Exchange Rates PDF

Exchange rates To provide a basis for answering such questions and carrying out such inquiries, this chapter will examine the following: what an exchange rate is what determines the demand and supply of a currency the types of exchange rates terms of trade the causes of appreciatio...

Exchange rates To provide a basis for answering such questions and carrying out such inquiries, this chapter will examine the following: what an exchange rate is what determines the demand and supply of a currency the types of exchange rates terms of trade the causes of appreciation and depreciation government policy response to exchange rate movements. 3 Exchange rates Exchange rates express the value of one currency in terms of another currency. Getty Images/Bunhill A common misconception is that international trade involves the direct exchange of commodities between nations. Even though we speak collectively of Australia's trade with other nations, the actual trade is undertaken by individuals and firms, or by organisations acting on behalf of individuals and firms. Commodities are paid for in much the same way as we pay for household goods. However, the payment procedure is more complicated because: the importer and exporter are usually separated by long distances and therefore cannot always meet to finalise transactions different currencies are involved the currencies involved usually have different purchasing powers numerous transport, handling and storage costs are involved governments frequently impose regulations and additional charges. 3.1 How are international payments made? Use various Internet sites to find current data for the following: 1 terms of trade 2 current and recent exchange rates of the Australian dollar 3 Australian dollar trade -- weighted index. Follow the links to the following sites, which are particularly relevant: the Australian Bureau of Statistics, the Reserve Bank of Australia and the Australian Parliamentary Library. Australian Bureau of Statistics Reserve Bank of Australia Australian Parliamentary Library ECONOMICS DATA When Australian producers sell goods overseas, they want to be paid in Australian dollars so that the wages of employees can be paid and debts arising from the use of materials in the production process can be settled. The same applies to Japanese manufacturers who sell goods to Australia. They want to be paid in Japanese yen so that their manufacturing debts can be settled. How then is the problem resolved? Businesspeople do not need to carry supplies of all the currencies in the world. This would be much too messy and would not be very profitable, because there would be vast sums of money lying idle. Instead, the banking system in each country comes to the rescue. Figure 3.1 provides a simple outline of the payment procedures followed when commodities are traded between nations. Let us suppose that an Australian fruit canner sells a quantity of canned fruit to a Japanese buyer. The Australian canner has arranged with the Japanese buyer to be paid in Australian dollars. When the actual payment is made will depend on the terms agreed between buyer and seller. Very often, payment is made when the importer receives shipping documents to indicate that the goods have been safely dispatched. However, the procedure is not set and varies according to the nature of the traded goods and the relationship between buyer and seller. Assume that the Japanese buyer has received International transactions require a process by which payments can be made. The role of financial institutions is of paramount importance in facilitating international currency exchange between economies. KEY IDEA hipping documents to indicate that a load of canned fruit is on its way to Japan. The buyer contacts their Japanese bank and negotiates to transfer funds in Australian dollars. The buyer pays for these Australian dollars in yen. The funds are transferred electronically to the Australian canner's bank account. As you can see, no actual money changes hands between buyer and seller. The entire transaction is accomplished electronically. Transactions involving large sums of money are often settled by using a third country's currency acceptable to both trading nations. For instance, trade between Australia and Japan is often settled in US dollars. It is possible for the international banking system to conduct its business through electronic entries without the need for frequent international movements of currency. KEY IDEA Q U E S T I O N S 1 Why might transactions involving two nations be settled in a third country's currency? 2 Describe the process you would need to follow if you were to buy a book from a US bookseller. Record this process with a flow chart. Pay particular attention to both flows: the movement of the book and the movement of the money. FIGURE 3.1 How foreign payments are made 5 Canner presents A\$ draft to bank 7 Australian bank sends A\$ draft 8 Japanese bank transfers yen 2 Buyer pays bank in yen 3 Buyer receives A\$ draft Australian bank Japanese buyer Australian fruit canner Japanese bank 1 Canner sends fruit shipment 4 Buyer sends A\$ draft in payment 6 Canner receives payment in A\$ 3.2 What is an exchange rate? Cost structure: the overall framework within a country that contributes to the final price of a commodity produced by that country Currency appreciation: an increase in the value of a currency relative to other currencies under a floating exchange regime Currency depreciation: a decrease in the value of a currency relative to other currencies under a floating exchange regime Currency devaluation: a deliberate downward adjustment to the value of a country's currency relative to another currency, group of currencies or standard under a fixed exchange rate Currency revaluation: a deliberate upward adjustment to the value of a country's currency relative to another currency, group of currencies or standard under a fixed exchange rate Exchange rate: the value of the currency of a nation expressed in terms of the currency of another nation Foreign exchange (forex) market: a market where international currencies are bought and sold CONCEPTS Perhaps the greatest complexity in international trade arises because each country has its own currency and each of these currencies has its own purchasing power. When an Australian importer buys Japanese television sets, the price of the sets must be converted from Japanese yen to Australian dollars. An Australian tourist arriving in France must exchange Australian dollars for euros. Each country has its own currency that is classified as legal tender for all domestic transactions. Consequently, we find that the conversion process is necessary whenever a foreign monetary transaction occurs. To allow transactions to proceed smoothly, exchange rates for all currencies must be readily available. We may, therefore, say that an exchange rate merely expresses the value or purchasing power of the currency of a nation expressed in terms of the currency of another nation. 