Download 3AECO – 6 Exchange rates - Economics Teachers` Association of

6.
Exchange Rates
Objectives:
 explain the concepts of exchange rates, an appreciation and a depreciation
 demonstrate and explain how a freely floating exchange rate is determined
 explain the relationship between the balance of payments and the exchange rate
 outline the factors that affect the exchange rate
 discuss the effects of movements in the exchange rate on various sectors of the economy
 identify the recent trends in Australian exchange rates
EXCHANGE RATES
• Countries have their own currencies which are used in domestic transactions, eg.
Australian dollars (AUD) are acceptable within Australia as a medium of exchange
between buyers and sellers but not within other countries. Australian producers of
exports want to be paid in AUD while Japanese buyers of Australian exports pay in
Yen. Somehow Yen must be converted into AUD (exchanged for AUD).
• The problem is solved through foreign exchange markets (markets in currencies).
When buyers of goods & services from another country (importers) and sellers of
goods & services to another country (exporters) make or receive payments, they do
so through the global financial system where currencies are bought and sold (forex
markets).
• Investment flows into and out of a country create a need for currencies to be
exchanged. Exchange rates can be flexible, managed or fixed.
• The demand for a currency is a derived demand because it is derived from the
demand for foreign goods, services or investment assets.
VOCAB: Exchange Rate (ER) - is simply the value of a currency in terms of another, eg. 1$A = 0.60cUS means
the price of one Australian dollar in terms of American currency is 60 cents or conversely, 1$US = $1.67A.
CHANGING EXCHANGE RATES
Flexible ER: A free market for foreign currencies is like a free market for anything market forces of supply and demand determine price. In other words the price of
AUD is determined by the interaction of the demand for, and supply of AUD. The
freely determined value of a currency is called a “floating exchange rate”.
In the diagrams below:
Price of AUD
in USD
SAUD
Demand curve = quantity of AUD buyers are willing to buy
at different ER. It is downward sloping because as the ER falls
the AUD becomes cheaper, making Australian goods and
assets
cheaper therefore demand for them rises → D$A expands.
Supply curve = quantity of AUD offered for sale at different
ER. It is upward sloping because as the AUD value rises,
holders of AUD are induced to sell them in exchange for other
currencies → SAUD expands.
US60c
DAUD
Quantity of AUD
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ER1 > 0.60USD (equilibrium ER). This means SAUD > DAUD → excess AUD in forex
markets (AUD value falls until equilibrium ER is restored at US60¢).
ER2 < 0.60USD. This means DAUD > SAUD → shortage of AUD in forex market →
AUD value rises until equilibrium ER is restored at US60¢.
Price of AUD
in USD
Price of AUD
in USD
oversupply
(glut)
SAUD
SAUD
ER1
0.60
0.60
ER2
DAUD
QD
Qe
QS
QAUD
excess demand
(shortage)
QS
Qe
QD
DAUD
QAUD
(Qe = equilibrium price)
Fixed ER: This occurs when a currency value is fixed either above or below the
equilibrium value such as the positions ER1 and ER2 in the diagrams above. The
only way to keep the value at ER1 is for the central bank to buy the excess supply.
In the case of ER2 the central bank must increase the supply of AUD to fill the
shortage. Fixing a currency requires constant central bank intervention and is
difficult to sustain in the face of constant market buying or selling of a currency.
Sometimes central banks are forced to revalue a currency (set at a higher value) or
devalue a currency (set at a lower value) due to the pressure of market forces.
Managed ER: This simply means that a currency’s value is allowed to fluctuate
freely between an acceptable upper and lower level, ie. within a desirable range.
The central bank will intervene to keep the currency within this range when
necessary or to slow down change if it is too fast and potentially destabilising to the
domestic economy.
STUDENT ACTIVITY 6.1
Work with a partner on this question and jot down your ideas in your file. How is
rapid change in the value of the AUD potentially destabilising to the domestic
economy? What can be done by economic authorities to prevent this?
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DEPRECIATION AND APPRECIATION
Depreciation: a fall in the value of a currency in terms of another eg. AUD in terms
of Japanese Yen.
