Unit 3 Exchange Rates - Topic 1 - PDF

EXCHANGE RATES Unit 3 Topic 1 1  WHAT IS AN EXCHANGE RATE? An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another. Exchange rates are traded in the global currency market. Exchange r...

EXCHANGE RATES Unit 3 Topic 1 1  WHAT IS AN EXCHANGE RATE? An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another. Exchange rates are traded in the global currency market. Exchange rates play a crucial role in international trade, finance, and investment, as they determine the relative value of different currencies and impact the cost of goods and services when traded between countries. 2 AUD EXCHANGE RATE AGAINST THE USD World currencies against the AUD – May 2024 4  Foreign currency/exchange reserves Foreign currency/exchange reserves are cash and other reserve assets such as gold held by Reserve Bank Of Australia (RBA). They are available to meet balance payments of the country, influence (managed) the foreign exchange rate of its currency, and to maintain confidence in financial markets. Foreign currency reserves typically include major global currencies like the US dollar, Euro, Japanese yen, and British pound, among others. 5 Foreign currency/exchange reserves  How much foreign currency is traded daily? Daily turnover of global foreign exchange market (Billion US dollars) 2001 2007 2013 2019 2022 Total 1239 3324 5357 6581 7506 US Dollar 1114 2845 4662 5811 6639 EURO 470 1231 1790 2126 2292 Japanese Yen 292 573 1235 1108 1253 Sterling (£) 162 494 633 843 968 Chinese Yuan 0 15 120 285 526 Australian 54 220 463 446 479 Dollar 7  How much currency is traded daily? Over 7.5 trillion worth of US dollars are traded on global currency markets each day. Key reasons for this huge volume of trading include: 1. International trade 2. Foreign direct investments 3. Currency Speculation EXCHANGE RATE SYSTEMS 9 EXCHANGE RATE SYSTEMS  FLOATING EXCHNAGE RATE SYSTEM Currency value is set purely by market forces(demand for and supply of currency). Strength of currency supply and demand drives the external value of a currency in the markets Currency value can either appreciate (rise) or depreciate (fall) No intervention by the Reserve Bank of Australia - RBA allows the currency to find its own exchange rate. There is no target for the exchange rate.  WHO DEMANDS AUD and WHY? Foreigners demand for AUD to make payments into Australia for following reasons. Purchasing Australian exports ( their imports) Investing in Australian businesses (Direct or buying Shares) Saving in Australian banks Speculative buying of AUD 12  SUPPLY OF THE AUD Australian people and institutions supply AUD when payments are made to other countries for following reasons; Importing from abroad Investing in foreign countries (Direct or buying foreign shares) Saving in foreign banks Speculative buying of foreign currency. 13  DECIDING THE ER IN FLOATING ER SYSTEM EQUILIBRIUM EXCHNAGE RATE Market-clearing exchange rate is the exchange rate at which the quantity supplied equals the quantity demanded of foreign currency. In the following diagram, the demand for and supply of AUD has decided its exchange rate against the USD. One AUD can be exchanged for 0.67 USD (or 67 US cents.) Therefore, the exchange rate between the AUD and the USD is; 1AUD =.67 USD. 14  FLOATING ER SYSTEM The supply of AUD is upward sloping because Australian goods become cheaper as the dollar price of pounds rises so more pounds will be supplied to buy AustralianS goods (AUD) ER- USD per AUD 0.67 The demand for AUD is downward sloping because as AUD become cheaper D (AUD) Australian goods become cheaper, Quantity of AUD and Americans are willing to buy  Equilibrium Exchange Rate Changes Equilibrium exchange rates change when the demand for and/ or supply of the domestic currency changes. i.e. Increase in demand for AUD Decrease in demand for AUD Increase in supply of AUD Decrease in supply of AUD 16  Exchange Rate Changes What if American businesses or people want to increase purchase of Australian commodities?. They should pay with AUD. Americans demand for AUD from their banks. (Demand for foreign currency is derived from the demand for foreign country’s goods, services, and financial assets) This increases the demand for AUD hence, the demand curve for AUD would shift to right. What if Americans want to save/invest more in Australia? Same as above!  Exchange Rate Changes Increase in demand for AUD shifts the D to D1. hghZBVBBBV Exchange rate 0.7 5 moves up to USD 0.75. D1(AUD) An AUD would cost more in terms of the USD. This increase in ER is called Appreciation of the AUD Appreciation the AUD against the USD Appreciation the AUD against the USD Appreciation the AUD against the USD 19  Impact of Currency Appreciation Value of domestic currency increases relative to the foreign currency. From being AUD 1= USD.67 to AUD 1= USD.75 Exports become expensive therefore, less price competitive. If one Australian apple was AUD 1, importers in US would buy an apple for USD 0.67 prior to appreciation of the AUD. After appreciation, the same apple would be USD 0.75 Imports become cheaper hence, more attractive. Australia could buy commodities worth USD 0.67 with one AUD before appreciation. After appreciation, the same AUD can buy commodities worth USD 0.75  Exchange Rate Changes Conversely, if American businesses or people want to reduce purchase of Australian commodities? Americans would reduce demand for AUD from their banks. This decreases the demand for AUD hence, the demand curve for AUD would shift to left. What if Americans want to save/invest less in Australia? Same as above! 