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Determination of exchange rates

This tutorial was written by
Ken Edge
Head Teacher Social Science
Cardiff High School

Outcomes
Overview
Content
Review exercises
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Outcomes

HSC topic: Australia’s Place in the Global Economy is covered in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 34-36. The specific outcomes for this tutorial are:

H1 demonstrates understanding of economic terms, concepts and relationships
H2 analyses the economic role of individuals, firms, institutions and government
H3 explains the role of markets within the global economy
H4 analyses the impact of global markets on the Australian and global economies
H8 applies appropriate terminology, concepts and theories in contemporary and hypothetical economic contexts
H11 applies mathematical concepts in economic contexts.
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Overview

The Australian government adopted a flexible or floating exchange rate in December 1983. At the time the government believed that this was the best way to expose the economy to international competitive pressures, address the current account deficit problems and encourage exports.

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Content

Determining exchange rates

There are a number of methods that can be used to determine an exchange rate:

  1. A flexible or floating exchange rate is where the market forces of supply and demand determine the exchange rate.

  2. A fixed exchange rate is where the government determines the exchange rate for a period of time based on the value of another country’s currency such as the US dollar.

  3. A managed exchange rate is where the government intervenes in the market to influence the exchange rate or set the rate for short periods such as a day or week.

  1. Flexible (or floating) exchange rates

    Under a flexible or floating exchange rate the value of a country’s currency changes frequently, even by the minute. The market rate will depend on the demand for, and supply of, that currency in the forex markets. When there is no intervention in the free market operations by a government agency a “clean float” is said to exist.

    Figure 1

    A graph showing the determination of exchange rates under a floating exchange system

    The determination of the exchange rate under a floating exchange rate is shown in figure 1.

    The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who hold US dollars) are willing to purchase at each possible exchange rate.

    The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those people who hold Australian dollars) at each exchange rate.

    At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces will force the exchange rate down towards equilibrium.

    If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation exits and market forces will put upward pressure on the value of the Australian dollar.

    Remember that there are many different exchange rates. The following examples illustrate how an appreciation (increase in value) or depreciation (decrease in value) of the Australian dollar against the US dollar has been created by changes in demand and supply conditions.

    1. A currency appreciation

      Figure 2

      Two graphs showing an appreciation in the Australian dollar

      1. In Figure 2a there has been an increase in demand (DD to D1D1) for Australian dollars. This has led to an increase (appreciation) in value of the Australian dollar from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also increased from 0Q to 0Q1.

        The shift in the demand curve could have been caused by an increase in the demand for Australian exports, such as coal, aluminum, beef or lamb

      2. In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian dollars. This has led to an increase in the value (appreciation) of the Australian dollar from $US0.50 to $US0.60. However the quantity of Australian dollars traded has decreased from 0Q to 0Q1.

        This decrease in the supply of Australian dollars may have been caused by a recession, slowing the demand for imports.

    2. A currency depreciation

      Figure 3

      Two graphs showing a depreciation in the Australian dollar

      1. In Figure 3a there has been a decrease in demand (DD to D1D1) for Australian dollars. This has led to a depreciation in the value of the Australian dollar from $US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased from 0Q to 0Q1.

        The decrease in the price of Australian dollars in terms of US dollars could have been generated by a slow down in global economic activity, so decreasing the demand for Australian exports, or because of foreign investors lacking confidence in the Australian economy and investing elsewhere.

      2. Figure 3b indicates an increase in supply of Australian dollars with the supply curve moving from SS to S1S1. Again the value of the Australian dollar has decreased from $US0.50 to $US0.40 while the quantity of Australian dollars traded has increased from 0Q to 0Q1.

        The depreciation may have resulted from strong domestic economic growth increasing the demand for imports, or from higher overseas interest rates, causing a capital outflow from Australia.

  2. Fixed exchange rates

    The World Bank and the IMF were both established in 1944 at a conference of world leaders in Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woods institutions" as they are sometimes called, was to place the global economy on a sound footing after World War II. To help reduce the economic instability that existed the conference favoured the use of a fixed exchange rate system.

    Under a fixed exchange rate system the value of a country’s currency is fixed by the government or one of its agencies, for example the Reserve Bank of Australia (RBA) to another currency for a specific time period.

    This method of determining exchange rates was to dominate until the 1970s.

    In Australia the dollar was fixed (pegged) from 1946 to December 1971 to the British pound and then to the US dollar until September 1974.

    From September 1974 to November 1976 the Federal Government, in an attempt to reduce the impact of exchange rate fluctuations on the economy pegged the Australian dollar to the trade weighted index (TWI).