PAUD in Japanese Yen
SAUD
a) A decrease in DAUD causes a depreciation of
the AUD. PAUD falls QAUD falls (eg. due to a fall
in Japanese demand for Australian goods)
ER1
ER2
DAUD 1
DAUD 2
Q2
Q1
QAUD
PAUD in Yen
SAUD1
SAUD2
ER1
ER2
b) An increase in SAUD causes a depreciation of
the AUD. PAUD falls QAUD rises (eg. due to
currency dealers selling the AUD in
anticipation of a fall in Australian interest
rates relative to overseas rates)
DAUD
Q1
Q2
QAUD
Appreciation: a rise in the value of a currency in terms of another.
PAUD in Japanese Yen
SAUD
a) An increase in DAUD causes an appreciation of
the AUD. PAUD rises QAUD rises. (eg. due to an
increase in demand for Australian exports or
investment into Australia)
ER2
ER1
DAUD 2
DAUD 1
Q1
Q2
QAUD
PAUD in Yen
SAUD2
SAUD1
b) A decrease in SAUD causes an appreciation of
the AUD. PAUD rises QAUD falls. (eg. due to a fall
in demand for imports by Australians or a fall in
Australian investment overseas).
ER2
ER1
DAUD
Q2 Q1
QAUD
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STUDENT ACTIVITY 6.2
Discussion topic: Can you think of any advantages which flexible ER have over
fixed ER?
• Effects of changes in the ER.
When the AUD depreciates →
i) X income rises immediately - most trade agreements are denominated in foreign
currencies such as the USD, so payments in forex immediately exchange into more
AUD.
ii) exports become cheaper in foreign currencies → Australia more competitive →
foreign demand for X↑ especially ETMs and services.
iii) imports more expensive → Aust. demand for imports ↓→ stimulus to Mcompeting industries which have a competitive advantage due to depreciation.
iv) M repayments rise immediately because agreements are mainly in foreign
currencies so more AUD are required to pay for M → pressure on importers to raise
prices.
v) income receipts on Australian overseas investments in AUD↑ immediately.
vi) income payments to overseas investors in Australia in their own currencies fall
immediately as AUD income is converted into foreign currencies.
vii) debt repayments to overseas lenders increase in AUD terms.
• Some of the above effects [i) ii) & v)] → lower CAD and improve the BoP position.
Others make CAD worse [iii), iv) & vii)].
If the BoP improves it is likely that the risk premium Australian borrowers have to
pay on foreign loans will fall (r↓) → I↑ → UE↓ and economic activity ↑. Also Australia
becomes a more attractive place for direct investment → I↑ → UE↓ and economic
activity↑. Overall national Y increases and Australia’s international competitiveness
and living standards improve.
An appreciation → opposite effects - exports become more expensive and imports
become cheaper for Australians → hurts exporting and import-competing firms become less competitive. However gradual appreciation is positive because it forces
firms to become more efficient and competitive in the longer term. Sudden
appreciation is damaging though since firms don’t have time to adjust (RBA has a
role here).
ER can be very volatile due to the activities of currency speculators.
STU
STUDENT ACTIVITY 6.3
In your file, make a list of an appreciation’s effects. Use the effects of a depreciation
as your guide.
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FACTORS AFFECTING EXCHANGE RATES
• Demand for AUD (credits on the BOP) is influenced by (ceteris paribus):
i) Demand for Australian exports by foreigners - as DX↑→ AUD↑
ii) The level of foreign investment in Australia - direct investment opportunities,
interest rates and the economic outlook will affect capital inflow, eg. as foreign
invest.↑→ AUD↑ and vice versa.
iii) Speculation in currency markets - expectations about future movements in the
AUD will influence demand for AUD. If AUD is expected to rise → DAUD rises → AUD
appreciates and vice versa. Anything which affects perceptions of the Australian
economy will impact on the AUD.
iv) Foreigners paying debt to Australians
v) RBA intervention - RBA increases DAUD if it is concerned about depreciation →
AUD ↑.
vi) Income flows to Australians from overseas assets.
• Supply of AUD (debits on the BOP) is influenced by (ceteris paribus):
i) Demand for imports. If import demand rises, then demand for foreign currency to
pay for imports rises, the SAUD increases (shifts right).
ii) The level of Australian investment overseas - if Australian investment overseas
↑→ SAUD ↑.
iii) Speculation - if AUD is expected to fall → SAUD increases as AUD holders sell off
AUD → AUD depreciates.
iv) Australian foreign debt repayments - as foreign debt rises → repayments ↑→
SAUD↑ → AUD↓.
v) RBA intervention - sells AUD if it appreciates too strongly.
vi) Income flows to foreigners on their investments in Australia.