3.2.1 Value of exchange rate It is important to understand that, when an exchange rate is established, the cost structure of all goods and services in one country is tied to the cost structure of all goods and services in another country. For instance, if we wish to make inter-country comparisons of wage levels or costs of living, it is necessary to use prevailing exchange rates. If the exchange rate is altered, the relative cost structures between countries are altered. The determination of exchange rates should be understood in terms of the price mechanism and the underlying market forces of supply and demand. KEY IDEA Figure 3.2 illustrates this very important relationship. We can see that a French motor vehicle that sells for €80 000 (euros) in France will cost the Australian importer A\$20 000 if the exchange rate is €4 = A\$1. The Australian consumer may then purchase the vehicle from the importer for A\$25 000. (In this simple example, we have disregarded the effects of transport costs and various government taxes and charges that may be levied on the imported commodity, which would boost this hypothetical Australian retail price.) If the exchange rate is altered to €5 = A\$1, the Australian consumer will pay less for the same motor vehicle. The situation illustrated here would arise if a currency appreciation of the Australian dollar occurred against the euro or, alternatively, if a currency depreciation of the euro occurred against the Australian dollar. Either an appreciation of the Australian dollar or a depreciation of the euro would result in fewer Australian dollars being needed to meet the equivalent French price of the motor vehicle. You will notice that, even though the exchange rate has altered, the French price of the vehicle remains the same. The only price to alter is the Australian price of the imported commodity. Figure 3.2 also illustrates the case of a German video camera imported into Australia. This time we are also dealing with the conversion of euros into Australian dollars. If the German price of the video camera is €600, and the prevailing exchange rate is €1.5 = A\$1, the Australian importer will pay A\$400. If the exchange rate is altered to €2 = A\$1, the importer will pay A\$300. Again, we see the effect of either a depreciation of the euro or an appreciation of the Australian dollar. Either will result in more euros being needed to meet the equivalent value of the Australian dollar. The result in either case is that the Australian price of the imported video camera will fall. The third example in Figure 3.2 differs from the other two. This time we have the case of a Japanese television set costing ¥30 000 (yen). At the prevailing exchange rate of ¥80 = A\$1, the Australian importer pays A\$375 for the set. You will notice that, if the exchange rate is altered to ¥60 = A\$1, the Australian price of the television set increases substantially. The new exchange rate means that fewer yen are needed to meet the equivalent value of the Australian dollar. How does the change in the exchange rate for Japanese yen differ from the change in the two previous examples? In this case, we have illustrated the effect of a depreciation of the Australian dollar or, alternatively, an appreciation of the Japanese yen. 3.2.2 Australian dollar appreciation As we have seen, an increase in the value of one nation's currency relative to another nation's currency is referred to as an 'appreciation'. An appreciation of the Australian dollar FIGURE 3.2 Application of exchange rates (Note: We have assumed that there is a 25 per cent mark-up on the imported commodity.) French motor vehicle costs 80 000 euros German video camera costs 600 euros Japanese TV set costs 30 000 yen The Australian importer pays If the exchange rate is The Australian consumer pays 4 euros = A\$1 5 euros = A\$1 A\$20 000 A\$16 000 A\$25 000 A\$20 000 1.5 euros = A\$1 2 euros = A\$1 A\$400 A\$300 A\$500 A\$375 80 yen = A\$1 60 yen = A\$1 A\$375 A\$500 A\$469 A\$625 reduces the price of imported commodities and, therefore, makes them more attractive to Australian consumers. Under the former fixed exchange rate, an increase in the value of the dollar was called a currency revaluation -- the result of a deliberate decision by the Reserve Bank of Australia (RBA) and the Australian Government to increase the value of the Australian dollar. 3.2.3 Australian dollar depreciation As we have seen, a decrease in the value of one nation's currency relative to another nation's currency is referred to as a 'depreciation'. A depreciation of the Australian dollar increases the price of imported commodities and, consequently, makes them less attractive to Australian consumers. Under the former fixed exchange rate, a decrease in the value of the dollar was called a currency devaluation -- the result of a deliberate decision by the RBA and the Australian Government to decrease the value of the Australian dollar. 3.2.4 Foreign exchange markets Foreign exchange ( forex) markets are international markets in which currencies are exchanged between countries. Foreign exchange markets, along with other financial institutions, buy and sell foreign currencies within their own country and with other countries. Foreign exchange markets operate 24 hours a day, as each centre throughout the world begins trading during their own 'office hours', or when their share market and banks are open. Speculators sometimes buy and sell currencies in expectation of making a financial gain. The Internet has simplified the calculation of the exchange rates for currencies, and the amount of currency needed to purchase another country's currency. 1 Using the websites of one of the major banks of Australia, examine the current exchange rates for various currencies, and the range of currencies available for purchase in Australia. Use the ready calculators on the site of the Commonwealth Bank of Australia, Westpac Bank or the National Australia Bank. If you were to visit the following countries and had \$10 000 to spend in each, how much of each country's currency would you obtain? Japan France USA China UK New Zealand 2 Using the newspaper, or the historical data available from the Australian Bureau of Statistics or the RBA website, graph the movement of the Australian dollar for a one- month period, noting the changes and why they have occurred on the graph. Commonwealth Bank of Australia Westpac Bank National Australia Bank Australian Bureau of Statistics Reserve Bank of Australia ECONOMICS AND ICT So far, we have said nothing about the effects of exchange rate movements on the price of Australian exports. These can be readily seen if we imagine that the commodities listed in Figure 3.2 are Australian exports and that foreign importers are buying the commodities for their home markets. Let us focus for a moment on motor vehicles. Imagine that a French importer buys Australian motor vehicles at A\$20 000 each. If the exchange rate is A\$1 = €4, the French importer must pay €80 000 for each vehicle. If the Australian dollar appreciates or the euro depreciates so that the exchange rate becomes A\$1 = €5, the importer must pay €100 000 for the same vehicle. On the other hand, if the Australian dollar depreciated or the euro appreciated so that the exchange rate was A\$1 = €3, then the importer would pay only €60 000 for the same vehicle. Some effects of a depreciation or appreciation of the Australian dollar are shown in Figure 3.3. Movements in exchange rates have a fundamental impact on the relative cost structures between economies, as well as on factor incomes, domestic prices and contractual payments. KEY IDEA FIGURE 3.3 Effects of changes in Australian exchange rates Depreciation of A\$ Appreciation of A\$ Australian exports become less expensive to overseas buyers. There is growth in income and employment in export-oriented industries. Australian imports become more expensive, and this could lead to a decline in imports and growth of import-substitution industries or increased inflation. There is an increased level of the external debt that is measured in overseas curren- cies; for example, US\$. The RBA may increase interest rates to slow down the depreciation of the dollar, and this may have an impact on domestic consump- tion and investment. Australian exports become more expensive to foreign buyers, and so income and employment in export industries may decline. Australian imports become cheaper, and increased demand for imports may lead to an increase in the current account deficit. There are decreased levels of external debt, where the debt is measured in overseas currencies. The government may be more able to repay interest on external debt and so reduce the income component on the current account deficit. Inflation may decrease as domestic prices on imports decline. Q U E S T I O N S 1 Imagine that you have saved A\$2000 spending money for a holiday in the USA. What effect would a 10 per cent depreciation in the value of the Australian dollar have? Using the current exchange rate on a reliable website, show the actual gain or loss in US dollars. 