1. Briefly summarise the main issues discussed in this article?
2. Using Demand and Supply model of exchange rate determination briefly explain how AUD is determined in the forex market, and what factors influence its fluctuations.
3. Using exchange rate data from Reserve Bank of Australia and graphs (monthly data of last three years) analyse the movement of AUD relative to that of the US dollar? Is it in line with the world commodity price movement during this period? Are there any other factors contributing to this behaviour of the Australian dollar?
4. Do you think that the AUD will fall as low as US 65C by the end of 2016? Justify your answer. What advantages do you think Australia will have in such a scenario?
5. If the market rate is US 65C then what action could the Reserve Bank of Australia take in order to maintain the exchange rate at US 70C, and what side effects might this action have on the Australian economy? Do you think that such actions would be effective?
1. The article is about the falling exchange rate of the Australian dollar. The author of the article, Mulligan (2016) began by noting that the silence of Glenn Stevens, the Reserve Bank of Australia governor, could tell that he was happy with the manner in which the Australian dollar fell in the year 2015. Further, the governor, in a statement of his monthly board meeting, replaced the observation that further depreciation in the value of the Australian dollar was both necessary and likely with the statement that the Australian dollar was adjusting to the momentous decline in the prices of the key commodities. The argument advanced by the RBA governor in support of the falling value of the Australian dollar is that it enhances the competitiveness of the country when it comes to exports. This is because it makes the export of the country to be desirable to its trading partners. Lastly, it has been posited in the article that there is an expectation that the value of the Australian dollar will decline further. One of the factors that have been suggested to be the cause of this is the decline in the terms of trade of Australia.
2. According to Adrian, Etula, and Shin (2015), Australian dollar is not an exception since the selling and buying of currencies take place in the markets known as foreign exchange markets just like any other commodity market. The determination of the Australian dollar’s exchange rate can be done by looking at its demand and supply in the foreign exchange market. The demand for Australian dollar in the foreign exchange market market arise from the demand for the exports of Australian goods, and from the speculators that are looking to make profit in the changes in the value of the Australian dollar (Bacchetta & Van Wincoop, 2013). The demand for imports from abroad in the Australian domestic market determines the supply of the Australian currency in the forex market. When Australia imports motor vehicles from Japan, it has to pay in Japanese yen ((¥), and for it to buy Japanese yen, it has to sell Australian dollar. This implies that it will be supplying the Australian dollar in the forex market. Given the demand of the goods produced by Australia and the supply of the Australian dollar in the forex market, market fixes its exchange rate against another currency at a point where its demand equates its supply as shown in the figure.
The figure above shows the Australian dollar’s (AUD) exchange rate vis-a-vis the U.S. dollar (USD). S is the supply curve of the Australian dollar while D is its demand curve. The point of intersection of the two curves is where the forex market fixes the Australian dollar’s (AUD) exchange rate vis-a-vis the U.S. dollar (USD).
The fluctuations of the exchange rate of the Australian dollar may result from the changes in its demand and supply (Bown & Crowley, 2013). For instance, if there is an increase in the exports of the Australian products, there will be an increment in the Australian dollar’s demand and this will shift the demand curve to the right. This eventually raises the Australian dollar’s exchange rate. Interest rate is another factor that can lead to fluctuations or changes in the Australian dollar’s exchange rate. When there is an increase in the interest rates in Australia as compared to other countries, investors will demand more of Australian dollar and this raises its exchange rate. On the other hand, if there is a decrease in interest rates in Australia, more will be invested in Australia and this will lead to a decrease in the Australian dollar’s demand and hence a decrease in its exchange rate.
3. The figure below shows the movement of the Australian dollar’s exchange rate vis – a – vis the U.S. dollar. The data used in coming up with the figure was drawn from the database of the Reserve Bank of Australia, and it shows data monthly data of last three years (from 2013 to 2015).
From the figure, it can be noted that there was a general decrease in the Australian dollar’s exchange rate vis – a – vis the U.S. dollar for the period between January 2013 and December 2015. This clearly indicates that the value of the U.S. dollar was strengthening agaisnt the Australian dollar. This trend is in congruent with the movement of the commodity price in the world during this period. This is because the U.S. government bonds or the U.S. currency proved to be popular ports in storm during this period. This is implies that there was an increment in demand for the U.S. government bonds because the U.S. dollar became stronger as compared to most currencies in the world. As such, there was an increase in demand for the U.S. dollar and this weakened a number of currencies, which saw them experience a decline in exchange rate within this period. The main reason behind this is that most commodities are priced in U.S. dollars. Another factor that might have led to the trend in the exchange rate of the Australian dollar that has been shown in the figure above is the decrease in demand for the Australian Iron ore.