    Using this system the value of the Australian dollar was allowed to adjust against each currency in the TWI. However in reality the value of the Australian dollar remained fixed for long periods of time.

    Click here for more on the TWI

    Figure 4

    Graph showing a fixed exchange rate regime

    In Figure 4 the official exchange rate has been fixed at a level of $A1.00 = $US0.60, which is above the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed at a level higher than the market rate requires official intervention by the Reserve Bank of Australia.

    At this level the RBA would have to buy the excess supply of Australian dollars equivalent to Q1Q2 at a price of $US0.60. To buy the surplus of Australian dollars the government would need to sell its reserves of foreign currency.

    A fixed exchange rate system does not imply that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments and the government might take action to devalue the exchange rate.

    A devaluation of a currency occurs under a fixed exchange rate system when there is deliberate action taken by a government to decrease its value in the forex market.

    OR

    Alternatively a revaluation occurs under a fixed exchange rate system when there is deliberate action taken by the government to increase the value of the currency in the forex market.

  3. Managed exchange rates

    A managed exchange rate occurs when there is official intervention by a government or an agency such as the RBA to determination the value of a country’s exchange rate. Through such official interventions it is possible to manage both fixed and floating exchange rates.

    The Australia dollar was pegged to TWI from September 1974 to November 1976. Then in November 1976, the government adopted a “managed flexible peg” or a “crawling peg system”. Under this new method of determining exchange rates, the value of the Australian dollar was changed relative to the TWI, not just relative to a single individual currency

    The exchange rate was announced each morning by the RBA and remained at that rate until the next morning. This system continued until the Australian dollar was floated in December 1983.

    Under the floating exchange rate system the value of the Australian dollar is not specifically targeted by the RBA. To intervene in the market and alter the exchange rate significantly in the long run is beyond the financial ability of the RBA. This is because Australia’s level of foreign reserves (gold and foreign currencies) are relatively small (A$34 billion) compared to volumes of currency trade in the market each day.

    However the RBA may decide to enter the foreign exchange market as either a buyer or seller to stabilise any short-term fluctuation in the value of the Australian dollar. To limit a fall in the value of the Australian dollar (depreciation) the RBA will buy Australian dollars, and to prevent a rise in the value of the Australian dollar, the RBA will sell Australian dollars in the market.

    Such intervention by the RBA is known as a “dirty float”, or more correctly a “managed float”.

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Review exercises

Exercise 1

The following table indicates the value of one Australian dollar in terms of New Zealand dollars and Japanese yen over a two day period.

Currency
Day 1
Day 2

Japanese yen

69.0

65.0

New Zealand dollars

1.20

1.25

  1. What has happened to the value the Australian currency from day one to day two?

    Answer

  2. All other things being equal, how would a movement in the value of the Australian dollar from $A1.00 = $NZ1.20 to $A1.00 = $NZ1.25 affect Australian producers and consumers?

    Answer

Exercise 2

The following diagram shows a hypothetical forex market for Australian dollars.

The Federal Government for economic reasons has decided to intervene in the market and maintain the exchange rate at $A1.00 = US$0.55.

  1. What would be the value of the Australian dollar if there were no intervention in the market by the Reserve Bank?

    Answer



  2. What must the Reserve Bank do to maintain the value of the Australian at this rate?

    Answer



  3. Under what circumstances would the RBA intervene in the forex market?

    Answer

Exercise 3

Select the correct answer.

Questions Answers
i) There are a number of different foreign exchange markets to buy and sell currencies. True False
ii) Under a floating exchange rate system the value of the Australian dollar determined by the Reserve Bank. True False
iii) Under a fixed exchange rate system a revaluation would tend to increase the volume of imports. True False
iv) Under a flexible or floating exchange rate system the balance of payment is zero. True False
v) An appreciation of the Australian dollar increases the price of imports. True False
vi) A depreciation of the Australian dollar encourages overseas travel by Australians. True False
vii) Under a fixed exchange rate system a country needs to reduce international reserves to prevent a currency depreciation. True False
viii) Speculation of an appreciation in the value of the Australian dollar tends to increase the demand for the Australian currency. True False
ix) A depreciation of the Australian dollar makes exports dearer and imports cheaper. True False
x) Intervention by the RBA in the market to alter the exchange rate is known as a dirty float or a managed float. True False

Answers

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Extension activity

On January 1, 1999 the Euro was launched onto the world financial markets and is now the official currency of the twelve participating EU countries. These countries domestic currencies are now converted at a fixed rate into Euro dollars.

As a result the Euro is now likely to become the second most important reserve currency, after the United States dollar.

To find out more about the countries that use the Euro and the conversion rates, access the x-rates (external website) web site.

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