthly data for the last three years) and analyse the movement of the AUD relative to that of the USD using a graph. In your opinion what are the factors contributing to this behaviour of the AUD?
Answer : Using nominal exchange rate data and trade weighted index data for the last 3 years the following graph has been drawn. The data has been sourced from the website of Reserve Bank of Australia.
Figure 2: AUD-USD Vs Trade Weighted Index over the last 3 years
The data spans across 36 months from March 2015 till February 2018.
Date AUD/USD Trade Weighted Index
31-Mar-2015 0.7634 63.3
30-Apr-2015 0.7981 65.3
29-May-2015 0.7663 63.7
30-Jun-2015 0.7680 63.8
31-Jul-2015 0.7294 61.4
31-Aug-2015 0.7149 60.9
30-Sep-2015 0.7010 59.9
30-Oct-2015 0.7099 60.3
30-Nov-2015 0.7189 61.8
31-Dec-2015 0.7306 62.7
29-Jan-2016 0.7100 61.5
29-Feb-2016 0.7140 61.4
31-Mar-2016 0.7657 64.4
29-Apr-2016 0.7655 63.8
31-May-2016 0.7242 61.7
30-Jun-2016 0.7426 62.5
29-Jul-2016 0.7522 63.3
31-Aug-2016 0.7514 63.2
30-Sep-2016 0.7630 63.9
31-Oct-2016 0.7613 65.0
30-Nov-2016 0.7474 65.3
30-Dec-2016 0.7236 63.9
31-Jan-2017 0.7567 65.8
28-Feb-2017 0.7688 66.7
31-Mar-2017 0.7644 66.2
28-Apr-2017 0.7475 64.5
31-May-2017 0.7450 63.8
30-Jun-2017 0.7692 65.5
31-Jul-2017 0.7987 67.3
31-Aug-2017 0.7898 66.3
29-Sep-2017 0.7839 66.2
31-Oct-2017 0.7673 64.9
30-Nov-2017 0.7585 63.6
29-Dec-2017 0.7800 64.9
31-Jan-2018 0.8073 65.6
28-Feb-2018 0.7792 63.6
The exchange rate has remained quite volatile and the movement has closely followed the movement in trade weighted index. The trade-weighted index or TWI does not refer to a price of the domestic currency in terms of only one foreign currency, but it is the price of the AUD in terms of the weighted average of a basket of currencies and, therefore, presents a measure of the rise or fall in the Australian dollar, on an average, compared to the currencies of the trading partners of the nation (RBA, 2018). The exchange rate tumbled from the peak reached in April 2015 to its lowest in September 2015 and then gradually climbed to its new peak in January 2018 which is higher than the exchange rate reached in April 2015.
The Australian dollar tumbled below 70 US cents at some point in 2015 when the commodity crash happened. The economy slowed down with GDP growth rates reaching the slowest pace in 2 years (Powell, 2015). Thereafter, AUD had been rising steadily against the greenback or the US dollar. The initial stage of the recovery was closely associated with the pick up in the prices of coal and iron ore in the international markets that acted as a booster for prices of exports from Australia and in course pushed up national incomes which had been moving south ever since the last, and the largest, commodity boom peaked out in 2012 (Janda, 2017). The Australian dollar has risen more than 8 per cent against its US counterpart since the beginning of June 2017, touching 80 US cents in July last year and had remained there for some time before heading southward.
Question : Summarise the main issues discussed in this article. Using the demand and supply framework discussed in part (a), show and explain how these main driving forces would impact the AUD/USD exchange rate..
Answer : Certain issues have been highlighted in the given article. They have been discussed below pointwise.
i. AUD’s strength is not sustainable. The currency might have rallied in the recent past but is unsupported by the fundamentals. The country’s yield premium shrank.
ii. US Fed rates continue to rise. (Ismail, 2018). As Fed rates firm up and RBA leaves the benchmark where it is eventually Australia is going to become less attractive to investors and reducing the demand for the currency further weakening the currency in terms of the US dollar.
iii. The Australian economy is not in favour of a strong currency over the longer term. The Government is unlikely to take any steps to firm the currency in the near future. However, the Government, at this point of time is finding it tough to fight against it. The Government’s such attitude could be possibly because over the long term a weaker currency is likely to boost exports. So they might want to keep the exchange rates low.
iv. The commodity prices continue to rise. As demand for exports from Australia of commodities such as iron ore has increased the demand for Australian dollar which made the currency rise against the US dollar. A look at figure 1 will help to understand that a rise in demand that pushes the demand curve outwards will result in the exchange rate firming up even if the supply does not change. The RBA does not want rates to remain too elevated. The commodity prices are not expected to sustain at the elevated levels for long and will eventually bring down the exchange rate.
Question : Suppose you are a manager of an Australian firm which imports electrical machinery from the US.Some of the analysts interviewed in the article expect that the AUD/USD exchange rate is going to change from US 80C per AUD now to US 70C per AUD one year from now. Explain the impact of this depreciation of the Australian dollar on your firm. Thinking about the overall Australian economy,who will benefit and who will lose from such a depreciation?
