Factors Affecting Foreign Exchange Rates: A Study Of Australian Dollar (AUD) And US Dollar (USD) Exchange Rate

Supply and demand framework for predicting exchange rate

Discuss about the Credit And Cross-Country Predictable Firm Return.

Foreign exchange rate is one of the essential parts of shaping the international trade, which stands for the value of domestic currency in terms of the monetary value of the foreign currency (Cooper 2014). Among many supply and demand framework is the simplest macroeconomic models that can effectively aid the economy to predict and determine the exchange rate of the domestic currency compared to the foreign currency (Corazza and Malliaris 2015). It not only determines the value of foreign exchange rate of domestic currency against the foreign currency, in addition to this, it aids to determine various key factors that can affect the economy’s exchange rate (Gabaix and Maggiori 2015).

Figure 1, showcase the foreign exchange market demand and supply outline of a nation, where the demand is perceived through the demand of export of a nation and the supply is achieved through the importable demand of the domestic market (Caballero, Farhi and Gourinchas 2016). Utilising the derived demand, AUD demand curve ‘D’ has been drawn and aggregate demand of the importable has been utilised to draw the supply curve ‘S’. Now, if the initial equilibrium occurs at E, then it can be seen that exchange rate of each unit of AUD is 80C in terms of USD and the demand of the importable is represented through Q. Considering, a rise in demand of the AUD from Q to Q1, it can be seen that there will be appreciation of the AUD. At new equilibrium E1, exchange rate of each unit of AUD is 81C in terms of USD (hypothetically). However, if there is fall in demand from Q to Q2, then the exchange rate will fall to from initial equilibrium situation, where the exchange rate is determined at 77C USD for every unit of AUD. Through this analysis it can be seen that demand and supply framework can easily explain the relative price of domestic currency compared to the foreign currency and in addition it can explain the factor too that influence the exchange rate (Knittel and Pindyck 2016).

According to the above mentioned analysis of AUD under the purview of supply and demand, it can be said that there are various factors that can lead to alteration in the demand and supply condition of the AUD, which can in turn lead to fluctuation in the exchange rate of AUD. Key factors that can alter the foreign exchange rate of AUD are as follows:

• Interest rate – With rise in interest rate there will be higher inflow of foreign currency in the Australian banks, which will lead to shift in the demand curve of Australian Dollar. Rightward shift of the AUD carve will resulting in higher price of the domestic currency in terms of USD (Ghosh et al. 2016).
• Inflation rate – with rise in inflation, there will be fall in demand of Australian dollar in front of the US citizens. It will lead to shift the AUD leftward and the Australian currency will be depreciated (Bussière et al. 2014).
• Growth rate – better growth rate will lead to higher demand of AUD. Thus, with better growth AUD exchange rate can get altered.

Key factors affecting the exchange rate of AUD

Nominal exchange rate is the value of domestic currency, which is required to buy a unit of foreign currency (Eichenbaum et al. 2017). If there is rise in nominal exchange rate of a nation’s currency, then it is acknowledged as the nominal appreciation of the domestic currency.  And in case of loss of purchasing power, there will be nominal depreciation. Trade Weighted Index (TWI) on the other hand is the multilateral exchange rate which is calculated through providing weighted average to magnitude of business with the partner country (Albuquerque et al. 2015).

Considering the nominal exchange rate of Australia for last three years (figure 2) along with the TWI o Australia for the same time frame (figure 3) it can be seen that there has been various fluctuations. From figure 2, it can be seen that AUD was at its best compared to USD during May of 2015; however, it fell sharply till November of the same year due to fall in the demand of the Australian goods and services in the market of US. Next to this, AUD rose to a moderate .76C USD for each unit of AUD during January of 2016 marking policy effectiveness of the Australian government (Baumgartner 2016). Apparently from the figure 2, it can be seen that there was a uplift of the US demand for the Australian goods and services along with this and weakening USD has allowed the AUD to soar to the 80C USD for each unit of AUD.

Figure 3, highlights the same figure as it has been seen in the figure 2. TWI of AUD hit its lowest during September of 2015 due to comparative fall in export to the US and it has been rising since then. Though there has been fluctuation in TWI over the time, however it has managed itself to remain steady. Presently with rise in demand of the Australian trade with US, TWI is rising again and leading itself towards 80C USD for each unit of AUD (Engel 2016).

Figure 2, and Figure 3, both highlights that foreign exchange rate of AUD is rising in terms of the USD since 2015. This rise has been christened from various sources and among them most important is the weakening USD. According xxx, under the floating exchange rate system, if a currency gets weaker compared to the other, then it inherently makes the other currency stronger compared to itself. Utilising this phenomenon, it can be said that though there is very little rise in demand of the AUD, weakening USD is allowing the Australian dollar to rise. On the other hand it can also been seen that there is very little rise in demand of Australian tech metals in US market that has aided the AUD to have some upward boost. This rise in demand has caused the AUD to rise against USD leading to better AU-US business situation in future.

