Topic 4: Macroeconomic Objectives: Economics

TOPIC 4: MACROECONOMIC OBJECTIVES 2012
SOUTH AUSTRALIAN MATRICULATION
ECONOMICS
TOPIC 4:
MACROECONOMIC
OBJECTIVES
Macroeconomics
Chapter 4.4 : External Balance

(Exchange Rate)
1
TOPIC 4: MACROECONOMIC OBJECTIVES
AREAS OF LEARNING
 Full employment of labour;

Concept of full employment; causes of unemployment, changing employment trends,
effects of unemployment
 Price Stability;
Concept of price stability, CPI as indicator, inflation and its effects
 Economic Growth;
Concept of economic growth, GDP as indicator, methods of calculating GDP, effects of
economic growth
 External Balance;
Concept of external balance, structure of current account, impact of capital flows,
indicators of external balance, causes and effects of external balance
Chapter 4.1 Full employment of Labour
Chapter 4.2 Price Stability (Inflation)
Chapter 4.3 Economic Growth
Chapter 4.4 External Balance
2
:
Materials have been extracted from
various sources for classroom teaching
purposes only.
Due credit is being given to relevant

authors.
3
Exchange rate:
The price of one country’s currency in terms of another. For a country to be involved in
international trade, finance and investment it is necessary to have across to the currencies of other
countries. For example, on 14th December 2011 1$A = $US 1.01 .
The Australian dollar is the seventh largest traded currency in the world. The Australian dollar
increased in value to US$0.98 by 2008, which was around double the rate it was in April 2001. The
dramatic rise in the value of the Australian dollar was brought about by strong world economic
growth (USA, China , Japan) , rising terms of trade, rising interest rates in Australia and increasing
trade liberalization.
Currencies are traded in the foreign exchange market (Forex Market) so that international traders
can settle their financial accounts. The foreign exchange (FOREX) market is the market in which
currencies of different countries are bought and sold. Foreign exchange is the currency of another
country that is needed to carry out international transaction.
Exchange Rates
Units of foreign currency per A$
28 Dec 2011 29 Dec 2011 30 Dec 2011
United States dollar 1.0156 1.0101 1.0156
Chinese renminbi 6.4251 6.3885 6.4096
Japanese yen 78.99 78.55 78.73
European euro 0.7775 0.7813 0.7847
South Korean won 1175.96 1162.98 1170.99
UK pound sterling 0.6486 0.6537 0.6589
Singapore dollar 1.3180 1.3144 1.3210
Indian rupee 54.05 53.96 54.02
New Zealand dollar 1.3128 1.3132 1.3145
Malaysian ringgit 3.2200 3.2084 3.2266
Swiss franc 0.9489 0.9521 0.9557
Swedish krona 6.9631 6.9816 7.0127
Trade-weighted Index (4pm) 75.7 75.5 75.8
Special Drawing Right 0.6584 0.6548 0.6636
4
Trade Weighted Index:
A ‘basket’ of currencies weighted according to their importance in trade flows with Australia.
 It is 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
 Also reflects changes in global economic conditions.
Table 1: Weights in the Trade-weighted Index Per cent
Trade weight*
1 October 2010 –
From 1 December 2011
Currency 30 November 2011
(Merchandise and services)
(Merchandise only)
* Weights are re-scaled to sum to 100

Sources: ABS; RBA
Chinese renminbi 22.5803 22.5371
Japanese yen 13.5025 14.9356
European euro 9.6731 9.9174
United States dollar 9.5351 8.5423
South Korean won 6.3500 6.4074
Singapore dollar 4.6714 4.3425
United Kingdom pound sterling 4.2808 3.5337
New Zealand dollar 4.2091 4.0894
Indian rupee 4.1947 4.9052
Thai baht 3.8040 4.6668
Malaysian ringgit 3.1463 3.1598
Indonesian rupiah 2.7554 2.4527
New Taiwan dollar 2.6874 2.7943
Hong Kong dollar 1.6188 1.0461
Papua New Guinea kina 1.3897 1.3340
Vietnamese dong 1.2197 1.2292
United Arab Emirates dirham 1.0614 1.1617
Swiss franc 1.0434 0.6820
Canadian dollar 0.9386 0.8213
South African rand 0.6818 0.7530
Swedish krona 0.6565 0.6885
5
Changes in exchange rate.
 Foreign exchange flows can be represented by a DD-SS diagram for each currency (AUD
& USD).
 In figure 1 - the SS of AUD = DD for USD Whatever happens in 1 market
- The DD for AUD = SS of USD will reflect in the other market.
Price of $Aust Price of 1 $U.S.