2 Why is an exchange rate important for a nation? 3 Which economic institutions are involved in the exchange rate process? to A\$, divide by the rate.) 1 You have A\$100 and you buy US dollars with it on 23 March Year 1. How many US dollars would you get? Repurchase the Australian dollars with the US dollars you now have. How much Australian currency would you get back? Explain the loss that you incurred in this buy--sell transaction. 2 Calculate the percentage loss in purchasing power of the Australian dollar between 23 March Year 1 and 23 March Year 2 by specific reference to US dollars, UK pounds, Japanese yen and NZ dollars. 3 Construct a table comparing the purchasing power of A\$10 000 against US dollars, UK pounds, Japanese yen and NZ dollars as at 23 March Year 1, 23 March Year 2 and the present. 4 a Imagine you have inside access to Australian Bureau of Statistics information about a forthcoming release of very poor balance of payments statistics. This information is likely to panic the market and cause a sudden depreciation in the Australian dollar. Explain how you could use this information to make a profit on the foreign exchange market. Use an example to explain your argument. b Should you take advantage of this inside information and the consequences? Justify the decision that you make. ECONOMICS IN ACTION 3.3 Types of exchange rates Fixed exchange rate: the value of a currency that is determined by the government fixing it to the value of another currency at a certain level, and guaranteeing to maintain that level Floating exchange rate: the value of a currency determined by the forces of supply and demand in the foreign exchange market Gold exchange standard: the system used by many countries until the late 1960s to determine the value of their currency; based on the fact that the value of the US dollar was fixed to the value of gold; that is, US\$35 = 1 ounce of gold Pound sterling: the currency of the UK Since the Second World War (1939--45), nations have used a variety of methods to maintain exchange rates. In July 1944, representatives of the Allied nations gathered at Bretton Woods, New Hampshire, USA, for the United Nations Monetary and Financial Conference. One outcome of the conference was the establishment of the International Monetary Fund (IMF), an organisation set up to maintain international monetary stability. Until about 1968, member nations of the IMF based their exchange rates on what was commonly known as the gold exchange standard. Basically, this meant that the value of currencies was fixed to the value of the US dollar, the value of which was, in turn, related to the price of gold. This was called a 'pegged' or fixed exchange rate system. How does a fixed exchange rate work? Consider the situation in Figure 3.5. In this case, under a fixed exchange rate system, the market rate for Australian dollars is 65 cents, while the government has fixed the Australian dollar at an artificially high rate of 72 cents. At this rate, which is above the market equilibrium level, the supply of Australian dollars exceeds demand by A\$6 billion. The government can maintain this fixed rate by intervening in the market and buying A\$6 billion in exchange for foreign currency. The government would use reserves of foreign currency or gold to conduct these purchases. The RBA could also fix the exchange rate below the market value and create a situation in which the currency is undervalued and the RBA will have a surplus of foreign currency. An undervalued currency creates an increase in the money supply, and stimulates economic growth and employment. Quantity A\$ billion 0.65 0.72 0 A\$/US\$ 25 2822 D S D S FIGURE 3.5 A fixed exchange rate Under the fixed exchange rate system, member nations of the IMF were obliged to maintain the value of their currencies relative to the value of the US dollar. Minor fluctuations of up to 1 per cent were permitted without a nation first having to seek the approval of the IMF. However, this condition was broken by many nations, including the UK. FIGURE 3.6 Advantages and disadvantages of a fixed exchange rate Advantages Disadvantages The stability and predictability of the exchange rate encourages growth of international trade and enables easier long-term planning for industry. A stock of international reserves and gold is required to maintain the artificially high or low value. It is open to speculation. Changes tend to occur in large steps, so they can have large impacts on the economy. Surpluses or deficits in the balance of payments can create internal instability, such as inflation. By the late 1960s, the US economy was experiencing severe balance of payments difficulties and confidence in the US dollar began to wane. The US Government was unwilling to devalue because it felt a responsibility to maintain confidence in the US dollar. However, in August 1971, the US Government decided to discontinue the US dollar's convertibility into gold when it became apparent that the nation no longer possessed sufficient gold reserves to support its liquid liabilities throughout the world. By 1973, after several devaluations of the US dollar, the fixed exchange rate system had disintegrated. In June 1972, the UK decided to adopt a floating exchange rate system for the pound sterling. The UK was followed in March 1973 by the countries of the European Economic Community, which tied the values of their own currencies and then floated them jointly against the value of the US dollar. A floating exchange rate is one that is determined by the action of the forces of supply and demand on a currency. Under this system, market forces, rather than the central banking authority, decide the value of a currency. If the exports of a country are in high demand, there will be equivalent demand for that country's currency to pay for the exports. This demand pressure would cause the value of the currency to float upwards. On the other hand, if demand for that country's exports declines, the value of its currency will float downwards and the exchange rate will alter accordingly. In international money markets, currencies are bought and sold like any other commodity. There is a buying price and a selling price for any particular currency. A managed or 'dirty' float is a floating exchange rate system where the central bank (the RBA in Australia) intervenes in the foreign exchange market by buying or selling a nation's currency. Quantity Price of Australian dollar 0 Q2 P1 P2 P3 Q1 D3 D3 Q3 S S D2 D2 D1 D1 FIGURE 3.7 Effects of government intervention on the floating Australian dollar A managed float can be explained by reference to Figure 3.7, which shows the effects on the exchange rate of a fall in demand for Australian dollars. The original price of the Australian dollar was P1 , and after depreciating, the dollar's new value is P3. If the Australian Government considers the dollar value to be too low, it can enter the foreign exchange market and buy Australian dollars, using its stock of foreign currencies or international reserves to do so. This changes demand, and the price increases to P2 , a price that is above the market-determined price. Clearly, the government wishes to avoid the adverse effects on the domestic economy of a falling exchange rate -- reduced investor confidence, higher inflation and the need for increased interest rates. FIGURE 3.8 Effects of government intervention after appreciation of the Australian dollar Similarly, Figure 3.8 shows the case where the dollar appreciates to a level considered too high, and the government sells Australian dollars in the market place, and increases its stock of foreign currencies. 