Chapter 5 Exchange Rates

Question 1

Exchange rate def

Answer 1

An exchange rate is one country’s currency in terms of another country’s currency.

Question 2

Depreciation def and meaning

Answer 2

depreciation is used when the value of a currency decreases against another.

A depreciation of currency means that it is worth less in terms of the foreign currency.

Question 2

Outline and explain concept of TWI

Answer 2

The Trade Weighted Index (TWI) is a “basket” of currencies.

It is a measure of calculating the exchange rates of “all” of the currencies.

The TWI is weighted according to their importance in trade flows with Australia.
The TWI is weighted so that currencies like the Chinese renminbi are weighted higher than the Indian Rupee for example.

The TWI can be used, as it more accurately reflects changes in the value of the Australian Dollar.

Question 2

What will demand for USD be matched with graph

Answer 2

A demand for USD is matched by a supply of AUD.
A demand for AUD is matched by a supply of USD.

If I want USD (demand) then I need to use my AUD (supply)

Question 3

trends/Decrease in demand could occur if

Answer 3

increase in spending on imports
increase in F1 to other foreing countries
increase in income payments to overseas residents

Question 4

Appreciation Def and meaning

Answer 4

appreciation is used when the value of a currency increases against another.

An appreciation of currency means that it is worth more in terms of the foreign currency.

Question 5

Trends/ Increase in demand could occur if

Answer 5

increase in demand for Aus exports
increase in FI into Aus and/or
increase in income receipts from overseas residents

Question 6

top four currencies include how much of TWI and list top 5

Answer 6

The top four currencies that make up the TWI make up 60% of the index.

Movements in these currencies will cause the TWI to move with it.
Chinese Yuan
USD
Japanese Yen
Euro
Sout Korean Won

Question 7

What are the main factors that affect the supply and demand for the AUD?

Answer 7

Exports/Imports, Foreign Investment, and Income payments into and out of Australia.

Question 7

What is the TWI and why is it significant?

Answer 7

The Trade Weighted Index (TWI) measures the AUD against a basket of currencies, and is a better indicator of currency movement than a single currency.

Question 8

What are the main factors influencing Australia’s exchange rate?

Answer 8

Terms of Trade & Commodity Prices

Relative Interest Rates

Relative Inflation Rates

Domestic Economic Growth

World Economic Growth

International Capital Flows

Question 9

Why is the AUD known as a “commodity currency”?

Answer 9

Because Australia’s exports, and hence demand for AUD, are dominated by commodities like iron ore, coal, and gas.

Question 10

What is the “interest rate differential”?

Answer 10

The difference between Australian interest rates and those of other countries.

Question 10

What happens when Australia’s Terms of Trade or commodity prices rise?

Answer 10

Demand for the AUD increases, causing currency appreciation.

Question 11

Relative Inflation Rates

Answer 11

High inflation relative to our trading partners decreases the international competitiveness of our goods and services. This will then decrease the demand for our traded goods.

Eg – Higher inflation in Australia relative to New Zealand will increase the price of sheep in Australia. Foreign countries will import from New Zealand over Australia.

IMPACT – This will decrease the demand for our G&S which will decrease the Demand for the AUD. At the same time, higher prices in Australia may lead to an increase in imports (which are cheaper) increasing the supply of the AUD. This will cause a large depreciation to the AUD.

Question 11

Domestic Economic Growth

Answer 11

Strong economic growth in Australia will lead to an increase in consumption. This includes an increase in the consumption of imports.

At the same time, a strong economy will also attract more foreign investment into Australia, which will increase the demand for the AUD.

IMPACT – The increase in the consumption of imports will increase the supply of AUD. At the same time, increased foreign investment will increase the demand for AUD. The value of the AUD is indeterminant as it relies on understanding the relative size of the shifts.

Question 11

Movements in the Terms of Trade and Commodity Prices affecting exchange rate

Answer 11

The movements of our ToT affects the exchange rate. Australia is known as a “commodity currency” as our exports and therefore the demand for the AUD is dominated by commodities such as iron ore, coal and gas.

IMPACT – When terms of trade increase/commodity prices increase, the demand for the AUD increases, which causes a currency appreciation.

Question 11

Relative Interest Rates (Our Interest Rate Differential)

Answer 11

The difference between interest rates in Australia and that of the rest of the world is called the “interest rate differential”

If interest rates in other countries rise relative to Australia, then there will be decrease in capital inflow and foreign investment into Australia. This is because overseas investors will have a lower rate of return on their investment.

At the same time, this will also increase the capital outflow and foreign investment from Australia.
IMPACT – The decrease in foreign investment into Australia will decrease the demand for the AUD. At the same time, the increase in capital outflow from Australia will increase the supply of the AUD. This will cause a large depreciation of the AUD.

Question 13

World Economic Growth

Answer 13

An increase in the growth of the GDP and economies of other countries in the world will increase the demand for commodities. Commodity prices will increase.
IMPACT - The increase in commodity prices will increase the D (AUD) which will create an appreciation of the Australian Dollar.