• Changes in the ER may cause:
a) Uncertainty and economic instability if the ER fluctuates too much → damages
investment and trade → UE.
b) Inflation may result from depreciation - import prices rise → domestic prices rise
and hence interest rates.
It’s important that changes in the AUD are not too rapid, prolonged or large. If they
are, uncertainty is created which damages the business environment and the
economy’s capacity to generate income and service debts. It is difficult for the
economy to adjust to rapid changes in the value of the AUD so economic policy
should focus on smoothing changes which naturally occur due to the fundamental
forces at work in and on the economy. In the long run, the AUD should rise in
value reflecting the rising real value of output over time and the growing
competitiveness and efficiency of the Australian economy. A gradual, sustained
appreciation will stimulate innovation and competitiveness which is what progress
is all about.
Reading the financial press is so important if you want to keep up with
what’s going on in the economy here and overseas and it’s a way to put theory
into practice.
BULL
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EFFECT OF A CHANGE IN EXCHANGE RATES ON VARIOUS SECTORS
OF THE AUSTRALIAN ECONOMY
Consider the effect of a depreciation or appreciation of the AUD on the economic
indicators below.
Examine the diagram carefully and complete the questions which follow.
Inflation
Capital &
Financial:
Equity &
financial
investment flows
Employment
Income
payments on
the Current
Account
A change in
the AUD will
cause a
change in ...
Imports
Import
replacement
industries
Interest
Rates
Exports
Foreign
Debt
Effects can flow in the opposite direction, for example, a rise in interest rates will
cause the AUD to appreciate (ceteris paribus). Think about how a change in any of
the others will impact on the AUD.
ACTIVITY
STUDENT ACTIVITY 6.4
1. Select any 3 of the indicators in the diagram above. Jot down ideas in your file
on how a change in the AUD will cause changes in your chosen economic
indicators. Discuss your ideas with a partner or partners and add to your list.
2. Read the two articles below on depreciation. Construct a 2 column table in your
file in which you list the main points of each article under the headings ‘For
depreciation’ and ‘Against depreciation’.
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Article 1: extract from the article (AFR, 6th September 2000).
Weak $A a boost for our exports to Asia
Worried about the brittleness of the Australian dollar,
investors from recovering Asian economies are far from
convinced that Australia is a bright place for their money.
And certainly not while the US economy holds court.
But there is a sunny aspect to Australia’s wobbly
currency as Asia’s post-crisis revival continues. As Asia
grows, Australian exports to the region will provide a
strong boost to the domestic economy and a weak $A will
increase the appetite for our exports. ...
Mr Halmarick (Salomen Smith Barney/Citibank co-head
of economic and market analysis) stressed that while the
soft $A added to inflationary and interest rate pressures, “it
is very much a positive for our exporting sector.” This
view was echoed elsewhere. “The low $A is not bad - in
fact, a sustained period of undervaluation might be just
what is required to turn around the chronic deficit on the
current account,” said Mr Tony Pearson, head of market
economics at National Australia Bank.
At Deutsche Bank, economist Mr Adam Boyton said,
“The Reserve Bank’s view that the low level of the $A and
the favourable world environment would support the
economy through strong exports growth has been
confirmed by the external sector data.”
The evidence was in the June quarter balance of
payments figures, where the weakness of the $A helped
export values rise 7.7 per cent in the quarter. Trade balance
data for the same period showed a 27 per cent leap in
exports from a year earlier. The current account narrowed
dramatically over the quarter to $7.869 billion, or 4.8 per
cent of GDP, from its 6.2 per cent high a year ago. It was
the fourth consecutive quarter of shrinkage in the deficit.
Article 2: extract from an article by Stephen Koukoulas in the AFR, 11th March
2000).
Really a weak $A is bad news
“Some people are trying to make a virtue of the slide in
the $A. The optimists suggest that it will help exporters to
sell goods and services, while at the same time import
volumes will be restricted - given prices of imported goods
are likely to rise in line with the $A fall. While it may be
virtuous to look for a silver lining in the dark clouds hanging
over the $A, the reality is that a weak $A is generally bad
news.
The low $A makes it more expensive for firms to
purchase capital equipment given that it is predominantly
imported. As investment levels are dented by the $A decline,
long-term growth is dampened. It also runs a risk that
Australian firms will find it more expensive to get access to
new technology at this stage of the technology revolution.
