Economics
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Exchange rates
This tutorial was written by
Ken Edge
Head Teacher Social Science
Cardiff High School
Outcomes
Overview
Content
Review exercises
More
Outcomes
HSC topic: Australia’s Place in the Global Economy is covered in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 34-36. The specific outcomes for this tutorial are:
| H1 | demonstrates understanding of economic terms, concepts and relationships |
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| H4 | analyses the impact of global markets on the Australian and global economies |
| H8 | applies appropriate terminology, concepts and theories in contemporary and hypothetical economic contexts. |
| H10 | communicates economic information, ideas and issues in appropriate forms. |
Being up to date and aware of contemporary issues
This tutorial is mostly based on 2002 Exchange Rates and this should be kept in mind as you read it. Students of Economics need to be aware of what is happening in the Australian Economy today and should, for instance know about recent changes in the value of the Australian dollar.
After completing this tutorial you may wish to do some research on the current situation for the Australian dollar by scrolling down to the section 'MORE' at the bottom of this page and visiting the websites such as that of the Reserve Bank of Australia.
Overview
In topic one, The Global Economy, you will have gained an understanding of the world financial markets.
For a country to be involved in international trade, finance and investment it is necessary to have access to the currencies of other countries. For example, an Australian company purchasing electrical equipment from Japan needs to exchange its Australian dollars for Japanese yen.
Similarly, if an Italian clothing manufacturer purchases wool to produce suits from an Australian farmer, it needs to exchange its Italian lira for Australian dollars.
The sale and purchase of foreign currencies takes place in the foreign exchange, or forex markets. This market allows for the movement of large volumes of funds (about three trillion dollars per year) for investment purposes around the world. The US dollar, the Japanese Yen and the European euro are significant currencies in the world’s financial markets.
In the foreign exchange market, supply and demand determines the exchange rate for each currency traded. As a result there is no single exchange rate, there are many different rates.
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What is an Exchange Rate?
A nominal or relative exchange rate is simply the price at which one currency exchanges for another currency. For example, as at 23 March 2002 one Australian dollar was worth 52.5 cents in United States currency or $A1.00 = $US0.52.5. This equation can also be written in reverse, as $A1.90 = $US1.00.
Table 1 Relative exchange rates for the Australian Dollar and the TWI
Year ending June $US Japanese yen British pound sterling Trade weighted index (TWI) 1991-1992
1992-1993
1993-1994
1994-1995
1996-1997
1997-1998
1998-1999
1999-2000
2000-2001
2002-2003
2003-2004
2004-2005
2005-2006
2006-2007
2007-2008
0.75
0.67
0.73
0.71
0.75
0.61
0.66
0.60
0.51
0.66
0.68
0.75
0/74
0.78
0.89
94.0
71.5
72.2
60.1
85.2
86.2
79.7
63.2
62.9
79.99
74.82
80.45
85.90
93.21
99.88
0.39
0.45
0.47
0.45
0.45
0.37
0.42
0.39
0.36
55.2
49.5
53.0
48.4
56.7
57.9
58.4
53.3
49.7
59.4
59.1
62.7
63.3
64.8
70.00
Source: RBA Statistical Bulletin series F.
Table 1 shows the changes in the relative exchange rates (over a sample 10 year period) of Australia’s major trading partners and the TWI which measures the value of the Australian dollar against the value of the currencies of 23 of Australia’s trading partners.
The value of the Australian dollar has been fluctuating in value since it was floated in December 1983. For example, between December 1993 and December 1994, the Australian dollar appreciated (increased in value) by 13.4 percent against the US dollar, and between December 1996 and September 1998 it depreciated (decrease in value) by some 24.7 percent. In 2001 the level of the Australian dollar hovered around $US0.51, a further 23 percent depreciation over the previous three years. In 2005 the Australian dollar is hovering around the $US0.75 mark. It was $US0.7617 at 4pm AEST on May 30 2005.
Between 2000 and 2008 the Australian dollar has mostly been slowly appreciating against those of its main trading partners. There are a number of reasons for this. During this time the United States dollar gradually depreciated (this pushes the value of the Australian dollar up). Also there was a commodity boom and Australia received an increased price for its exports of raw materials. This was a result of the resource boom in selling raw materials to the growing Chinese economy. As well, Australia had much higher interest rates than its trading partners, which encouraged foreigners to bring funds to Australian and invest in Australia, and increase the demand for Australian dollars. The Australian dollar is the seventh most traded currency in the world and is used by international investors and currency traders as a proxy for commodity prices and world growth. What this means is that if raw material prices rise internationally, currency traders and investors purchase Australian dollars.
Any changes in exchange rates are important because of the effect they have on the prices we pay for imports, the prices we receive for our exports and the amount of money flowing into and out of the economy.
