Essay - Economic effects of exchange rate movements Flashcards
Define Exchange Rates
Exchange rates refer to the value of one currency relative to the value of another currency, or another basket of currencies.
Intro context
Australia operates under a floating exchange rate system where the value of the AUD is determined by the forces of supply and demand in the FOREX markets
Intro
The depreciation of the $A boosts economic growth by increasing the international competitiveness of Australian exporters, acting as a buffer for economic shocks and increasing employment in the long term
The appreciation of the $A during the commodities boom lead to structural change in the Australian economy and acted as a constraint on economic growth
The fluctuations in the $A can affect the domestic inflation rate, although these effects have been insignificant due to the low inflationary pressures averaging 2.2% over the past two years.
Fluctuations in the exchange rate also affects external stability through impacting the BOGS and the NPI, contributing to the recent improvement in Australia’s CAD.
Theory:
Define appreciation
Define depreciation
An appreciation of the $A is defined as the increase in the value of the $A relative to the value of other currencies.
A depreciation is defined as the decrease in the value of a currency relative to the value of other currencies.
As seen in the diagram, a depreciation can occur through an increase in supply, with the increase in supply from SS to S1S1 leading to a depreciation of the $A from 0.80 to 0.75 USD
However, a depreciation can also occur through a decrease in demand.
Body 1 intro + theory- Impact of depreciation on growth an employment
Thesis - A depreciation of the $A should increase economic growth and employment in the long run through increasing the international competitiveness of Australian exporters.
A depreciation makes domestic exports relatively cheaper in foreign currency terms and increases the international competitiveness of Australian exporters.
Body 1 - depreciation on growth examples
The depreciation of the $A from 2013-15 from parity with the USD to 0.75 USD increases the international competitiveness of Australian exporters and helped Australia transition away from resource led growth.
This has helped Australia to maintain sustainable economic growth rates averaging 2.6% over the past decade and maintain an unemployment rate below 6% over the past four years (Prior to COVID 19)
Furthermore, the depreciation has contributed to the growth in employment in the tourism and financial services sectors, which now generate over $140 billion in annual export revenue (X) and employ 14% of Australia’s workforce.
Body 2 - ER as a stabiliser for economic shocks
Australia’s flexible exchange rate insulates the economy from external shocks. This is because the exchange rate depreciates during periods of economic crisis, known as capital flight. However, this increases the international competitiveness of exporters and improves economic growth in the long run.
The depreciation of the $A in 2008-09 during the GFC, falling from 0.97 USD to 0.67 USD, supported Australia’s export industries and contributed to Australia’s resilient economic growth of 1.9%, avoiding technical recession.
RBA economist quote if necessary
Christopher Kent
“considerable resilience in the face of external shocks since floating”
Nonetheless, it must also be considered that Australia’s economic resilience during the GFC can be attributed to the use of a countercyclical macroeconomic policy mix.
Body 3 - Appreciation -> structural unemployment
Thesis
+ theory
The appreciation of the AUD can affect Australia’s economic performance/economy by causing structural unemployment and acting as a constraint on economic growth.
As exports become more expensive in $A terms for foreign buyers, the international competitiveness of Australian exporters will decrease in the long run
Appreciation Dutch Disease - Examples + Analysis
Although the mining sector remained resilient despite the appreciating $A during the commodities boom, with the AUD rising from 0.67 USD in 2008 to 1.10 USD in 2011, other sectors were negatively impacted by the appreciating dollar.
In particular, the tourism, agriculture and financial services sector were significantly impacted by reduced IC, creating a phenomena known as Dutch Disease, whereby the strong performance in the mining sector negatively impacted the performance in the other export industries.
This contributed to the decrease in the size of the manufacturing sector, estimated to have decreased manufacturing output by 5% in 2013 and contributing to 20 000 job losses in manufacturing from 2012-13.
Further reflected in the long term decline in manufacturing
LINK
Body 4 - Inflation thesis + theory
Fluctuations in the value of the Australian dollar have implications for the domestic inflation rate.
A depreciation of the $A should increase domestic inflationary pressure through rising import prices, whilst also increasing the cost of import for firms.
This would encourage firms to raise the prices of their goods in order to maintain profit margins, leading to cost push inflation
Body 4 - Inflation examples + analysis
Implications on the RBA
This may have implications for the RBA, who will be pressure to increase the cash rate and place upward pressure on market interest rates in order to reduce economy activity and maintain the inflation rate within the target band of 2-3%.
However, as evident in the recent ER depreciation from 0.80 in January of 2017 - 0.70 in January of 2019, the depreciation dollar has insignificantly impacted inflation, with the inflation rate averaging a mere 2.1% over 2017-19 in the lower region of the target band.
External Stability: theory
Fluctuations in the ER have direct implications for Australia’s external stability through affecting the BOGS and NPI components of the CA.
In the short term, a depreciation of the $A should lead to a deterioration of the BOGS through short run price effects, as seen in the J curve effect diagram
This is because demand will be relatively inelastic in the short term, and so a rise in import prices and a fall in export prices will lead to an increase in import expenditure (M) and a decrease in export expenditure (X) respectively .
Draw Diagram
However, after point t2, the BOGS should improve due to the long run volume effects.
This is because the international competitiveness of Australian exporters will rise, which should therefore lead to an increase in export revenue (X), whilst import expenditure should fall due to rising prices.
Example of Dutch Disease in manufacturing sector
This contributed to the decrease in the size of the manufacturing sector, estimated to have directly decreased manufacturing output by 5% in 2013 and contributing to 20 000 job losses in manufacturing in 2013.
External Stability examples
The depreciation of the Australian dollar from 2017-19 contributed to improvement of the BOGS from a $7 billion surplus to a $50 billion surplus from 2017-18 to 2018-19.
This contributed to the improvement in Australia’s external stability through reaching a Current Account Surplus in 2019.
Whilst the exchange rate also has implications for the NPI component of the CA, and therefore Australia’s external stability, they are insignificant due to the currency hedging conducted by firms and investors, with 60% of foreign debt hedged to mitigate external risks.
