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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
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.
H10 communicates economic information, ideas and issues in appropriate forms.

 

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Being up to date and aware of contemporary issues

The exchange rates in this tutorial were updated in early 2010 and this should be kept in mind as you read it. Students of Economics need to be aware of what is happening in the Australian Economy today and should, for instance, know about recent changes in the value of the Australian dollar.

After completing this tutorial you may wish to do some research on the current situation for the Australian dollar by scrolling down to the section 'MORE' at the bottom of this page and visiting the websites such as that of the Reserve Bank of Australia.

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Overview

In topic one, The Global Economy (external website), you will have gained an understanding of global financial markets.

For a country to be involved in international trade, finance and investment it is necessary to have access to the currencies of other countries. For example, an Australian company purchasing electrical equipment from Japan needs to exchange its Australian dollars for Japanese yen.

Similarly, if an Italian clothing manufacturer purchases wool to produce suits from an Australian farmer, it needs to exchange its Euros for Australian dollars.

The sale and purchase of foreign currencies takes place in the foreign exchange, or forex, markets. This market allows for the movement of large volumes of funds (about three trillion US dollars per year) for investment purposes around the world. The US dollar, the Japanese Yen and the European Euro are significant currencies in the world’s financial markets.

In the foreign exchange market, supply and demand determines the exchange rate for each currency traded. As a result there is no single exchange rate, there are many different rates.

  1. What is an Exchange Rate?

    A nominal or relative exchange rate is simply the price at which one currency exchanges for another currency. For example, as at 29 January 2010 one Australian dollar was worth 89 cents in United States currency or $A1.00 = $US0.89 (indirect quote). This equation can also be written in reverse, as $A1.12 = $US1.00 (direct quote).

    Table 1 Relative exchange rates for the Australian Dollar and the TWI

    Year ending June $US Japanese yen British pound sterling Trade weighted index (TWI)

    1991-1992

    1992-1993

    1993-1994

    1994-1995

    1996-1997

    1997-1998

    1998-1999

    1999-2000

    2000-2001

    2002-2003

    2003-2004

    2004-2005

    2005-2006

    2006-2007

    2007-2008

    0.75

    0.67

    0.73

    0.71

    0.75

    0.61

    0.66

    0.60

    0.51

    0.66

    0.68

    0.75

    0/74

    0.78

    0.89

    94.0

    71.5

    72.2

    60.1

    85.2

    86.2

    79.7

    63.2

    62.9

    79.99

    74.82

    80.45

    85.90

    93.21

    99.88

    0.39

    0.45

    0.47

    0.45

    0.45

    0.37

    0.42

    0.39

    0.36

     

     

     

     

     

     

    55.2

    49.5

    53.0

    48.4

    56.7

    57.9

    58.4

    53.3

    49.7

    59.4

    59.1

    62.7

    63.3

    64.8

    70.00

    Source: RBA Statistical Bulletin series F.

    Table 1 shows the changes in the relative exchange rates since 1991/2 of Australia’s major trading partners and the TWI which measures the value of the Australian dollar against the value of the currencies of 23 of Australia’s trading partners.

    The value of the Australian dollar has been fluctuating in value since it was floated in December 1983. For example, between December 1993 and December 1994, the Australian dollar appreciated (increased in value) by 13.4 percent against the US dollar, and between December 1996 and September 1998 it depreciated (decreased in value) by some 24.7 percent.

    Between 2000 and 2008 the trend in the Australian dollar was appreciation against the value of its main trading partners. In June 2008 the AUD reached as high as $US0.9626 and was even predicted to reach parity by the end of the year (prior to the impact of the GFC). There are a number of reasons for this. During this time the United States dollar gradually depreciated, and this is a significant factor which pushes the value of the Australian dollar up. Also due to the commodity boom Australia received increased prices for its exports of raw materials. This was a result of the resources boom and rising demand for raw materials from the growing Chinese economy in particular. Further, Australia had much higher interest rates than its trading partners, which encouraged foreigners to bring funds to Australia and invest in Australia, and increase the demand for Australian dollars. The Australian dollar is the sixth most traded currency in the world and is used by international investors and currency traders as a proxy for commodity prices and world growth. What this means is that if raw material prices rise internationally, currency traders and investors purchase Australian dollars.