For example, if the value of the Australian dollar appreciates (increases in value) exports become dearer and overseas customers have to find more Australian dollars to buy the same volume of exports. On the other hand, imported goods become cheaper for Australian consumers and producers.
If the Australian dollar depreciates (decreases in value), Australian exports become cheaper and imports dearer. Australian exports are now less competitive in global markets because of the appreciation of the Australian dollar in recent years. Currently, overseas buyers of Australian products have to find more Australian dollars to buy the same volume of exports.
Decreasing i mport prices can decrease production costs and inflation rates in any domestic economy.
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The trade weighted index (TWI) is shown in table 1. It measures the Australian dollar against a basket of 23 currencies of Australia's main trading partners.
The TWI is then a more comprehensive measure of the purchasing power of the Australian dollar as it takes into account the relative importance (trade weighted) of each of our major trading partners and the performance of Australia's balance of payments.
The TWI also reflects changes in global economic conditions. There is usually a decline in the TWI when our major trading partners experience a downturn in economic activity. This is because growth in the global economy slows and the demand for imports and exports decreases.
Table 2 Trade Weights of major partners
TRADE-WEIGHTED INDEX
The new weights for the trade-weighted index (TWI) of the Australian dollar have been compiled and are reported in the table below. These weights, which reflect the composition of Australia’s two-way merchandise trade in 2007/08, will apply from 1 October 2008.
Weights in the Trade-Weighted Index
(per cent)Currency Trade Weight 2008/09 2007/08 Chinese renminbi 16.3672 15.4486 Japanese yen 15.4040 15.4860 European euro 11.6517 12.1703 United States dollar 9.8797 10.7432 South Korean won 5.7786 5.9057 Singapore dollar 5.2102 4.5637 United Kingdom pound sterling 4.7535 4.1943 New Zealand dollar 4.6565 4.6553 Thai baht 3.8019 3.5465 Malaysian ringgit 3.2705 2.9989 Indian rupee 3.0844 3.5320 New Taiwan dollar 2.9903 3.2771 Indonesian rupiah 2.4053 2.7489 Vietnamese dong 1.9640 1.9032 United Arab Emirates dirham 1.5930 1.2801 Papua New Guinea kina 1.2341 1.1564 Hong Kong dollar 1.1934 1.3785 South African rand 1.1040 1.1496 Canadian dollar 1.0786 1.1892 Saudi Arabian riyal 0.8916 0.9166 Swiss franc 0.8685 0.9401 Swedish krona 0.8190 0.8158
The number and composition of the 22 currencies included in the index are unchanged from the previous year. These currencies account for 93.2 per cent of Australia’s two-way merchandise trade.
The weight of the Chinese renminbi is now the highest in the index, having increased by 1 percentage point from last year and by 10 percentage points since 2000/01. The Japanese yen, which had received the highest weight since 1983/84, is now ranked second, though its weight is broadly unchanged from last year. The weight on the euro fell by ½ a percentage point and the weight on the US dollar fell by ¾ of a percentage point from last year.
The combined weight of the Asian-Pacific currencies, excluding Japan, increased to 52.0 per cent while the combined weights of the North American and European currencies fell to 11.0 per cent and 18.1 per cent. These declines reflect a large increase in the value of two-way trade with the Asia-Pacific region, in particular with China, rather than a decline in the value of two-way trade with Europe and North America.
Source: Reserve Bank of Australia
- Factors affecting the demand for Australian
dollars
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The demand for Australian exports
When Australian goods and services are bought by overseas consumers, they need to convert their currency into Australian dollars to pay the exporters. Therefore, any increase in the demand for Australian exports, should increase the value of the Australian dollar.
There are a number of factors that can influence the demand for exports:
Tastes and preferences of overseas consumers for Australian exports
A good example is the Australian tourism industry. During the 1990s a large growth in tourism meant an increase in the demand for Australian dollars. However, the events in the United States on 11 September 2001 reduced the number of tourists coming to Australia, and consequently, the demand for Australian dollars.
Changes in the world economic conditions
Changes in the international business cycle can also affect the demand for Australian exports. The high levels of world economic growth during 2000 increased the demand for goods and services and the demand for Australian dollars. However the economic recession in 2001–2002 had the opposite effect on our major trading partners with the Australian dollar reaching lows of $US0.48 in March 2001, and $US0.49 in September 2001. The resources boom of 2002-2008 had an big impact on the value of the Australian dollar which gradually appreciated over this time as Australian sold more and more raw materials to major manufacturing nations such as China and Japan.
International competitiveness
To be competitive in the global market, Australia’s goods and services must be as cheap as its international competitors. If Australia’s inflation rates and costs are relatively higher than its overseas competitors, our goods will be more expensive. High Australian inflation rates help cause a loss of export markets, reduce demand for Australian dollars, and force a depreciation of the Australian dollar.
On the other hand, lower rates of inflation typically increase the demand for Australian exports, and appreciate the value of the Australian dollar.
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Capital inflow
Foreign investors wishing to invest in Australia must also exchange their own currency for Australian dollars. A number of factors may influence their investment decisions. For example, if Australian interest rates are relatively higher than overseas interest rates this will increase capital inflow and the demand for Australian dollars.
The expectation of higher levels of domestic economic growth will also influence the size of the capital inflow and increase the demand for Australian dollars, causing a currency appreciation. On the other hand, a decline in the level of capital inflow may cause a fall in the demand for Australian dollars, resulting in a currency depreciation.
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Speculation
Speculation occurs when currencies are bought and sold by foreign investors for the purpose of making a profit. If foreign investors expect the value of the Australian dollar to increase in the future, they may sell other currencies and buy Australian dollars. This would increase the demand for Australian dollars and put upward pressure on the exchange rate.
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Factors affecting the supply of Australian dollars
Demand for imports
Just as foreigners must pay for our exports with Australian dollars, we must pay overseas producers foreign currency for imported goods. If the Australian demand for imported goods and services increases, so does the supply of Australian dollars. The increase in supply of Australian dollars puts downward pressure on the value of the Australian dollar.
The level of financial flows out of Australia
An increase in capital outflow can occur as a result of higher interest repayments on overseas loans (net income transfers) or increased demand for foreign assets, such as shares and real estate by domestic Australians.
This means that investors need to sell Australian dollars (increasing supply) in the forex markets to obtain other countries’ currencies. The increase in the supply of Australian dollars could cause a decrease (depreciation) in the value of the Australian dollar. The level of domestic interest rates and investor confidence in the Australian economy can also influence supply of Australian dollars.
Inflation rates
If there were high rates of inflation in Australia imported goods and services would be cheaper relative to domestically produced products. As consumers subsequently purchase d increasing amounts of imported goods and services, the supply of Australian dollars in the forex market would increase s, causing a decrease or depreciation in the value of the Australian dollar.
An interesting point
Over the two decades from 1970 to 1990, Australian consumer prices rose by a cumulative 55 per cent more than consumer prices in the United States. So, to maintain the competitiveness of our industries, this inflation difference required the dollar to depreciate from $US1.10 in 1970 to about US70c in 1990.
Since 1990 our prices have risen by less than our trading partners’ average, which does not explain the dollars continual decline.
Source: Gittins on Saturday 2 December 2001
Speculation
If speculators lose confidence in the economy and feel that future values of the Australian dollar will be lower than present levels, a depreciation of the exchange rate can occur. This is because when speculators sell Australian currency to avoid future losses, the supply of dollars increases, putting downward pressure on the exchange rate.
Review Exercises
Review exercise 1
Click to select the correct answers for the true/false questions.
| Questions | Answers | |
|---|---|---|
| i) The forex market is used for the exchange of currencies to pay for exports and imports. | True | False |
| ii) Different foreign exchange markets exist around the world. | True | False |
| iii) More tourists coming to Australia will create an increase in supply of Australian dollars. | True | False |
| iv) The trade weighted index measures the Australian dollar against Australia’s main trading partners. | True | False |
| v) High domestic inflation rates will make imports cheaper and increase the demand for Australian dollars. | True | False |
| vi) If speculators lose confidence in the economy a depreciation in the value of the Australian dollar will occur. | True | False |
| vii) Lower rates of inflation increases the demand for Australian exports resulting in an appreciation of the Australian dollar. | True | False |
| viii) When business confidence in the Australian economy deteriorates capital outflow decreases. | True | False |
| ix) Speculation is the buying and selling of foreign currencies to make a profit. | True | False |
| x) The Australian dollar was floated in December 1993. | True | False |
Explain following terms.
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Nominal exchange rate
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International competitiveness
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Trade weighted Index
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“Real” exchange rate
You are employed as a consultant for an international investment company. A new customer has asked you to explain the following situations would affect the value of the Australian dollar.
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An international investor in New York has read some current information on an improvement in Australia’s terms of trade.
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A recent World Bank report expects a rise in world economic growth during the next twelve months.
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Current economic indicators point to a rise in the inflation rate in the Australian economy.
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A newspaper report suggests a rise in the Australia’s interest rates relative to other countries.
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News headline, “An improvement in Australia’s net foreign liabilities and current account deficit.”
Find out the current exchange rates for the $US, YEN, EURO
and the TWI by accessing the Reserve Bank of Australia Daily Statistical
Releases 
or at http://www.x-rates.com/
More
The Reserve Bank of Australia has a large
number of articles located in Media Releases.
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