1 $Aust $US in
SS SS
in $US 1 $Aust
SS
$0.71 $1.45
$0.69 $1.41
DD DD1
DD
Qty of $Aust Qty of $US
If Australia increases its imports from the US, there will be an increase in the SS of AUD and
an increase in DD for USD. Thus, AUD will depreciate; USD will appreciate.
 An increase in demand for AUD cause AUD to Appreciate
 A decease in demand for AUD cause AUD to Depreciate
 An increase in supply for AUD cause AUD to Depreciate
 A decease in supply for AUD cause AUD to Appreciate
6
Activity:
Increase in DD for AUD Decrease in DD for AUD
Increase in SS of AUD Decrease in SS of AUD
7
International Transaction
 The DD and SS of a currency are determined by the international transactions that are
recorded in the BOP.
 Exp: Use AUD as an example,
Panel A: Australia Exporting to US Panel B: Australia Importing from US
Australian Australian
Exporter Importer
Sends cheque in $US

Supplies Demand$ Supplies Demand$
Sends cheque in $US
Sells iron ore
$US Aust $Aust US

Sells computers
Bank Bank
American American
Importer Exporter
 Assume an Australian mining company is exporting iron ore to the US.

 This contract is likely to be priced in USD.
 When the Australian exporter sells his iron ore, he will receive a cheque in USD.
 He then must exchange this at his bank for AUD.
 The US buyer has supplied American dollars, while the Australian exporter will
demand AUD from the Forex market.(Panel A)
 Panel B shows the opposite transaction where an Australian importer purchases a
computer from an American firm.
 If the contract is written in USD, then the Australian buyer will first exchange AUD at
his bank to obtain US currency to send to the seller in the US as payment for the
computers he is importing.
8
Essentially, the DD for a currency will be determined by:
 Exports of goods and services

These are all credits
 Receipts of income from overseas
in the BOP
 Capital inflow (foreign investment)
The SS of a currency will be determined by:
 Imports of goods and services

These are all debits
 Payment of income to overseas
in the BOP
 Capital outflow (investment abroad)
Thus, changes in BOPs transaction involving goods, services, income or financial capital,
will affect either the DD and/or the SS of the currency and thus affects its value.
9
Australia’s Exchange Rate System.
There are two basic methods for determining the price of a country’s currency – by allowing
the market forces of supply and demand to freely set the value or by artificially setting the
price at a fixed rate. Exchange rate therefore can be either floating or fixed. Australia
adopted a freely floating exchange rate in December 1983. Prior to that it used an
administered or ‘crawling peg’system where the value of the currency was tied to a specific
group or ‘basket’ of currencies. A fixed exchange rate system implies that the value of the
currency is maintained at the same rate for long periods of time. Most countries now use
floating exchange rate system with differing degrees of intervention by their central bank.
Floating Exchange Rate
 Value is determined by the market forces of SS and DD. Its value can change daily and
even by minute as it reflects changes in the DD and SS of its currency.
 When there is no intervention in the free market operations by a government or its agency
a ‘clean float’ is said to exist.
 A managed exchange rate occurs whenever there is official intervention in the foreign
exchange market by the Reserve bank (RBA). The RBA can either act as the buyer of
seller of the currency to influence AUD’s rate.
 When there is intervention in the free market operations by a government or its agency a
‘dirty float’ is said to exist.
 A floating exchange rate simply means that the equilibrium price will change whenever
the DD or SS curves shift.
 If the DD for AUD increases because there is an increase in the DD for Australian
exports, then the value of AUD will rise, AUD will appreciate against USD.
 If there is an increase in the SS of AUD, due to increase in imports, then the value of
AUD would decrease, AUD will depreciate against USD.
10
 Thus, as long as the value of the AUD is allowed to move in accordance with shifts in DD
and SS, then it is a free or floating exchange rate.
 A floating exchange rate means that the total BOP will always balance.
 Sum of all credit transactions (DD for $A) = sum of all debit transactions (SS of $A)
 Thus, if there is a deficit on current account, then under free exchange rate, a matching
surplus on the capital and financial account will occur.
Price of 1 Increased DD ($A): $A Appreciates