4. I believe that the Australian dollar’s value will decline as low as U.S. 65C by the end of 2016. One of the justifications for this is that the prices of the commodities produced by Australia like Iron ore will fall and this implies that they will cost less in the international markets. A fall in the prices of the Australian Iron ore implies that there will be a decrement in the value of the Australian exports. A decrease in the value of the Australian exports implies that there will be less demand of the Australian dollar and this means that its exchange rate will decrease (Cenedese, Payne, Sarno, & Valente, 2016). Another factor that points to a further decline in the exchange rate of the Australian dollar is the most recent monetary policy in the United States, which has created an expectation that there will be an increase in the U.S interest rates. This indicates that most investors will prefer investing in the United States and this will eventually lead to an increase in the value of the U.S. dollar (Burstein & Gopinath, 2013).
A decline the Australian dollar’s value will be advantageous to Australia in the sense that it will lead to job creation and as such lowering the unemployment rate. When the exchange rate of the Australian dollar goes down, it implies that imports will be more expensive while Australian exports will become cheaper (Bergsten & Halm, 2015). This will lead to a decrement in imports and an increment in exports. When there is an increase exports, it implies that the domestic firms will benefit from an increase in sales volume. As such, they will hire more workers to help in the production process to allow them meet the increased demand for their products. Hiring more workers implies the domestic firms have created jobs and this implies there will be a decrease in the unemployment rate.
5. In case the rates prevailing in the market is U.S 65C then the action that the action that could be taken by the Reserve Bank of Australia for the purposes of maintaining the exchange rate at a level of US 70C is to increase its interest rates. This is because high interest rates will attract foreign investors into the Australian economy. This will increase the Australian dollar’s demand in the international market. When the demand for the Australian dollar increases in the forex market, it implies that its exchange rate will increase and as such, the Reserve Bank of Australia will be able to maintain the exchange rate at US 70C. The effect that this action will have on the economy of Australia is that it will lead to a decrease in the supply of money in the economy. This is because an increase in interest rates will discourage borrowers and the private citizens from borrowing money from the banks. This implies less money supply in the Australian economy.
High interest rates may discourage domestic firms that depend on the loans offered by the banks, as their source of capital for operating their business activities (Basher, Haug, & Sadorsky, 2012). This indicates that there will be a decrease in the production in the economy and it may eventually results into a decrease in economic growth. A decrease in production level and economic growth may results into an increase in the unemployment rate in the economy. As such, this action would not be effective. However, it will only be effective in a situation where there is high level of inflation in the economy. Nevertheless, in the long – run, the action is not viable.
References
Adrian, T., Etula, E., & Shin, H. S. (2015). Risk appetite and exchange rates.
Bacchetta, P., & Van Wincoop, E. (2013). On the unstable relationship between exchange rates and macroeconomic fundamentals. Journal of International Economics, 91(1), 18-26.
Basher, S. A., Haug, A. A., & Sadorsky, P. (2012). Oil prices, exchange rates and emerging stock markets. Energy Economics, 34(1), 227-240.
Bergsten, C. F., & Halm, G. N. (2015). Approaches to Greater Flexibility of Exchange Rates: The Burgenstock Papers. Princeton University Press.
Bown, C. P., & Crowley, M. A. (2013). Import protection, business cycles, and exchange rates: evidence from the Great Recession. Journal of International Economics, 90(1), 50-64.
Burstein, A., & Gopinath, G. (2013). International prices and exchange rates (No. w18829). National Bureau of Economic Research.
Cenedese, G., Payne, R., Sarno, L., & Valente, G. (2016). What do stock markets tell us about exchange rates?. Review of Finance, 20(3), 1045-1080.
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Darvas, Z. (2012). Real effective exchange rates for 178 countries: a new database.
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Hameed, A., & Rose, A. K. (2016). Exchange Rate Behavior with Negative Interest Rates: Some Early Negative Observations.
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