The Exchange Rate

Meaning and Measurement

• Definition: The exchange rate is the price of one country’s currency expressed in terms of another country’s currency. It determines how much of one currency you can buy with another.

• Measurement:

  • Direct Quote: The price of one unit of foreign currency in terms of the domestic currency (e.g., AUD/USD = 0.70 means it costs AUD \$1.43 to buy USD \$1).
  • Indirect Quote: The price of one unit of domestic currency in terms of the foreign currency (e.g., USD/AUD = 0.70). Less common in Australia.
  • Trade Weighted Index (TWI): A multilateral measure. A weighted average of the value of the AUD against the currencies of our major trading partners. Weighting is based on the relative importance of each country to Australia’s trade. Indicates the overall international value of the AUD.

• Types of Exchange Rate Systems:

  • Floating Exchange Rate: The value of the currency is determined by the forces of supply and demand in the foreign exchange market. Australia uses this system.
  • Fixed Exchange Rate: The value of the currency is set and maintained by the government. The central bank intervenes in the foreign exchange market to keep the exchange rate at the desired level.
  • Managed (or Dirty) Float: The exchange rate is primarily determined by market forces, but the central bank intervenes occasionally to smooth out fluctuations or to achieve specific policy goals.

KEY TAKEAWAY: The exchange rate is the price of one currency in terms of another, crucial for international trade and financial transactions. Australia operates under a floating exchange rate system.

Factors Affecting the Exchange Rate

The exchange rate is determined by the supply and demand for a currency in the foreign exchange market. Factors that shift the supply and demand curves will affect the exchange rate.

1. Relative Interest Rates

• Impact: Higher interest rates in Australia relative to other countries attract foreign investment, increasing the demand for AUD and causing it to appreciate. Lower relative interest rates lead to capital outflow, decreasing demand and causing the AUD to depreciate.
• Mechanism: Investors seek higher returns. If Australian interest rates are higher than those overseas, foreign investors will want to buy AUD to invest in Australian assets, increasing demand for AUD.

2. Commodity Prices and the Terms of Trade

• Impact: Australia is a commodity exporter. Higher commodity prices improve Australia’s terms of trade (TOT), increasing demand for AUD and causing it to appreciate. Lower commodity prices have the opposite effect.
• Terms of Trade (TOT): Ratio of export prices to import prices.
  • \[TOT = \frac{Index \: of \: Export \: Prices}{Index \: of \: Import \: Prices} \times 100\]
• Mechanism: Higher commodity prices mean Australia earns more foreign currency from its exports. This increases the demand for AUD as exporters convert their foreign currency earnings.

3. Demand for Exports and Imports

• Impact: Increased demand for Australian exports increases demand for AUD, causing it to appreciate. Increased demand for imports increases the supply of AUD (as Australians sell AUD to buy foreign currency), causing it to depreciate.
• Factors Affecting Demand: Economic growth in trading partners, changes in consumer preferences, changes in relative prices (international competitiveness).

4. Foreign Investment

• Impact: Increased foreign investment in Australia (inflows) increases demand for AUD, causing it to appreciate. Increased Australian investment overseas (outflows) increases the supply of AUD, causing it to depreciate.
• Types of Foreign Investment:
  • Direct Investment: Establishing a new business or buying a significant stake in an existing business.
  • Portfolio Investment: Buying shares or bonds.

5. Relative Rates of Inflation

• Impact: Higher inflation in Australia relative to other countries makes Australian goods and services less competitive, decreasing demand for exports and increasing demand for imports. This decreases demand for AUD and increases its supply, causing it to depreciate.
• Purchasing Power Parity (PPP): The theory that exchange rates should adjust to equalize the prices of identical goods and services in different countries.

6. Credit Ratings

• Impact: A higher credit rating indicates a lower risk of default on government debt. This attracts foreign investment, increasing demand for AUD and causing it to appreciate. A lower credit rating has the opposite effect.
• Credit Rating Agencies: Standard & Poor’s, Moody’s, Fitch.

7. Speculation

• Impact: If speculators believe the AUD will appreciate in the future, they will buy AUD now, increasing demand and causing it to appreciate. If they believe it will depreciate, they will sell AUD, increasing supply and causing it to depreciate.
• Self-fulfilling Prophecy: Speculation can drive exchange rate movements, even if the underlying economic fundamentals do not support the change.

EXAM TIP: When discussing factors affecting the exchange rate, always explain the mechanism by which the factor affects the supply and demand for the AUD.

Summary Table of Factors

COMMON MISTAKE: Students often forget to explicitly link the factor to changes in the supply and demand for the Australian dollar. Make sure you clearly explain this connection in your responses.

Appreciation vs. Depreciation

• Appreciation: An increase in the value of a currency relative to another currency.
• Depreciation: A decrease in the value of a currency relative to another currency.

STUDY HINT: Create flashcards with each factor affecting the exchange rate on one side and its impact on the AUD (appreciation or depreciation) on the other.

Effects of Exchange Rate Movements

The exchange rate affects various aspects of the Australian economy, including:

• International Competitiveness: A higher exchange rate makes Australian exports more expensive and imports cheaper, reducing international competitiveness. A lower exchange rate has the opposite effect.
• Inflation: A depreciation can lead to imported inflation, as imported goods become more expensive.
• Economic Growth: Exchange rate movements can affect net exports, which is a component of aggregate demand.
• Terms of Trade: Exchange rate movements can influence the terms of trade, although commodity prices are usually a more significant driver for Australia.
• Living Standards: Fluctuations in the exchange rate can impact purchasing power, international trade, and overall economic stability, all of which affect living standards.

APPLICATION: Consider the impact of a significant increase in iron ore prices on the Australian dollar and the subsequent effects on different sectors of the Australian economy (e.g., mining, tourism, manufacturing).

Exchange Rate and Macroeconomic Goals

• Economic Growth: A depreciated exchange rate can boost economic growth by increasing exports and decreasing imports (net exports). This stimulates domestic production and employment.
• Inflation: A depreciated exchange rate can lead to higher inflation due to increased import prices. The RBA needs to manage this inflationary pressure through monetary policy.
• External Stability: A floating exchange rate helps to absorb external shocks and maintain external stability. It automatically adjusts to changes in the balance of payments.

VCAA FOCUS: VCAA often asks about the impact of exchange rate movements on Australia’s macroeconomic goals (economic growth, inflation, external stability) and living standards. Be prepared to discuss both positive and negative effects.