In addition, the weak $A lowers living standards in
Australian households by making imported items more
expensive, and therefore less likely to be consumed. The
weak $A also has an important macroeconomic effect that
inhibits growth. It increases the cost of servicing Australia’s
net foreign debt. How is this so?
Around 40 per cent of Australia’s foreign currency
liabilities are denominated in $US, with a further 20 per cent
in other foreign currencies. As the $A falls, the amount of
$A needed to pay interest on that debt plus the $A needed to
repay the principle rises. By necessity, this diverts funds
away from other potential investment destinations.
A sustained fall in the $A also adds to inflation risks,
particularly if it occurs when the economy is growing at a
reasonable clip.”
3. Work with a partner and identify in the boxes provided the effects of an
appreciation of the $A on the sectors listed.
TOURISM
MANUFACTURING
RURAL
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4. Read the following information for each diagram carefully. Show on each
diagram the likely resulting movement in the supply or demand curve and change
in currency price (exchange rate). Indicate in the space provided whether the
change represents a depreciation or appreciation of the currencies involved.
i) Australians demand more Japanese cars.
The Yen ____________________________
Price of Yen in AUD
S
The AUD ____________________________
D
QYen
ii) Japanese investors who currently hold Australian assets decide Australia is not
the place to invest and pull their funds out of Australia.
The AUD ____________________________
Price of AUD in Yen
S
D
QAUD
APPRECIATION OF $A
ii) Strong global economic growth causes commodity prices to rise steeply boosting
domestic inflationary pressures which causes interest rates to rise in Australia
relative to US rates.
Price of AUD in USD
The $US ____________________________
S
The AUD ____________________________
D
QAUD
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iv) Slow decline in demand for Australian exports due to a decline in Australian
competitiveness.
Price of AUD in USD
The AUD ____________________________
S
D
QAUD
v) The RBA takes action to counter the above situation (in iv).
The AUD ____________________________
Price of AUD in USD
S
Gimme all your foreign
exchange. I’m going on a
holiday overseas.
D
QAUD
5. Multiple Choice:
i) A depreciation of the AUD would:
a) raise Australia’s export prices in terms of foreign currencies.
b) raise the prices of imports in terms of AUD.
c) is likely to occur in response to a rise in world economic growth.
d) will assist in overcoming domestic inflation.
ii) Australia can obtain Yen to pay for imports from Japan by:
a) take-overs of Japanese companies by Australian interests.
b) drawing on Japan’s reserves of AUD.
c) dis-investment by Japanese interests in the Australian economy.
d) increasing exports to any country if the contracts are denominated in Yen.
iii) If trade agreements are written in foreign currencies, then when the AUD rises
in value relative to other currencies, other things remaining constant,
a) the price of imports in terms of foreign currencies will rise.
b) Australian demand for imports will fall.
c) export income to Australians will fall.
d) Australia will increase its trade with China.
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iv) Which of the following would tend to lead to an increase in the foreign currency
value of the AUD?
a) Falling interest rates in New York.
b) A rise in the net income deficit.
c) The Foreign Investment Review Board imposes restrictions on capital
inflow.
d) A fall in aggregate demand in Japan.
v) “The Australian dollar fell below US75c yesterday, after the odds of an interest
rate rise by the Reserve Bank of Australia this year halved on a sudden surge of
concern about a broad US economic slowdown.” (AFR, 26-9-06) Which of the
following statements is correct in relation to this quote?
a) Investors are more likely to invest in the US rather than Australia because
money is cheaper in the US so the US dollar has risen against the AUD.
b) Slower growth in the US could mean slower growth in the rest of the world
including Australia.
c) Australia doesn’t need further interest rate increases because it is at a
peak in its business cycle so the Australian dollar has fallen.
d) The AUD has fallen below 75c US because people don’t want to buy a
currency that is not equal in value to the USD.
vi) If the value of the AUD moves from 95Yen to 60Yen over a year, then the most
likely consequence would be:
a) a fall in demand for Australia’s exports to Japan.
b) cheaper imports from Japan.
c) an increase in inflationary pressures in Australia.
d) decreased competitiveness of Australia’s exports to Japan.
vii) If the $A rises in value on forex markets the result will most likely be:
a) an increased inflow of capital investment into Australia.