3.3.1 Factors affecting demand and supply for Australian dollars Demand To buy Australian exports, purchasers must use Australian dollars. An increase in demand for Australian exports should result in an appreciation of the Australian dollar, as more overseas consumers demand more Australian dollars to pay for their purchases. Demand can be influenced by relative inflation rates (for example, if the Australian general price level is lower than that in other countries), a change in the relative income of consumers, or a movement in a trend for or against Australian goods and services. Australians earn money overseas in the form of dividends, profits and interest on loans. Moving this money back to Australia creates demand for Australian dollars. Capital inflows due to investment in Australia are largely determined by relative interest rates and investor confidence. An increase in domestic interest rates relative to overseas rates means investors are more likely to move their money to Australia, thereby creating an increase in demand for the Australian dollar. Speculation in the foreign exchange market that the Australian dollar is about to appreciate will encourage an increase in demand for the Australian dollar. Supply Demand for imports will lead to an increase in supply of Australian dollars in the market, as consumers change Australian dollars for foreign currency. Demand for imports is essentially determined by inflation rates in Australia relative to those overseas, changes in consumer preference and changes in relative incomes of Australian consumers Australia must pay dividends, interest and profits to the foreign sector when foreign investments and loans are made in Australia. Moving this money overseas creates a supply of Australian dollars. Capital outflows due to investment overseas are largely determined by relative interest rates. Speculation in the foreign exchange market that the Australian dollar is about to depreciate relative to other currencies would lead to cashing-in of Australian dollars for other currencies. Figure 3.9 shows the factors that affect demand for, and supply of, the Australian dollar. Price Quantity a b export of goods and services incomes received capital inflow speculation D S D S Price Quantity import of goods and services incomes payable capital outflow speculation FIGURE 3.9 Factors affecting (a) the supply of and (b) the demand for Australian dollars P1 P2 0 a b US\$ D1 D2 D1 D2 S S P1 P2 0 US\$ D D S2 S2 S1 S1 Q Q FIGURE 3.10 Appreciation of the Australian dollar due to changes in supply and demand: an increase in the demand for the Australian dollar in (a) from D1 to D2 will lead to an increase in the price of the Australian dollar in terms of the US dollar. Also, a decrease in the supply of the Australian dollar in (b) from S1 to S2 will lead to an appreciation of the value of the Australian dollar in terms of the US dollar. FIGURE 3.11 Depreciation of the Australian dollar due to changes in supply and demand: a decrease in the demand for the Australian dollar in (a) from D1 to D2 will result in a depreciation of the Australian dollar in terms of the US dollar. Similarly, in (b), an increase in the supply of the Australian dollar from S1 to S2 will result in a depreciation of the value of the Australian dollar in terms of the US dollar. P2 P1 0 a b US\$ D1 D2 D1 D2 S S P2 P1 0 US\$ D D S2 S2 S1 S1 Q Q Although the floating exchange rate system was seen initially only as a stop-gap measure for overcoming the monetary turmoil of the early 1970s, it has gained acceptance as a relatively efficient means of maintaining currency values. The floating system has removed some of the pressures that plagued governments under the fixed exchange rate system. Under the old system, governments frequently resorted to manipulation of their domestic money supply to support an artificial parity value for their currency. As mentioned earlier, in the late 1960s the US Government was reluctant to devalue the US dollar. Instead, it chose to expand its money supply. Finally it was realised that the US dollar was grossly overvalued and drastic measures had to be taken to restore external equilibrium. Under the fixed exchange rate system, if balance of payments conditions continued to deteriorate, massive devaluations were necessary to restore equilibrium. With the floating system, a nation's currency can be subtly depreciated or appreciated from day to day. Fluctuations can be minor and spontaneous. FIGURE 3.12 Advantages and disadvantages of a floating exchange rate Advantages Disadvantages The balance of payments is always in equilibrium; that is, the deficit in the current account is always equal to the surplus in the capital finance account. Money supply is not affected by international exchanges, so domestic policy can operate independently of overseas exchange pressures. It is not necessary for the RBA to hold large amounts of foreign reserves to maintain the artificial exchange levels at a fixed rate. The volatility of exchange rates can create uncertainty for exporters and importers: see Section 3.5. The level of external debt can change when debt is largely measured in overseas currency, such as US dollars. Perhaps the greatest disadvantage of the floating system is the uncertainty concerning the future movement in the value of a nation's currency. Because of the time lags involved in payments for international trade, businesses must insure against a possible loss of revenue because of changes in currency values..4 How Australia's exchange rate is determined Q U E S T I O N S 1 a What is meant by a floating exchange rate? b Using a demand and supply diagram, explain how a floating exchange rate is determined. 2 What would be the result of a fall in the price of the Australian dollar? 3 Using a diagram, show how the demand and supply for Australian dollars would be affected by each of the following. a an increase in US interest rates relative to Australian interest rates b an increase in Australian inbound tourism for a large event such as the World Cup in a sport c the signing of a free trade agreement between Australia and the United Kingdom. Basket of currencies: a method for determining exchange rates that uses a selection (basket) of currencies instead of fixing the value of one currency to one other currency, thereby minimising the effects of any fluctuations Trade-weighted index: an index compiled on the basis of importance of trade; at one stage used in determining the value of the Australian dollar CONCEPTS Until December 1971, the value of the Australian currency was determined by the value of the pound sterling. (Note that until 14 February 1966, the official currency of Australia was the Australian pound; after that date it became the Australian dollar.) The exchange rate between the two currencies was fixed, so that if the value of the pound altered, so did the value of the Australian dollar. However, with mounting balance of payments problems facing the UK economy in the late 1960s, it became apparent to Australian monetary authorities that to continue the fixed link with sterling would impose undesirable pressures on the Australian dollar. Consequently, in December 1971, Australia turned to the US dollar to determine the value of its currency. This meant that the fixed link with the pound sterling was replaced by a fixed link with the US dollar. As the value of the US dollar fluctuated, so too did the value of the Australian dollar. This relationship survived until September 1974. By September 1974, the world had been shaken by the action of the Organization of the Petroleum Exporting Countries (OPEC) to boost the international price of