$Aust in SS($A)
$US
SS2
- Increased exports
- Increased income receipt
$0.75US - Increased capital inflow
$0.70US
$0.65US Increased SS ($A) : $A Depreciates
DD2
DD($A)
Qty of $Aust - Increased imports

- Increased payments of income
- Increased capital outflow
Based on the above figure:
 Initial equilibrium exchange rate is 1AUD = US0.70

 If the demand for Australian dollar increases because of an increase in demand for Australian
exports, then the value of the Australian dollar will rise, that is, the AUD will appreciate against
USD to perhaps AUD 1 = USD0.75
 If there is increase in supply of AUD due to an increase in imports, then the value of AUD against
USD would depreciate to AUD 1 = USD 0.65
 A floating exchange rate means that the total BOP will always balance. Sum of all credit
transactions (DD for $A) = sum of all debit transactions (SS of $A). Thus, if there is a deficit on
11
current account, then under free exchange rate, a matching surplus on the capital and financial
account will occur.
Balance of payment and floating exchange rate
A floating exchange rate regime has the advantage of providing automatic adjustment in
the BOP. For example, if there is an excess supply of AUD, then depreciation will raise the
prices of imported goods and services in domestic currency and lower the price of exported
goods and services in the foreign currencies. This will automatically help remove excess
supply. Under floating exchange rate, the balance of payments does not affect the domestic
money supply and this is seen as being highly desirable.
A free exchange rate helps to reduce swings in the current account balance. Usually rises
in the CAD will lead to exchange rate depreciation - this increases the price of imported
goods and services and decreases the price of Australian exports. Demand for imports should
fall while demand for exports will be increased helping to reduce CAD. But this assumes that
the demand for both imports and exports is responsive or elastic to the change in price. If
demand is relatively inelastic, then higher import prices may actually lead to an increase in
import payment. Similarly is exports are relatively inelastic, then lower prices may initially
lead to lower export receipts. The result is that depreciation may actually increase CAD.
12
Treads in Australia’s exchange rate
13
Australian Dollar and TWI

US Index 80.0
1.4
70.0
1.2 US$ per
60.0 $A
1.0
0.8 50.0 TWI May

1970 =
0.6 40.0 100
0.4 30.0
Exchange rate and TWI
$A 1 = TWI TOT
Renminbi Yen Euro USD
As at June (1970 = 100) 2009-10 =100
2007 6.46 104.70 0.63 0.85 68.9 93.5