21  Exchange Rate Changes Decrease in demand for AUD shifts the D to D1. Exchange rate moves down to USD 0.55. An AUD costs less 0.5 5 than the initial ER in terms of the USD. D1(AUD) This decrease in ER is called currency DEPRECIATION. 22 Depreciation of the AUD Depreciation the AUD against the USD Depreciation the AUD against Depreciation the AUD against the USD the USD 23  Impact of Currency Depreciation Foreign currency becomes more valuable than the home currency. The foreign currency’s value has appreciated against the home currency. Domestic prices fall relative to foreign prices. Exports become more price competitive. Imports become less attractive  IMPACT OF CURRENCY DEPRECIATION Macroeconomic Impact variable Inflation Higher import prices feed into increased consumer prices – may help a country to avoid deflation. But higher inflation threatens real living standards. Economic growth Weaker currency stimulus to GDP growth (higher net exports) but much depends on the price elasticity of demand for exports. Unemployment Increased domestic production due to increasing demand for exports would create more jobs. Business Likely improvement in profitability and capital investments investment in foreign sector of the economy. International Increase in export revenue and decrease in import Trade sending leading to a better trade balance. Wider effects Depreciation helps to boost the economy like a cut in interest rate. However, there would be higher costs of importing components, raw materials and  IMPACT OF CURRENCY APPRECIATION Macroeconomic Impact variable Inflation Economic growth Unemployment Business investments International Trade Wider effects Complete the above table in line with information available in this PowerPoint IMPACT OF CURRNCY DEPRECIATION  IMPACT OF CURRNCY APPRECIATION Create a flow chart (like above) to show the impact of appreciation of the AUD  Factors Affecting Floating Exchange Rate Inflation rates Interest rates Economic growth rates Current demand for and supply of currency Expectation of future exchange rate 29  Australia Floats the Dollar https://www.nma.gov.au/defining- moments/resources/australian-doll ar-floated 30  FIXED EXCHANGE RATE SYSTEM This is a system of currency exchange in which the value of one currency is tied/fixed against another by the financial authority of the country. Two currencies will always be exchanged at the same price Sometimes referred to as pegged exchange rate. This system provides stability, reducing uncertainty in international trade. 31  Fixed Exchange Rate System A country's currency is pegged to the value of another major currency in the fixed ER system, most often the USD or the Euro. 32 Change in currency value Under Fixed ER System  Exchange rate changes under Fixed ER System In a fixed ER system, the government authority is responsible for changing the exchange rate of the currency. Exchange rate undergoes Revaluation or Devaluation. Revaluation and devaluation are terms that only apply under a fixed exchange rate regime and not under a floating exchange rate regime. The meaning of revaluation and devaluation of a currency is when the government issuing a currency changes its value in relation to a foreign currency that it has been fixed to. 34 Revaluation of a currency occurs when the value of a currency is increased relative to another currency in a fixed exchange rate regime. This creates the same impact as currency appreciation of currency under floating ER system. Devaluation of a currency occurs when the value of the currency is decreased relative to another currency in a fixed exchange rate regime. Devaluation leads to same outcomes as depreciation would create under floating ER system. 35 38 RBA Explains… https://www.rba.gov.au/education/r esources/explainers/pdf/exchange- rates-and-the-australian-economy. pdf?v=2024-10-11-11-01-50 40  MANAGED EXCHANGE RATES A hybrid system that combines elements of both floating and fixed exchange rates. The exchange rate is allowed to fluctuate within a band or target zone set by the central bank. The central bank intervenes in the market to prevent the exchange rate from moving outside the target zone. Offers some degree of flexibility for monetary policy while maintaining a degree of exchange rate stability. 41  MANAGED EXCHANGE RATES Central bank allows the exchange rates to fluctuate according to changes in supply and demand factors. Central bank may intervene occasionally – Buying to support a currency (selling their FX reserves) Selling to weaken a currency (adding to their FX reserves) Currency becomes a key target of domestic monetary policy Higher exchange rate to control inflationary pressures “Managed depreciation” to improve competitiveness & trade balance This is called a dirty float as well 42 Managed ER Systems SINGAPORE DOLLAR – A MANAGED FLOAT 43 Managed ER systems 44 45  LIMITS TO THE ABILITY TO MANAGE A CURRENCY The volume of speculative trading of currencies is huge – central banks may find they have little impact when buying and selling to move the currency in a particular direction. Central banks might have multiple objectives, such as price stability and employment. These objectives can sometimes conflict with each other, making it challenging to devise a single 46 policy approach. EXCHNAGE RATE REGIMES 47 48