Question 14

International Capital Flows

Answer 14

If investors believe that Australia is a relatively more attractive location to invest their funds compared to other economies, then we will see an increase in international capital flows.

This is not a standalone argument – and should be used in conjunction with the other factors such as interest rates and economic growth.

IMPACT – Increase in international capital flows, will increase the demand for the AUD, which will appreciate it.

Question 15

Causes for decrease in demand for AUD

Answer 15

Decrease in exports
decrease in income credits
decreased capital inflow
fall in commodity prices
fall in interest rate differntial
higher relative inflation

Question 16

Causes for increase in supply for AUD

Answer 16

increase in imports
increase in income debits
increased capital outflow
fall in interest rate differential

Question 17

Depreciation effect on macroeconomy

Answer 17

A currency depreciation will change the relative price of imports and exports.

The prices of Australian G&S in foreign currency (Our exports) will fall.

The prices of overseas G&S in Australian currency (Our imports) will rise
Domestic producers who compete against imports are now more competitive as import prices have increased.

It will also provide a boost to the domestic tourism industry and encourage tourists to visit Australia (an export).

A depreciation should increase exports and decrease imports in the long run. This will increase net exports and aggregate demand in the economy.

Due to the increase in net exports, a depreciation will have an expansionary effect on the economy. When net exports increase (X > M), aggregate demand rises, stimulating economic activity.
Increased income
Increasing real GDP
Increasing economic activity

At the same time however, the increase in import prices will increase the consumer price index and therefore cost inflation.
Demand inflation may also increase due to the increased income and consumption.

Question 18

Effects of depreciation exchange rate movements – Businesses and Consumers

Answer 18

A depreciation will harm consumers as they pay more for imported goods and services such as petrol, clothing, cars and overseas travel. Domestic (Australian) business that sell imported goods will see a decline in sales (eg Harvey Norman, who sells imported fridges). A depreciation of the currency will see higher input and production costs, such as freight, petrol and machinery. Many Australian businesses rely on imported goods and services. Businesses that focus on exporting goods and services will obviously gain, as they see an increase in demand for their products. Businesses that compete against imports will gain, as the price of imports will increase against their product (increase in competitiveness). Eg an Australian business who makes clothes, competing against imported clothes.

Question 19

Effects of exchange rate movements depreciation – The Trade Balance

Answer 19

A depreciation of the AUD has impacts on the trade balance. In the short run a depreciation of the AUD will decrease the trade balance. However, in the long run, a depreciation can increase the trade balance. Impact of AUD Depreciation Exports Become Cheaper → Foreign demand for Australian goods and services increases. Imports Become More Expensive → Reduced demand for foreign goods as they cost more in AUD. The Trade Balance initially worsens in the short term as it takes time for foreign demand for Australia’s exports to increase. Import demand will not decrease immediately in the short term. Trade Balance Improves Over Time → Due to increased exports and decreased imports.

Question 20

J CURVE EFFECT

Answer 20

Short-Term Impact → Initially, trade balance may worsen as import costs rise before export demand responds. Long-Term Adjustment → As exports grow and import demand adjusts, trade balance improves. This called the “J curve”

Question 21

HOW IS BOP AND ECHANGE RATES LINKED

Answer 21

BOP BoP records all economic transactions between Australia and the rest of the world These transactions will require foreign currency and therefore an exchange rate.

Question 22

An increase in the trade balance or an increase in capital inflow (foreign investment into Aus) will cause ....

Answer 22

AUD TO APPRECIATE

Question 23

increase in imports or an increase in Australian investment abroad, increasing the supply of the AUD

Answer 23

causing it to depreciate

Question 24

relationship between the balance of payments and the exchange rate

Answer 24

Australia’s exchange rate is based on a freely floating exchange rate (which is based on the forces of supply and demand). A freely floating exchange rate will provide automatic adjustments to the Balance of Payments. It helps to reduce the swings in the current account balance, especially within the trade balance. For example a negative economic shock such as a recession in China. If exports decrease  trade balance will decrease. As the demand for the AUD decreases, the AUD depreciates. A depreciating AUD  increases the price of imports and decreases the price of Australian exports in foreign currency. After a lag  Demand for imports will fall domestically. Demand for exports will increase The trade balance will increase again, decreasing the trade deficit (if there is one).

Question 25

Why is free exchange rate good for BOP

Answer 25

A free exchange rate will also shield the economy from negative external shocks. At the end of the mining boom, the AUD depreciated as demand for commodities dropped off. A depreciation reduces the price of exports and provides Aus exporters with a competitive advantage. Services such as tourism and education exports also win. This subsequently will increase demand for Australia’s exports and have an expansionary effect, to assist it to recover.

Question 26

What is Aus exchange rate based on

Answer 26

Australia’s exchange rate is based on a freely floating exchange rate (which is based on the forces of supply and demand).