2008 6.60 101.93 0.61 0.96 73.4 105.4
2009 5.54 77.76 0.58 0.81 64.7 94.1
2010 5.79 75.46 0.70 0.85 67.3 113.6
2011 6.94 86.33 0.74 1.07 77.8 128.1
Source: RBA statistics
The above table and charts shows changes in the value of Australian Dollar, TWI and TOT.
The Australian dollar generally strengthened across the period shown until the second half of
2008 when there was a significant depreciation in dollar. Until mid 2008 the relative strength
of AUD was partly due to Australia’s sustained period of strong economic growth which
encouraged foreign investment. There was also a greater interest rate differential between
Australia and key overseas economies which attracted inflows of foreign investment which
increased the demand for AUD. Continued high commodity prices is partly due to demand
from high growth economies of China and India, also impacted positively on Australia’s
TOT. As Australia is a commodity exporter, this was important in maintaining strong demand
for Australia’s exports and therefore the Australian dollar at that time.
14
In mid 2008 the Australian dollar depreciated. This coincided with the global recession and
trade collapse. Demand for Australian exports slowed considerably as did commodity prices
after successive increase in key bulk commodity prices had driven the TOT to a six decade
high in the first half of 2008. This had an impact on TOT which fell back to 2008 levels.
By late 2009 it became clear that Australia had avoided the worst effects of the global
downturn and that demand for key commodities had held up because of continued high levels
of demand coming from China and the Asian region. Commodity prices started once again to
rise which had encouraged inflow of foreign investment which also increased demand for
Australian Dollar. By mid 2010, it appeared that Australia’s exchange rate and TOT were
once again returning to pre GFC levels.
15
Factors influencing Exchange Rates
Global Economic Conditions
The demand for Australian commodity exports is highly dependant on the level of income of
our trading partners. When world economic activity increases, this results in an increase in
the demand for Australian exports, particularly comodities. High demand from the US and
Japan and the emergence of China and India increased export volume and lead to
appreciation of AUD.
Domestic Economic Conditions
When the domestic economy is growing, output, employment and income are rising and the
demand for imports will also rise, increasing the supply of AUD. Australia has a high
marginal propensity to import when the domestic economy is growing strongly , the firm’s
sector undertakes investment on capital equipment which is predominantly sourced from
overseas. The household sector experiencing improved employment conditions and increased
income response by increasing spending on consumer durables which are imported. This
transactions increase the supply of AUD causing depreciation.
Relative Inflation Rates
The demand for Australia’s exports will be influenced by the degree of international
competitiveness of the domestic exporters’ i.e. if Australia’s inflation rate is relatively low
compared to its trading partners, exports will be relatively cheaper and more attractive to
foreign buyers .Relative inflation rates also effects demand for imports i.e. if Australia’s
inflation rate in relatively low, this improves the competitiveness of domestic import
computing producers, which reduces the demand for imports and reduces the supply of AUD.
RBA Intervention
The RBA may intervene in the currency market by buying or selling currency if it wishes to
prevent sharp falls or rises in the value of AUD.
16
Terms of Trade
Historically, changes in commodity prices and the TOT have tendered to have an immediate
impact on AUD. An increase in commodity prices and an improvement in the TOT are
expected to improve the CAD and the financial markets will often respond by increasing the
value of AUD with the expectation that the CAD will improve over the short to medium
term. Speculators will respond to changes to commodity prices, which will affect the demand
for and supply of AUD on the foreign exchange market. Australia has witnessed a 30%
increase in TOT. Given Australia’s imports and exports are priced inelastic, this should result
in an improved balance of trade, increase in demand for AUD causing AUD to appreciate.
Relative Interest Rates
The level of capital inflow will be affected by the level of Australia’s interest rates as well as
the level of confidence in the Australian economy. Relatively higher interest rates compared
to overseas competitors (interest rate differentials) and stronger confidence in the Australian
economy will encourage capital inflow and increase the demand for AUD. In late 2004,
Australia’s cash rate was 4.7% while the USA federal reserve set their cash rate at 1% ; this
represented a 3.75% greater for investors in Australian financial institutions compared to the
US.
Capital Flows
Foreign investor confidence in Australia and the expectations about the performance of the
Australia economy will influence investment decisions and the demand for the AUD.
Australia’s perceptions of overseas investment opportunity influence the level of capital
outflow therefore supply of AUD. Low inflation rate, increased productivity and high interest
rate differentials and stable political and legal environments are all examples of the
fundamental strength of the Australian economy act as incentives for foreign investment.
Speculators
The majority of foreign currency purchased and sold is done by speculators, buying and
selling currencies, with the aim of making relative shorter gains. Daily trade in the AUD is
over $100b and it is generally estimated that over 80% of the currency transactions are for the
speculative purposes rather than for trading a good or service. If speculators think the AUD
will appreciate, they will buy the currency (and vice versa)
17
Effects/Implications of changes in Exchange rate
Depreciation:
Prices of imports and exports
Depreciation makes the foreign exchange (forex) price of exports decrease and AUD price of
imports increase. Exports and domestic import-competing industries should become more
competitive. Resources should flow into the sector, depreciation encourages structural change
and helps reduce the CAD.
Inflation
Depreciation caused the AUD price of imports to increase:
- Some imports are included in the CPI