Answer : I am the manager of an Australian firm that imports electrical machineries from the US. I require US dollar to make payments for these products I purchase. I get US dollars in exchange for the Australian dollar. How many Australian dollars I need to sacrifice to get one unit of the US Dollar or vice versa gives me the exchange rate. Movements in the exchange rate affect the relative prices of traded goods and services (Cole & Nightingale, 2016). According to the interviews of the analysts published in the article AUD/USD exchange rate is expected to change from US 80 cents per AUD to US 70 cents per AUD. Which means, if this change really happens, 1 AUD will now fetch lower US currency than before. So I will need to spend more AUD on the imports despite the price of the import remaining same. It will mean that the imports will now become more costly due to an unfavourable change in the exchange rate. I will have to shell out more money in terms of the domestic currency for the same volume of import as before even though the seller has not actually increased the price of the product. If I want to keep the expenses on imports at the levels reached prior to the depreciation in the value of the domestic currency, I will have to purchase or import lower volume of the product now. I will now try to look for indigenous products that may not be perfect but the closest substitute I can get for the product I import. Internally, therefore, a depreciation in the value of the Australian dollar in terms of the US dollar is most likely to encourage substitution of imports by goods and services that are produced domestically, simply because imported products become more expensive in comparison to earlier due to depreciation of the domestic currency (Cole & Nightingale, 2016). Extending the same logic the exports become cheaper which will boost exports of products and services from the country. Thus boosting export earning for Australia which may help to keep the current account balances in favour. It is highly likely that the resources will be redistributed in favour of the export and import substitution industries pushing growth in these sectors.
Question : Suppose that the AUD/USD exchange rate stabilises at around US 72C per AUD one year frombnow. What action could the Reserve Bank of Australia take in order to bring the exchange rate back to US 80C per AUD, and what side effects might this action have on the Australian economy? Do you think that such actions would be a reasonable economic policy? Explain your answer.
Answer : Suppose AUD/USD exchange rate stabilizes at approximately US 72 cents per Australian dollar, a year from now. The Reserve Bank of Australia can intervene in order to pull the exchange rate up to US 80C per Australian dollar. Australia has a floating exchange rate system (RBA, 2018). The Reserve Bank of Australia or RBA can intervene in the foreign exchange market to keep the exchange rate at the desired level. It has already been explained in section “a” that the foreign exchange rate – the price of the domestic currency in terms of another currency, is determined by the forces of demand and supply. The RBA can create demand for or supply of the domestic currency through purchase or sale of Australian dollar against other currencies (Newman, et al., 2011). If the RBA keeps buying the domestic currency it creates demand for AUD and reduces its supply. The demand curve for AUD moves outwards raising the price for AUD (refer to figure 1). The supply can also be restricted through a contractionary monetary policy. In that case the supply curve will move upwards to raise the price. It will also lead to interest rates being higher creating demand for the domestic currency in the international market as Australia becomes a better investment destination due to high interest rates. Both curves rising upwards will create equilibrium with the same quantity but with a higher price, over the long term. A flexible exchange rate combined with an independent monetary policy results in an exchange rate that is higher as also higher interest rates in comparison with the rest of the world during that period, both of which will play a significant role in preserving the general macroeconomic stability (RBA, 2018).
Cole, D. & Nightingale, S., 2016. Sensitivity of Australian Trade to the: RBA Bulletin. SENSITIVITY OF AUSTRALIAN TRADE TO THE EXCHANGE RATE, pp. 13-20.
Economics Help, 2016. Factors which influence the exchange rate. [Online]
Available at: https://www.economicshelp.org/macroeconomics/exchangerate/factors-influencing/
[Accessed 27 Mar 2018].
Ismail, N., 2018. Australian dollar tipped to slide back to 70 US : The Sydney Morning Herald. [Online]
Available at: http://www.smh.com.au/business/markets/currencies/australian-dollar-tipped-toslide-
[Accessed 27 Mar 2018].
Janda, M., 2017. Australian dollar pushed higher by US dollar weakness. [Online]
Available at: http://www.abc.net.au/news/2017-09-20/australian-dollar-pushed-higher-by-us-dollar-weakness/8963216
[Accessed 27 Mar 2018].
Newman, V., Potter, C. & Wright, M., 2011. Foreign Exchange Market Intervention : RBA Bulletin – December Quarter 2011, s.l.: Reserve Bank of Australia.
Powell, R., 2015. Australian dollar may fall below US60¢ in 'benign collapse', Deutsche's Adam Boyton says: The Sydney Morning Herald. [Online]
Available at: https://www.smh.com.au/business/investments/aussie-may-fall-below-us60-in-benign-collapse-deutsches-adam-boyton-says-20150903-gje5ka.html
[Accessed 27 Mar 2018].
RBA, 2018. The Exchange Rate and the Reserve Bank's Role in the Foreign Exchange Market. [Online]
Available at: https://www.rba.gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html
[Accessed 27 Mar 2018].