CHAPTER FIVE

SUMMARY –
EXCHANGE RATES
Tahni Valentine
HSC SYLLABUS EXTRACT:
EXCHANGE RATES
 The mechanism that allows people and firms
to ‘convert’ one currency to another
 Currencies are traded – or ‘bought and sold’
 Allowing people to buy goods from around
the world and invest in foreign countries
 The price of one currency in terms of
another currency
 Australian dollar worth 78 US cents – one
Australian dollar costs 78 US cents
FOREX MARKET
 Where currencies are bought and sold
 Rarely a physical market, technology &
cyberspace
MEASUREMENT OF EXCHANGE
RATES
Two methods:
 Measurement against another currency
 Not always accurate
 E.g. $A may rise against the $US, but lose value
against the Yen – making it difficult to tell whether
or not the overall value of the $A has fallen or risen
 TWI (Trade Weighted Index):
 Most accurate measure
 Measures the $A against a basket of 23 currencies of
Australia’s main trading partners
 Reflects changes in global economic conditions
DEMAND FOR $A
 The demand to convert other currencies into
Australian dollars
 Demand rises  exchange rate appreciates
 Demand falls  exchange rate depreciates
INCREASE IN DEMAND FOR $A
DECREASE IN DEMAND FOR $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
 Exports:
 Australian firms sell more exports 
exchange the earned foreign currency for $A
 increased demand for $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
 Investments (capital inflows):
 Foreign companies invest money into
Australia  foreign currency must be
exchanged for $A  increased demand for $A
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
 Reserve Bank:
 Reserve bank aims to raise price of $A  RBA
buys $A on FOREX  $A appreciates
FACTORS AFFECTING DEMAND
FOR AUSTRALIAN DOLLARS
 Speculation:
 Speculators expect $A to appreciate 
purchase more $A (hoping to make a profit
when selling them)  in itself causing a
higher demand for $A
SUPPLY FOR $A
 Australian dollars being converted into other
currencies
 Dollars are put on the market to be sold in
return for other currencies
 Supply rises  $A depreciates
 Supply falls  $A appreciates
INCREASE IN SUPPLY OF $A
DECREASE IN SUPPLY OF $A
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
 Imports:
 Australian’s buy more imports  exchange
$A for foreign currency  supply of $A
increases
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
 Investment (capital outflow):
 Australian’s invest more overseas (e.g.
purchase of shares)  $A exchanged for
foreign currency  supply of $A increases
FACTORS AFFECTING SUPPLY
FOR AUSTRALIAN DOLLARS
 Reserve Bank:
 Reserve bank aims to lower $A  RBA sells
$A on FOREX market  supply of $A
increases  depreciation of $A
CHANGES IN EXCHANGE RATES
 Appreciation:
 Increase in the relative value of a currency
 A rise in the price of one currency in terms of
another
 A rise in the exchange rate
 Occurs in a floating/flexible exchange rate system
 Depreciation:
 Decrease in the relative value of a currency
 A fall in the price of one currency in terms of
another
 A fall in the exchange rate
 Occurs in a floating/flexible exchange rate system
CHANGES IN EXCHANGE RATES
 Revaluation:
 An appreciation which occurs in a fixed
exchange rate system
 Devaluation:
 A depreciation which occurs in a fixed
exchange rate system
FIXED EXCHANGE RATE SYSTEM
 The value of the currency is set and
converted by the government or central bank
 Value is maintained by buying or selling
currencies
 Sometimes it is made illegal to trade
currency at any other price
 Usually pegged to the value of another
currency (e.g. 75% of the $US)  the
currency changes when the US currency
changes
FIXED EXCHANGE RATE SYSTEM
FIXED EXCHANGE RATE SYSTEM
 Forces of supply and demand do not play a
role in determining the exchange rate
 Supply and demand are counteracted by
either buying or selling foreign currency in
exchange for $A
 Previous slide: the government has bought
the excess supply of $A (Q1  Q2) at a price
of US 90c in order to lift the exchange rate
to US 90c from the naturally occurring US 80c
FLEXIBLE EXCHANGE RATE
SYSTEM
 Floating exchange rate
 Market forces of supply and demand determine
the value of the currency
 Australian dollar was floated in December 1983
 FOREX market operates like any other free
market
 Dirtying the float:- central bank (RBA)
participates in the FOREX market as either a
buyer or a seller to influence the exchange rate
 Clean float:- an exchange rate system with no
central intervention at all i.e. only the market
forces of supply and demand determine the
