Recognition must be giving to Prof. Werner Antweiler, University of British
Columbia, Vancouver BC, Canada for granting the permission to reproduce the
graph image of exchange rate fluctuation, on the basis of which I have made
my assignment. I would also like to thank my Lecturer and Subject
Coordinator Assoc. Prof. Ann Hodgkinson for her guidance and useful tips
which have helped me in completion of this task.
This assignment defines the exchange rate and then introduces two different
ways by which the price of a currency can be determined (fixed or floating
exchange rates). Finally discusses and analyses some of the most important
factors which have caused changes in exchange rate of Australian Dollars
during the last five years and give conclusion on the basis of analysis.
An exchange rate is the rate at which one currency can be exchanged for
another. In other words, it is the value of another country’s currency
compared to that of your own. If you are traveling to another country, you
need to “buy” the local currency. Just like the price of any asset, the
exchange rate is the price at which you can buy that currency.
There are two ways the price of a currency can be determined against
another. A fixed, or pegged, rate is a rate the government (central bank)
sets and maintains the official exchange rate. A set price will be
determined against a major world currency (usually the U.S. dollar, but
also other major currencies such as the euro or yen. In order to maintain
the local exchange rate, the central bank buys and sells its own currency
on the foreign exchange market in return for the currency to which it is
Unlike the fixed rate, a floating exchange rate is determined by the
private market through supply and demand. Generally countries which have
mature stable economy market adopts floating exchange rate. A floating rate
is often termed “self-correcting,” as any differences in supply and demand
will automatically be corrected in the market. For example, if demand for
a currency is low, its value will decrease, thus making imported goods more
expensive and stimulating demand for local goods and services. This in turn
will generate more jobs, and hence self-correction would occur in the
market. A floating exchange rate is constantly changing. The Australian
government floated Australian dollar in December 1983.
FACTORS DETERMINING THE FLOATING EXCHANGE RATES
Relative Price Levels
Also known as the “Law of One Price,” which states that if two countries
produce an identical good, the price of the good should be the same
throughout the world no matter which country produced it. The application
of this law into real life is often referred to as Purchasing Power Parity
(PPP). PPP theory states that exchange rates between any two currencies
will adjust to reflect changes in the price levels in both countries.
Therefore, when the prices of country X’s goods rise (holding prices of
foreign goods constant), the demand for country X’s goods falls until its
currency depreciates so that it can still sell abroad. Thus, over the long
run, a rise in a country’s price level (relative to foreign price levels)
causes its currency to depreciate, and vice versa.
Tariffs and Quotas or Government Policies
First we must define these two terms before examining their impact on
. Tariffs: Refers to the taxes levied by a country on the goods it
. Quotas: Refers to the physical restrictions levied by one country on
the quantity of specific foreign goods that can be imported.
Imposing these taxes and restrictions (trade barriers) on foreign goods
creates an increase in demand for domestic products. The result of which
will be an increase in the comparative value of that country’s currency.
That is because barriers rid foreign products of their competitive ability
in terms of price. Thus demand on domestic products flourishes. Accordingly
buyers will demand less of the foreign currencies and more of the local
currency, causing the above mentioned price increase in the local currency.
Tariffs and quotas have a positive long run effect on a country’s currency.
Under the floating system Australian government through RBA (Reserve Bank
of Australia) can interfere directly (by buying or selling foreign
exchange), indirectly (by changing the level of interest rate) or by
adaptation of macro-economic mix policies to increase or decrease the rate
of economic growth in Australia in relation to rest of the world.
Consumer Preferences of Domestic Vs Foreign Goods
This factor revolves around the mechanism of supply and demand. Basically
if country X begins to demand more of the goods of country Y, i.e. increase
its imports from country Y, then the value of country Y’s currency will
rise. It happens simply because when country X imports from country Y, it
has to purchase country Y’s currency to conclude the transaction.
Therefore, an increase in imports will result in an increase in demand for
country Y’s currency, which in turn will result in an increase in price of
country Y’s currency. Therefore it can be concluded that increased demand
for a country’s exports causes its currency’s comparative value to increase
over the long run. Likewise, increased demand for imports causes the
domestic currency to depreciate.