- Many imports are capital goods, increases cost of production for domestic firms, cost push
inflation will occur
- Domestic import-competing industries face with less price competition can increase their
prices. Inflation may trigger wage demand, wage/price spiral
Foreign debt
Depreciation causes the AUD value of foreign debt denominated in Forex to increase – the
valuation effect. This also increase interest servicing costs on foreign debt – increases income
debit on the CAD
External shocks
Depreciation can protect the domestic economy from external shocks. The competitive boast
to export and import competing industries can help prevent domestic recession.
18
Appreciation:
 Appreciation makes overseas purchases cheaper and purchases from Australia more
expensive for overseas residents. Overseas competitiveness is reduced.
 As a result export volumes will tend to fall and import volumes rise. Thus exporters and
import competing industries may suffer. This will create a smaller surplus or larger
deficit in net exports and reduce Aggregate demand.
 Some export sectors suffer more than others. The mining industry is less adversely
affected than say manufacturing since high levels of demand for minerals have caused
the appreciation
 Lower aggregate demand will reduce sales, output and employment in the non trading
sectors of the economy.
 Investment may decline in response to the fall in AD
 On the other hand appreciation tends to lower inflation and this has beneficial effects
 Lower inflation allows the RBA to maintain the stimulatory effect of low interest rates.
 Lower inflation enhances international competitiveness minimising the initial impact of

the appreciation.
19

Topic 4: Macroeconomic Objectives: Economics

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Topic 4: Macroeconomic Objectives: Economics

Uploaded by

Copyright:

Available Formats

TOPIC 4: MACROECONOMIC OBJECTIVES 2012

SOUTH AUSTRALIAN MATRICULATION

Chapter 4.4 : External Balance

TOPIC 4: MACROECONOMIC OBJECTIVES

 Full employment of labour;

Chapter 4.1 Full employment of Labour

Chapter 4.2 Price Stability (Inflation)

Chapter 4.3 Economic Growth

Chapter 4.4 External Balance

Due credit is being given to relevant

Units of foreign currency per A$

28 Dec 2011 29 Dec 2011 30 Dec 2011

United States dollar 1.0156 1.0101 1.0156

Chinese renminbi 6.4251 6.3885 6.4096

Japanese yen 78.99 78.55 78.73

European euro 0.7775 0.7813 0.7847

South Korean won 1175.96 1162.98 1170.99

UK pound sterling 0.6486 0.6537 0.6589

Singapore dollar 1.3180 1.3144 1.3210

Indian rupee 54.05 53.96 54.02

New Zealand dollar 1.3128 1.3132 1.3145

Malaysian ringgit 3.2200 3.2084 3.2266

Swiss franc 0.9489 0.9521 0.9557

Swedish krona 6.9631 6.9816 7.0127

Trade-weighted Index (4pm) 75.7 75.5 75.8

Special Drawing Right 0.6584 0.6548 0.6636

Trade Weighted Index:

* Weights are re-scaled to sum to 100

Chinese renminbi 22.5803 22.5371

Japanese yen 13.5025 14.9356

European euro 9.6731 9.9174

United States dollar 9.5351 8.5423

South Korean won 6.3500 6.4074

Singapore dollar 4.6714 4.3425

United Kingdom pound sterling 4.2808 3.5337

New Zealand dollar 4.2091 4.0894

Indian rupee 4.1947 4.9052

Thai baht 3.8040 4.6668

Malaysian ringgit 3.1463 3.1598

Indonesian rupiah 2.7554 2.4527

New Taiwan dollar 2.6874 2.7943

Hong Kong dollar 1.6188 1.0461

Papua New Guinea kina 1.3897 1.3340

Vietnamese dong 1.2197 1.2292

United Arab Emirates dirham 1.0614 1.1617

Swiss franc 1.0434 0.6820

Canadian dollar 0.9386 0.8213

South African rand 0.6818 0.7530

Swedish krona 0.6565 0.6885

Changes in exchange rate.

Price of $Aust Price of 1 $U.S.

 An increase in demand for AUD cause AUD to Appreciate

 A decease in demand for AUD cause AUD to Depreciate

 An increase in supply for AUD cause AUD to Depreciate

 A decease in supply for AUD cause AUD to Appreciate

Increase in DD for AUD Decrease in DD for AUD

Increase in SS of AUD Decrease in SS of AUD

Panel A: Australia Exporting to US Panel B: Australia Importing from US

Sends cheque in $US

Sells iron ore

$US Aust $Aust US

 Assume an Australian mining company is exporting iron ore to the US.

Essentially, the DD for a currency will be determined by: