Factors that effect Exchange Rates Flashcards
(8 cards)
Movements in the Terms of Trade and Commodity Prices
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.
Relative Interest Rates (Our Interest Rate Differential)
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.
Relative Inflation Rates
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.
Domestic Economic Growth
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.
World Economic Growth
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.
International Capital Flows
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.
Other factors
It is important to understand that these are not the only factors that affect the exchange rate. There are other factors that can be discussed.
For example – A change in foreign investment will impact the income flows (dividends and interest) into and out of Australia. This would then further impact the exchange rate.
IMPACT – An increase in dividend or interest payments out of Australia will increase the supply of the AUD, which will depreciate it.
Key Factors
The textbook sites two key factors to Australia’s exchange rate (page 120 and 121). These are Commodity Prices and Interest Rate Differential
Commodity Prices – Changes in the price of commodities have a significant effect on export values and national income. There is a very strong correlation between export prices and the value of the AUD.
Interest Rate Differential between AUS and US – There is a strong positive relationship between the interest rate differential and the AUD. The interest rate differential affects the flow of foreign investment both into AND out of Australia. This affects both S and D (AUD). A fall in the interest rate differential (the difference between interest rates in Australia and the USA) should cause the AUD to depreciate.