By definition, productivity refers to the ability of the factors of
production to produce goods and services with a minimal consumption of
resources. Thus an increase in productivity refers to a more efficient use
of resources, thus indicating a cheaper production process. If we apply
this mechanism on a larger scale, such as that of countries, it would be
possible to identify the effect of productivity levels on exchange rates.
Increasing productivity leads to a decrease in production costs and thus
prices. This comparative advantage will result in both a local and foreign
increase in demand for the goods of, let’s say, country X for example. This
will lead to an increase in demand for country X’s currency causing its
value to rise in comparison to other currencies.
Interest Rates on Exchange Rates
Now a days there is a high level of capital mobility that is, foreigners
can easily purchase local assets, such as Australian dollar deposits, and
locals can easily purchase foreign assets such as U.S. Dollar or French
Franc deposits etc. Since foreign and local bank deposits have similar risk
and liquidity, and there are few obstacles in front of capital mobility, it
is reasonable to assume that both local and foreign deposits are equal
substitutes, and thus should be equally desirable. When this situation
occurs, if the expected return on Australian dollar (i.e. interest rates)
is above that on foreign deposits, both foreigners and Australians will
want to hold only Australian dollar deposits and will be unwilling to hold
foreign deposits. Thus interest rates are the value of a currency, and the
currency with the highest expected return value i.e. interest rate, will
experience an increase in its relative value, or exchange rate, in
comparison to other currencies, once again the opposite is also true.
But interest rates exhibit only a short-term effect on exchange rates i.e.
on a daily basis or even shorter, that is due to the multitude and
frequency of the daily transactions carried out in the capital market. For
example, foreign exchange transactions in the US each year are well over 25
times the amount of US exports and imports all together.
Now that important factors affecting exchange rates have been discussed,
fluctuation in Australian Dollar in last five years can be reviewed with
the help of a chart (see appendix).
By late 1998 the world economy became very uncertain but 1999 was period of
relative calm. For Australia it was a good year although Australian economy
was caught up in some of the early instability in world financial market.
The Australian performance over the two years since the Asian crises began,
has attracted international attention and improved its understanding in
international market. Domestically, year 2000 was a successful year for the
Australian economy with strong growth rate and falling unemployment
although inflation was higher then it had been for several years. Apart
from overseeing the smooth transition in to new century (due to Y2K
problem), the period was quite uneventful. The Australian economy entered
the new century while growing strongly, as it had done for most of the
1990’s. It showed similarity to rest of the world with one difference that
was the transition effect of introduction of GST which caused an
exceptionally sharp temporary contraction in house building in the second
half of 2000. This in turn resulted in the small fall in GDP in the same
period before moderate growth resumed in first half of 2001. The major
development in 2000/01 was the designation of the three credit card schemes
operation in Australia so that the payment system board could determine the
regulation applied by the schemes. The world economy experienced very
sluggish growth in 2001/02 with the two biggest economies, the United
States and Japan. The event of September 11th added additional element of
uncertainty and it seemed that condition might worsen in 2002. In the
event, slow and uncertain recovery occurred despite further economic shocks
in the form of sovereign debt crises and the revelation of serious
deficiencies in corporate governance in the United States.
RBA eased monetary policy three times in the second half of 2001 that was
once before September 11th and one after it. On all three occasions, the
easing was motivated by a desire to preempt the effects on Australia of a
probable downturn for the world economy was unlikely, monetary policy was
tightened again in the first half of 2002.
In the first half of 2003, the world economy received further disruption
from the short lived Iraq war and fear that the outbreak of Sever Acute
Respiratory Syndrome would turn in to a major epidemic. Australian economy
performed well throughout the year but there was a clear difference in tone
between the beginning and end of year. By the end of the year with further
fall in world interest rates and talk of further deflation abroad, both of
which were leading to a rising Australian dollar. There were no changes in
official interest rates in 2002/03 in Australia.
After a thorough analysis of exchange rates fluctuation of Australian
Dollar in past five years, it can be concluded that there are several
factors which have caused these change. But the most important factor is
government policies which are implemented by government through RBA in
order to support the economy and keep the right balance in inflows and
outflows in both domestic and international markets.
Jackson, John and McIver, Ron (2004), Microeconomics, 7th edition, McGraw-