b) an improvement in Australia’s Balance of Payments.
c) Australia’s terms of trade improve.
d) a decline in export earnings in $A terms.
viii) A depreciation of the AUD would tend to make Australian manufactured goods:
a) more competitive in global markets.
b) less competitive in global markets.
c) more expensive in some markets overseas but not others.
d) none of the above.
ix) In a floating exchange rate regime, appreciation of the AUD would tend to cause:
a) Australian share prices to fall.
b) Australia’s import prices to fall.
c) Australia’s exports to increase.
d) a surplus on Australia’s current account.
x) If there is an increase in the Australian demand for Indonesian textiles then,
other things being equal,
a) the demand for Indonesian rupiah shifts to the right and the rupiah
depreciates.
b) the supply of rupiah shifts to the right and it depreciates.
c) the demand for the rupiah shifts to the left and it depreciates.
d) the demand for the rupiah shifts to the right and it appreciates.
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6. Study the graph of the Australian dollar in terms of the US dollar. Data from
http://www.rba.gov.au/statistics/hist-exchange-rates/index.html
Exchange Rate AUD in USD
1.10
1.00
0.80
0.70
0.60
0.50
a) The trend in the AUD before 2002 was one of (appreciation or depreciation)
_____________________________
b) The trend in the AUD after 2001 to the end of 2008 was one of (appreciation or
depreciation)
_____________________________
c) Since 2001, the change in the value of the AUD has made exports (more or less
competitive)
_____________________________
d) Since 2001, imports have become (more or less expensive for consumers)
___________________________________________________
e) Suggest 3 reasons for the change in the AUD between 2002-08.
i) ____________________________________________________________
ii) ____________________________________________________________
iii) ____________________________________________________________
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Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
0.40
Jan-90
AUD in USD cents
0.90
f) Suggest reasons for the collapse in the AUD in 2008 and its recovery in 2009-11.
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
g) Explain the possible effects of the movement in the AUD 2002-08 on the level of
economic activity in Australia.
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
h) Explain the possible effects of the movement in the AUD 2009-11 on the
Australian economy.
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
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THE TRADE-WEIGHTED INDEX (TWI)
Media Release
New weights for the trade-weighted index (TWI) of the Australian dollar have been
compiled by the Reserve Bank and are attached. These weights, which reflect the
country composition of Australia's merchandise trade in 2009/10, will apply from
1 October 2010.
Weights in the Trade-weighted Index Per cent
Currency
Trade weight
2010/11
2009/10
1999-2000
Chinese renminbi
22.5371
18.5621
6.0401
Japanese yen
14.9356
17.1230
18.1324
European euro
9.9174
10.4411
13.5273
United States dollar
8.5423
8.9794
17.3523
South Korean won
6.4074
6.2613
6.1411
Indian rupee
4.9052
4.2608
1.5174
Thai baht
4.6668
3.8159
1.9278
Singapore dollar
4.3425
4.6111
3.8268
New Zealand dollar
4.0894
3.7914
5.8713
UK pound sterling
3.5337
4.9916
5.9896
Malaysian ringgit
3.1598
2.9284
2.8257
New Taiwan dollar
2.7943
2.9741
4.3130
Indonesian rupiah
2.4527
2.2685
3.2884
Papua New Guinea kina
1.3340
1.1229
#
Vietnamese dong
1.2292
1.3672
#
United Arab Emirates dirham
1.1617
1.3446
#
Hong Kong dollar
1.0461
1.1207
2.5823
Canadian dollar
0.8213
0.9619
1.6953
South African rand
0.7530
0.8056
0.9382
Swedish krona
0.6885
0.7310
1.0432
Swiss franc
0.6820
0.7631
0.9225
Saudi Arabian riyal
#
0.7743
0.9567
Source: http://www.rba.gov.au/media-releases/2010/mr-10-22.html
# - these countries were not included in list for that year because our trade with them
was insignificant.
There are 21 currencies included in the index for 2010/11. The regions associated
with the 21 currencies account for 93 per cent of Australia's merchandise trade.
The order of the top five currencies in the index is unchanged from the previous
year. The weight of the Chinese renminbi remains the highest in the index, and has
increased by around 4 percentage points from last year. The Japanese yen is
ranked second, although its weight decreased by 2 percentage points from last
year. The weights on the euro and US dollar each fell by around a ½ percentage
point from last year.
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