oil. The USA, and in particular the US dollar, were severely affected by the move, and world trade slipped into its worst downturn since the Great Depression of the 1930s. Consequently, in September 1974, the Australian Gov Until December 1971, the value of the Australian currency was determined by the value of the pound sterling. (Note that until 14 February 1966, the official currency of Australia was the Australian pound; after that date it became the Australian dollar.) The exchange rate between the two currencies was fixed, so that if the value of the pound altered, so did the value of the Australian dollar. However, with mounting balance of payments problems facing the UK economy in the late 1960s, it became apparent to Australian monetary authorities that to continue the fixed link with sterling would impose undesirable pressures on the Australian dollar. Consequently, in December 1971, Australia turned to the US dollar to determine the value of its currency. This meant that the fixed link with the pound sterling was replaced by a fixed link with the US dollar. As the value of the US dollar fluctuated, so too did the value of the Australian dollar. This relationship survived until September 1974. By September 1974, the world had been shaken by the action of the Organization of the Petroleum Exporting Countries (OPEC) to boost the international price of oil. The USA, and in particular the US dollar, were severely affected by the move, and world trade slipped into its worst downturn since the Great Depression of the 1930s. Consequently, in September 1974, the Australian Government devalued the Australian dollar by 12 per cent and severed the fixed link with the US dollar. The exchange rate reflects our international performance. Governments may seek to influence or control exchange rates through regulation and intervention in the market. KEY IDEA Between 1974 and December 1983, the value of the Australian dollar was calculated on the basis of a number of currencies belonging to the major nations with which we traded. This collection of currencies was referred to as a basket of currencies. Every day, the RBA monitored the value of each of the currencies in the basket and compiled a trade-weighted index that reflected the significance of each country's trade with Australia. Each foreign currency in the basket was apportioned a weighting based on its country's overall trade with Australia (exports and imports), expressed as a percentage of Australia's total trade. Linking the Australian dollar to a trade-weighted basket of currencies meant that the value of the dollar would tend to vary from day to day against all other currencies. However, because of the averaging effect of weighting, the fluctuations of the dollar against other individual currencies tended to be less extreme than if it were fixed to a single currency. In December 1983, the Australian Government announced the float of the Australian dollar. In essence, the announcement meant that market forces -- that is, the forces of supply and demand -- would determine the value of the dollar. The RBA would no longer be burdened with the daily task of announcing the value of the Australian dollar. Previously, the RBA had been responsible for maintaining our foreign reserves, and trading banks were obliged to clear all foreign exchange transactions through the RBA at the conclusion of each day's trading. The RBA served the role of a net buyer and seller of foreign currency for the trading banks. Under the floating exchange rate system, the RBA has withdrawn from this role and now the trading banks are permitted to maintain reserves of foreign currency within limits prescribed by the RBA. The RBA still retains its overall control of the Australian banking system, and, in the event of a crisis involving foreign exchange, it would be expected to intervene. While the RBA does have a long-term impact on the value of the Australian dollar, it is also able to achieve short- term effects and to reduce the degree of change of the value of the dollar. The RBA may intervene by buying Australian dollars in the foreign exchange market to slow down a rapid depreciation. Alternatively, the RBA may sell Australian dollars to slow down an excessive appreciation of the currency. When the government or the RBA can intervene in the foreign exchange market to influence the value of the currency, it is said to be managing or 'dirtying' the float. The management of exchange rates by the RBA can affect the domestic money supply. For example, when intervening in the foreign exchange market to slow a depreciation (that is, buying Australian dollars), the money supply is reduced. To lessen the impact on the domestic economy, the RBA employs a process called 'sterilisation' to buy government securities and pump Australian dollars back into the money supply. The RBA can also influence the value of the dollar indirectly by altering interest rates. By increasing Australian interest rates (monetary policy) relative to overseas interest rates, the RBA would encourage a larger than normal inflow of overseas savings into the foreign exchange market. This would result in an increased demand for Australian dollars and a consequent appreciation of the dollar. The floating of the Australian dollar has virtually severed the influence of foreign exchange activity from our internal financial system. In the past, unpredictable flows of foreign capital had brought pressure to bear on our domestic interest rates and played havoc with the government's attempts to control the domestic money supply. Previously, the RBA was obliged to buy quantities of foreign currency entering the country. This required the exchange of foreign currency for Australian dollars and ultimately led to the release of more dollars into our domestic money supply. Situations such as this would often occur when the government's aim was to restrain money supply growth. Under the floating exchange rate system, each trading bank maintains its supply of foreign currencies. If this supply exceeds the acceptable limit, the bank is obliged to sell its surplus on the open market. As with any commodity, the price will rise or fall until the market is cleared. This is the essence of a floating exchange rate system. Since the floating exchange rate was introduced, the changes in the level of the Australian dollar can be explained by a number of factors: speculation by investors the changes in the current account deficit for Australia the impact of domestic monetary and fiscal policy in Australia the long-term interest rate differential between Australia and its trading partners changes in the terms of trade trends in Australia's net overseas liabilities. Q U E S T I O N S 1 Why would the RBA want to intervene in the market for Australian dollars? 2 What is the difference between a clean float and a managed or 'dirty' float? 3 When has the RBA intervened in the market place and why? 4 What factors explain the changes in the level of the Australian dollar? ECONOMICS CHALLENGE Exchange rates now vary on a daily (and sometimes hourly) basis. Figure 3.13 shows the value of the Australian dollar against the euro and the Japanese yen, and Figure 3.14 shows the movement of the Australian dollar. These graphs show the extent to which the Australian dollar moves in value over time. Go to the current RBA Chart Pack to find the latest graphs for the exchange rates and the trade-weighted index. FIGURE 3.13 The Australian dollar against the US dollar, the euro and the yen RBA Chart Pack 1987 \*ECU per A\$ until 31 December 1998 1993 1999 2005 2011 2017 50 100 150 200 ¥ 1.60 1.20 0.80 0.40 US\$, € Australian dollar ¥ per A\$ (LHS) US\$ per A\$(RHS) € per A\$\* (RHS) Source: © Reserve Bank of Australia, 2001--2018. All rights reserved. Research the movement in the value of the Australian dollar, and give reasons for the changes in values -- in particular, the low value in September 2008 and the peak in August--September 2010. 