value of the currency
MANAGED EXCHANGE RATE
SYSTEM
 Exhibits elements of both a floating and
fixed exchange rate system
 Often a step towards floating the exchange
rate
 Value of currency changes because of market
forces but only within a certain range
 Central bank determines the upper and lower
limits of which the currency can fluctuate
 China’s Yuan is allowed to float either 0.5%
above or below a value determined by the
central bank
RESERVE BANK OF AUSTRALIA
 Holds foreign currency reserves
 May intervene in the FOREX market either
directly or indirectly
 Directly:
 To prevent a depreciation in currency the RBA
may exchange its foreign currency for $A thus
increasing demand for $A – causing an
appreciation of the $A
 To prevent an appreciation in currency the RBA
may sell $A and buy more foreign currency
which will increase supply for $A – thus causing a
depreciation of the $A
RESERVE BANK OF AUSTRALIA
 Indirectly:
 The RBA may intervene indirectly through the
use of monetary policy, specifically interest
rates
 To prevent a rapid depreciation in the $A the
RBA may set interest rates higher  this will
increase capital inflows since Australia will
become an attractive investment opportunity
due to higher interest rates  increasing
demand for $A (foreign investors must
exchange foreign currency for $A) – thus
causing an appreciation of the $A
FACTORS CAUSING AN
APPRECIATION OF $A
 Increase in Australian interest rates or
decrease in overseas interest rates
 Improved investment opportunities in
Australia or deterioration in foreign
investment opportunities
 A rise in commodity prices and an
improvement in Australia’s terms of trade
 Improvement in Australia's international
competitiveness
 Lower inflation in Australia
 Increased demand for Australia’s exports
 Speculation of a currency appreciation
FACTORS CAUSING A
DEPRECIATION OF $A
 Decrease in Australian interest rates/increase in
overseas interest rates
 Deterioration in investment opportunities in
Australia/improvement in foreign investment
opportunities
 Fall in commodity prices & deterioration in
Australia’s terms of trade
 Deterioration in Australia’s international
competitiveness
 Higher inflation in Australia
 Increased demand for imports
 Speculation of a currency depreciation
POSITIVE EFFECTS OF AN
APPRECIATION
 Increased purchasing power for Australian
consumers
 Decrease in interest servicing cost on
Australia’s foreign debt – Australians can buy
more foreign currency with $A  reducing
outflow on the net income component of the
current account reducing the CAD
 Reduction in the $A value of foreign debt
 Imports become cheaper – reduced inflationary
pressures  reducing pressure on the RBA to
raise interest rates to defend its inflation
target
NEGATIVE EFFECTS OF AN
APPRECIATION
 Australian exports  more expensive on world markets,
difficult to sell  decrease in export income 
deterioration in Australia’s CAD in medium term
 Imports less expensive  encouraging import spending 
worsening Australia’s CAD
 Higher import spending & reduced export revenue 
reduce Australia’s economic growth rate
 More expensive for foreign investors  lower capital
inflows (if foreign investors expect currency to continue
rising financial inflows may continue)
 Reduces $A value of foreign income earned on Australia’s
investments causing a deterioration in the net income
component of the CAD
 Value of foreign assets reduced in $A terms
POSITIVE EFFECTS OF A
DEPRECIATION
 Australian exports cheaper on world markets, easier
to sell – increase in export income – improvement in
Australia’s CAD
 Imports more expensive – discouraging import
spending potentially improving Australia’s CAD
 Lower import spending – increased export revenue
increasing Australia’s growth rate
 Increase in $A value of foreign income earned on
Australia’s investments abroad  causing an
improvement in the net income component of the
CAD
 Increase in value of foreign assets in $A terms
 Greater capital inflows – foreign investors find it
cheaper to invest in Australia
NEGATIVE EFFECTS OF A
DEPRECIATION
 Reduced purchasing power for Australian
consumers
 Australia can buy less foreign currency with
its domestic currency – increased interest
servicing cost on Australia’s foreign debt
 Higher $A level of foreign debt which has
been borrowed in foreign currency as
expressed in $A terms
 Imports more expensive – increased
inflationary pressures in Australia  may
increase pressure on the RBA to raise interest
rates to defend its inflation target