Impact of exchange rate on the Australian economy

Given report highlights various reasons for the rise in AUD compared to USD. According to the given article, recent slump in the USD is one of the main reasons that lead to rise in Australian dollar compared to the USD (Ismail, 2018). Besides this, rising price of iron ore is another key element that has lead to rise in the AUD. However, according to the given report, Australian dollar appreciation is not sustainable owing to the stagnant inflation rate of the country as well as persistent labour wage rate. In addition to this, Hong et al. (2017), argues that it has been seen that recently there is a fall in demand of Australian iron due to rise in Chinese export promotion as well as Fed hikes are amongst the key factors that leading to rise in interest gap between the two countries. The report concludes with the idea that AUD will fall back to 70C USD soon, once the US interest rate outshine the prevailing bank interest rate of Australia (Arteta et al. 2015).

In order to explain the effect of the abovementioned driving force on the AUD considers the Figure 4. Point E highlights the present equilibrium situation of the , where exchange rate is Ex. With rise in the demand of Australian iron ore and enhancement in the Fed rate gap, demand of AUD shifts from D to D₁, which caused in a rise in exchange rate from Ex to Ex₁ (Feenstra 2015). Once there will be fall in demand of the AUD, demand curve D₁ will shift to D₂, making new equilibrium E₂, where the exchange rate is Ex₂, which is much lower than the initial equilibrium. 

If the AUD is going to cheaper compared to the USD one year from now, then it will hamper the country’s economy positively. On the other hand, being the manager of an Australian firm, it can be said that the firm will face loss with weak AUD compared to the USD. According to the general economic theory, if there is depreciation of one currency, then importable will be expensive compared to the present situation (Cole and Nightingale 2016). In addition to this, higher price of the importable will lead to rise in the price of the importable, which will force the aggregate demand of the importable to fall. With falling demand, price will rise again and the cycle will continue until there is balance between the demand and supply of the importable (Friedman 2017). Considering the company that imports electric machinery from the US, it can be said as a manager of the firm, that it will face loss. With stronger USD, the firm will fail to import as much as goods that it is importing now. With lesser importable, the firm will raise the price to keep the profit intact, which will in turn lead to fall in the demand (Galbraith 2015). With lower demand firm will face loss, however, it will raise the price again to cover the Average Variable Cost. Further deterioration in demand will take place with rising price and the cycle will continue until equilibrium is established between the supply and demand of the electrical machinery.

Strategies for enhancing AUD/USD exchange rate

On the other hand with weaker AUD, there will high demand of the Australian goods and services in the US market (Dwyer et al. 2016). With higher export, Australia will have better trading proposition, which will enhance the Balance of Trade of Australia as well as, with higher trade, TWI of Australia-US will be better off.

If the government wants to enhance the AUD/USD exchange rate from 72C USD to 80C USD, then there are various plans. Australia is growing at 6.9% annual growth rate and a large portion of its GDP comes from the mining sector (Nakamura et al. 2017). There has been substantial drop in Australian mining good in US market during past few years. Presently with rise in demand of tech metals, mining trade with US is rising and utilising this situation Australian government can use export promotion and enhance its exchange rate through increased trade with US (Irwin 2015). On the other hand there is large gap in Australian and US interest rest, which is leading to fall in foreign investment in the Australian banks. Thus if the Australian Reserve Bank can enhance its interest rate, then there will substantial rise in US investment in Australian banks, leading to rise in AUD compared to USD (Calomiris et al. 2016). Next to this, import substitution can be handy if the Australian government want to restrict the importable that hurt the Balance of Payment of the country largely.

Bringing in AUD/USD exchange rate from 72C USD to 80C, has both the bright and dark side. If the government of Australia need to promote growth, then it would be require for the government to implement the aforementioned policies so that the country can have stronger AUD compared to the USD. With stronger AUD, the country can enhance its trade balance and let the trading participating as an engine of country’s economic growth. On the other hand, with stronger AUD, imports will raise leading to deterioration of the Australian trade balance (Hofman et al. 2016). Moreover, import quota is not possible under the AUSFTA pact between these two trade participating countries (Gantz 2016). Besides this, once the AUD gets appreciated through raising the interest rate, it will dry up the market leading to fall in aggregate demand. Thus it can be said that, government can use these actions to gauge the deteriorating AUD, however it need to be aware of the side effect (Blanchard et al. 2016). Proper balance between interest rate and market liquidity and import substitution can be helpful for the Australian government.

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