2 To what extent do world events influence the value of the Australian dollar? 3 Do domestic events influence the value of the Australian dollar more than international events? Explain your answer. 4 What is the current value of the Australian dollar? Is the recent trend in the price of the dollar showing an appreciation or depreciation? 5 What current events are causing the movements in the value of the Australian dollar? 6 If you were an adviser to an investor, would you recommend that the investor buy or sell Australian dollars at the moment? Why? 3.5 Forward-exchange facilities Exchange risk: the risk encountered by traders because of floating exchange rates Futures market: the market in which contracts are written for the purchase or sale of commodities on a date specified in the future Spot rate: the exchange rate quoted for a currency at a particular time CONCEPTS Source: © Reserve Bank of Australia, 2001--2018. All rights reserved. Perhaps the greatest disadvantage of the floating exchange rate system is that businesspeople are faced with uncertainty about future movements in the values of international currencies. Because of time lags involved in finalising trade transactions, businesspeople are always concerned with the possibility of sudden changes in currency values. They face what is usually referred to as an exchange risk. Unless a business takes the precaution of insuring against exchange risk or incorporating into sales contracts provisions that guard against exchange fluctuations, it stands to lose substantially if exchange rates fluctuate against the business. To offset the element of exchange risk in trade transactions, Australian trading banks offer forward-exchange facilities. This means that businesspeople can enter into contracts with their banks to buy or sell a certain volume of foreign currency by some future specified date. The forward-exchange contracts are written in terms of a rate of exchange that is agreed to by both the bank and the businesspeople at the time of signing the contract. Consequently, no matter what happens to currency values after a contract is signed, both parties to it must honour the terms of the contract at the time of settlement. The forward-exchange facility offered by trading banks is closely supervised by the RBA. Each day, the RBA distributes to trading banks an Exchange Rates Schedule that lists both spot rates and forward-exchange margins. The spot rate is the rate of exchange quoted to customers for the sale or purchase of foreign currency on the same day, as opposed to the forward-exchange margin, which attempts to account for future fluctuations. Forward- exchange facilities are offered at a cost to the entrepreneur. Since banks are in the business of making a profit, the forward-exchange rate for the purchase or sale of a volume of foreign currency is set accordingly. By offering forward-exchange facilities, trading banks transfer the burden of exchange risk from businesspeople to themselves. Because the forward-exchange facility is recognised as an official banking activity, the risks incurred by the trading banks are underwritten by the RBA. The advent of floating exchange rates also saw the growth of a futures market for most commonly traded commodities. The market allows traders to hedge against price changes, and gives them an opportunity to plan ahead and organise deliveries of commodities in advance. 3.6 The terms of trade 3.6.1 What are the terms of trade? Export price index: a statistical measurement used by economists to produce an index number used to monitor fluctuations in export prices Import price index: a statistical measurement used by economists to produce an index number used to monitor fluctuations in import prices Terms of trade: a statistical concept that highlights the relationship between export prices and import prices Terms of trade index: a statistical measurement used by economists to produce an index number used to monitor price fluctuations CONCEPTS The terms of trade is the relationship between the price of exports and the price of imports. By exporting goods and services, a country gains some of the foreign currency it needs to purchase imports. If the price of exports rises and the price of imports remains stable or falls, then a fixed unit of export ( for example, 1 tonne of wheat) will earn more foreign exchange than before and will thus make it possible to buy an increased quantity of imports. In this case, we say the country's terms of trade are favourable. In the opposite situation, when the prices of exports are falling and import prices are stable or rising, the fixed unit of export (that is, 1 tonne of wheat) will purchase fewer imports than before because it will be earning less foreign exchange. The terms of trade for the country are then unfavourable. Both import and export prices tend to vary over time as a result of the interaction of demand and supply and other forces. Primary products, in particular, tend to fluctuate in price from year to year. This is usually a response to changes in supply associated with seasonal conditions or demand in response to economic conditions. For example, weaker demand for Chinese steel would reduce demand for coal and iron ore, thus lowering world prices. Australia's exports, being mainly primary products, have tended to fluctuate considerably over time. There have been boom times for products such as wool, wheat, sugar, coal and iron ore, but they are often followed by a severe fall in prices. Simply, the terms of trade can be expressed as an equation: Terms of trade = General level of export price General level of import price A terms of trade index is calculated by using the following formula: Terms of trade index = Export price index Import price index × 100 The export price index shows the change in the weighted average of the price of goods exported. The import price index shows the change in the weighted average of the prices of goods imported. The terms of trade index also shows whether the relative movement in exports and imports is favourable or unfavourable. Australia's terms of trade have become more favourable since 2000, as seen in Figure 3.15. This is a reflection of the mining boom experienced since then. Economists are mainly concerned with the movement in the terms of trade index from year to year; that is, the relative movement in import and export prices. If the terms of trade index falls, there is an unfavourable movement. If the terms of trade index rises, there is a favourable movement. 3.6.2 Effects of changes in the terms of trade There is a close relationship between changes in the terms of trade and the balance on current account (see Chapter 4). The value of exports or imports is found by calculating price multiplied by quantity. If a price decrease results in a larger proportional increase in the quantity of exports, then the result in the fall in the terms of trade may be an improvement in the value of exports and the balance on current account. But when the fall in the terms of trade is large and there is no compensating increase in the volume exported, the current account deficit is increased. The terms of trade can also have an effect on the exchange rate. The exchange rate is likely to depreciate if there is a persistent decline in the terms of trade because of the effect of the current account deficit. A persistent decline in the terms of trade also affects domestic prospects for employment and growth in export industries, and on the economy generally. If the price elasticity of demand is such that the lower export prices result in an increased value of exports, while the high import prices cause a fall in the value of imports, a minor or small decline in the terms of trade may result in an improved current account deficit. An improvement in the terms of trade will have the opposite effect. 3.7 Government policy and exchange rate movements Changes in the exchange rate can affect government policy. Governments need to ensure economic policies are altered because of their influence on economic activity. KEY IDEA An appreciation or depreciation of the Australian dollar has a direct effect on the prices of goods and services in the domestic market. These effects can be almost immediate, and many Australians are used to these. For example, after a depreciation of the Australian dollar, we can expect the prices of petroleum to rise almost immediately. This is because Australia imports most of its petroleum from overseas and depreciation means we need to use more Australian dollars to purchase it. This has an immediate effect in the market place, and the price of petroleum generally increases. Apart from such immediate effects, an appreciation or depreciation can have a wider effect on economic activity, inflation and employment. 3.7.1 Exchange rates and the Australian economy If the Australian dollar depreciates, overseas tourists will be encouraged to visit Australia as they will receive more Australian dollars for their own currency. This means Australia will be a more attractive country to visit. Governments may need to adjust policies in terms of the development of facilities such as resorts, increased flight numbers by overseas airlines and increased employment in the tourism industry. The price of our exports affects the volume of exports. If there is an appreciation, the volume of exports will fall, as our exports will become dearer in the international market place. Similarly, if there is a depreciation, the volume of exports will rise, as our exports will become cheaper in the international market place. Exchange rates affect the labour market When an appreciation occurs, Australian goods become more expensive relative to overseas goods, and foreign firms will demand less of our goods and services. At the same time, imported goods and services become less expensive in Australia. This means that a domestic producer competing against importers is less able to be competitive, and it is likely that there will be a loss of employment in the industry. Governments need to be aware of this and develop policies to cope with the higher level of unemployment, and another set of policies to enable the domestic producer to be more internationally competitive. Exchange rates affect inflation and interest rates A depreciation in the value of the Australian dollar will have the effect of increasing the price of imports, placing inflationary pressure on the economy. At the same time, more domestic goods and services may be exported, resulting in an expansion of aggregate demand and increasing employment. This might increase production costs, which would mean higher prices for domestically produced goods, also resulting in inflationary pressure. Should this occur, the government and the RBA, through monetary policy, may need to increase interest rates in order to stay within the inflation target band. It would be necessary for the government to alter or change the existing policies in these situations. 3.7.2 Effectiveness of government response Government policy response to exchange rate movement needs to be evaluated using a number of criteria. These could be as follows: The impact on employment in trade-exposed industries: government needs to minimise any loss of employment at all times, and would wish to see job opportunities increased as a result of suitable policies designed to counter any job losses domestically. Economic growth: this is a sustained increase in the productive capacity of Australia over a specific period of time, usually one year. Any alteration to government policy must always consider economic growth, as continued growth will enhance employment and make Australia more competitive in the global economy. Efficiency: efficiency is the (often measurable) ability to avoid wasting materials, energy, efforts, money and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully and without waste. If the maximum efficiency possible can be achieved, then economic growth will be enhanced. You should consider allocative efficiency and dynamic efficiency: \- Allocative efficiency occurs when a country's productive resources are used in combinations that generate the maximum benefits for consumers and the country. \- Dynamic efficiency refers to the ability of an economy to respond to changing consumer demands by relocating resources to new industries or production processes. Prices of imported goods and services: government policy should aim to reduce or minimise any increase in the prices of imported goods and services, to ensure that there will not be upward pressure on inflation in the economy. Using the Internet and newspapers, locate two or three articles that refer to the impact of an exchange rate movement on the Australian economy. Try to locate major movements when there has been a prolonged appreciation or depreciation of the Australian dollar. Indicate what actions the Australian Government took or could have taken in this situation and, using the criteria set out above, evaluate the adequacy of the government action. ECONOMICS IN ACTION 3.1 True/False For each statement, indicate whether you consider it to be True (T) or False (F). 1 Depreciation of our currency tends to decrease the price of imported commodities, thereby making them more attractive to domestic consumers. 2 When an Australian business exports goods or services overseas, they expect to receive payment in Australian dollars. 3 The US dollar is the major currency held as part of Australia's official reserve assets. 4 The exchange rate is the price of one country's currency in terms of another currency. 5 A decrease in demand for Australia wool increases the demand for Australian dollars. 6 When Australian firms invest in China, the supply of Australian dollars falls on the foreign exchange market. 7 An appreciation of the Australian dollar will make imports cheaper. 8 A fixed exchange rate is one that is determined by market forces. 9 Under a floating exchange rate, a decline in the value of the Australian dollar is known as a devaluation. 10 A managed exchange rate is controlled by the Australian Government. 3.2 Terminology Select the correct term from the list below that describes each statement. A Currency appreciation E Trade-weighted index I Currency depreciation B Exchange risk F Spot rate J Foreign exchange (forex) market C Gold exchange standard G Fixed exchange rate D Exchange rate H Terms of trade 1 The system used by many countries until the late 1960s to determine the value of their currency; based on the fact that the value of the US dollar was fixed to the value of gold; that is, US\$35 = 1 ounce of gold 2 A decrease in the value of a currency relative to other currencies under a floating exchange regime 3 An index compiled on the basis of importance of trade; at one stage used in determining the value of the Australian dollar 4 The value of the currency of a nation expressed in terms of the currency of another nation 5 The exchange rate quoted for a currency at a particular time 6 The relationship between export prices and import prices 7 An increase in the value of a currency relative to other currencies under a floating exchange regime 8 The risk encountered by traders because of floating exchange rates 9 A market where international currencies are bought and sold 10 The value of a currency that is determined by the government fixing it to the value of another currency at a certain level, and guaranteeing to maintain that level 3.3 Multiple-choice questions Select the correct response to each of the following: 1 If the Australian dollar were depreciated by 10 per cent, which one of the following would not be true? A Imported Japanese motor vehicles would cost more in the Australian market. B Imported Japanese motor vehicles would cost less in the Australian market. C Japanese buyers would pay less for Australian wool. D Australian consumers would be encouraged to buy locally manufactured goods. 2 An improvement in Australia's terms of trade is said to occur when: A the general level of export prices decreases relative to the general level of import prices. B the general level of export prices increases relative to the general level of import prices. C there is a decline in the terms of trade index. D the terms of trade index remains constant. 3 The rate of exchange: A measures the relationship between the prices of imports and the prices of exports. B is the rate at which the composition of Australia's trade is changing. C is the number of units of a foreign currency that can be purchased with an Australian dollar. D is the quantity of foreign exchange that Australian banks hold. 4 Under Australia's floating exchange rate system, the Reserve Bank of Australia acts in the foreign exchange market to: A encourage speculation in the Australian dollar. B prevent excessive movements in the value of the Australian dollar. C fix the value of the Australian dollar. D achieve a target exchange rate. 5 An appreciation of the exchange rate of the Australian dollar means that: A more Australian dollars are needed to buy one US dollar. B one Australian dollar can buy more US dollars. C the Australian dollar has been devalued. D there has been a fall in the trade-weighted index. 6 Appreciation of the Australian dollar is most likely to: A increase the value of foreign currency in terms of the Australian currency. B make Australia less attractive to foreign investment. C lower the value of overseas reserves. D all of the above. Which of the following will occur if the Reserve Bank of Australia increases domestic interest rates? A increased financial inflows leading to an appreciation B decreased financial inflows leading to a depreciation C decreased financial inflows leading to an appreciation D increased financial inflows leading to a depreciation 8 If the Australian dollar appreciated against the euro, then one result would be that: A Australian wool would be more expensive in Germany. B French tourists would receive more Australian currency in exchange for euros. C the demand for Australian goods by the Netherlands would increase. D all of the above. 9 Australia's exchange rate is described as: A a fixed system. B a flexible system. C a free floating system. D a managed floating system. 10 Which of the following increases the demand for Australian dollars on the foreign exchange market? A Australian imports of goods and services B interest and dividend payments to US firms C purchases of military equipment overseas by the Australian Government D interest and dividend payments from overseas to Australian firms 11 A change in the value of the Australian dollar from US\$0.75 to US\$0.85 represents: A an appreciation of the Australian dollar. B a depreciation of the Australian dollar. C a devaluation of the Australian dollar. D an appreciation of the US dollar. 12 Everything else being equal, for products priced in Australian dollars, a fall in the exchange rate value of the Australian dollar: A will raise the price of imported goods and services in Australian dollars in Australia. B will lower the price of exports from Australia in Australian dollar terms. C will lower the price of exports from Australia in both Australian dollar and local currency terms. D will lower the price of imported goods and services in Australia in both Australian dollar and overseas currency terms. 13 Everything else being equal, a rise in the sale of exports to Asia would be reflected in: A a fall in the value of the Australian dollar. B an equal inflow of capital from Asia. C a rise in the foreign exchange value of the Australian dollar. D a rise in interest rates in Australia. Under a system of floating exchange rates, a shift to the right in the demand curve for the Australian dollar will: A ultimately cause Australian exports to increase and its imports to fall. B cause the Australian dollar to appreciate. C cause other currencies to appreciate. D cause the Australian dollar to depreciate. 15 The Reserve Bank of Australia can increase the level of the Australian dollar by: A reducing interest rates in the Australian economy. B increasing the level of government expenditure. C buying Australian dollars on the foreign exchange market. D reducing the level of lending of domestic banks. 3.4 Short response questions 1 Explain the meaning of a floating exchange rate. What is the difference between a clean float and a managed or 'dirty' float? 2 Explain with the use of diagrams how a floating exchange rate is determined. 3 List factors that may cause the exchange rate to depreciate. 4 Under a floating exchange rate, what can the Reserve Bank of Australia do to slow down or prevent a depreciation of the Australian dollar? 5 What happens to the international competitiveness of Australian industry when the exchange rate rises? What impact might a rise in the exchange rate have, therefore, on the structure of the Australian economy? 6 Describe how the exchange rate is affected by changes in commodity prices. 7 Suggest how fluctuations in the domestic interest rates would affect the value of the Australian dollar? 8 Describe what might be the likely effect on Australia's exchange rate of an increase in interest rates in the rest of the world. 9 What might cause a decline in the exchange rate for the Australian dollar? What effects might such a decline have on the relative volume of exports and imports? 10 Explain the effects a fall in the interest rate in the USA might have on the Australian dollar. 3.5 Activities 1 Imagine you are an importer of Japanese television sets. You have negotiated a price with your supplier for 100 television sets at ¥54 000 per set. a If the current exchange rate is A\$1 = ¥250, how much will you pay the supplier for 100 television sets, expressed in Australian dollars? b Suppose the Australian dollar appreciates by 10 per cent against the Japanese yen. i What will the new exchange rate be? ii How much, expressed in Australian dollars, will you now be required to pay for 100 television sets (rounded to the nearest dollar)? Imagine the Australian Government decided to manage the float and attempted to prevent the Australian dollar falling below A\$1 = US\$0.80. a Would there be a shortage or a surplus of the Australian dollar? b Would the Reserve Bank of Australia have to buy or sell Australian dollars? c How many Australian dollars would be bought or sold? d What would happen to Australia's international reserves as a result of this intervention? 6 Of the following groups, who would gain and who would lose as a result of this managed float? a exporters b importers c import-competing industries d foreign tourists in Australia 7 Using Figure 3.17, calculate the terms of trade for Ozland. In which year/s did Ozland experience a favourable movement in its terms of trade? FIGURE 3.17 Ozland terms of trade Year Export price index Import price index Terms of trade index Year 1 100 100 Year 2 120 80 Year 3 150 120 Year 4 160 160 Year 5 140 210 Year 6 130 90 8 Everything else being equal, what effect will the following events have on the value of the Australian dollar? Illustrate each event with a demand and supply diagram. a an increase in export sales from Australia b a fall in purchase of imports by Australians c a fall in investment from overseas in Australia d a move by the Reserve Bank of Australia to use its reserves to buy up Australian dollars on the foreign exchange market e a decline in overseas aid provided by the Australian Government