    The value of the Australian dollar depreciated against most currencies in the first few months of 2009, declining to $US0.6873, but then rose sharply in the second half of the year, rising 30% against the US dollar by the end of the year, reaching $US0.8969 in December 2009. On 4 February 2010 the AUD was valued at $US0.8805.

    Any changes in exchange rates are important because of the effect they have on the prices we pay for imports, the prices we receive for our exports and the amount of money flowing into and out of the economy.

    For example, if the value of the Australian dollar appreciates (increases in value) exports become dearer and overseas customers have to find more Australian dollars to buy the same volume of exports. On the other hand, imported goods become cheaper for Australian consumers and producers. Decreasing import prices can decrease production costs and inflation rates in any domestic economy. Non-resource Australian exports became less competitive in global markets because of the appreciation of the Australian dollar in recent years. Currently, overseas buyers of Australian products have to find more Australian dollars to buy the same volume of exports.

    Conversely, if the Australian dollar depreciates (decreases in value), Australian exports become cheaper and imports dearer. This helps to improve our international competitiveness and has an expansionary effect on the economy. Rising import prices, however, can lead to inflation and also increase the costs to businesses of imported inputs.

    Changes in exchange rates are also important in terms of the reasons underlying the changes. The recent appreciations of the Australian dollar, for example, reflect strong global demand for Australian raw materials exports and improving terms of trade which can have positive effects on the balance of payments and economic growth.

  2. The trade weighted index

    The trade weighted index (TWI) measures the Australian dollar against a basket of 23 currencies of Australia's main trading partners.

    The TWI is then 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.

    The TWI also reflects changes in global economic conditions. There is usually a decline in the TWI when our major trading partners experience a downturn in economic activity. This is because growth in the global economy slows and the demand for imports and exports decreases.

    Table 2 Trade Weights of major partners

    TRADE-WEIGHTED INDEX

    The latest weights for the trade-weighted index (TWI) of the Australian dollar are reported in the table below. These weights, which reflect the composition of Australia’s two-way merchandise trade in 2007/08, apply from 1 October 2008. These currencies account for 93.2 per cent of Australia’s two-way merchandise trade.

    Weights in the Trade-Weighted Index
    (per cent)
    Currency Trade Weight
    2008/09 2007/08
    Chinese renminbi 16.3672 15.4486
    Japanese yen 15.4040 15.4860
    European euro 11.6517 12.1703
    United States dollar 9.8797 10.7432
    South Korean won 5.7786 5.9057
    Singapore dollar 5.2102 4.5637
    United Kingdom pound sterling 4.7535 4.1943
    New Zealand dollar 4.6565 4.6553
    Thai baht 3.8019 3.5465
    Malaysian ringgit 3.2705 2.9989
    Indian rupee 3.0844 3.5320
    New Taiwan dollar 2.9903 3.2771
    Indonesian rupiah 2.4053 2.7489
    Vietnamese dong 1.9640 1.9032
    United Arab Emirates dirham 1.5930 1.2801
    Papua New Guinea kina 1.2341 1.1564
    Hong Kong dollar 1.1934 1.3785
    South African rand 1.1040 1.1496
    Canadian dollar 1.0786 1.1892
    Saudi Arabian riyal 0.8916 0.9166
    Swiss franc 0.8685 0.9401
    Swedish krona 0.8190 0.8158


    The weight of the Chinese renminbi is now the highest in the index, having increased by 1 percentage point from last year and by 10 percentage points since 2000/01. The Japanese yen, which had received the highest weight since 1983/84, is now ranked second, though its weight is broadly unchanged from last year. The weight on the euro fell by = a percentage point and the weight on the US dollar fell by ½ of a percentage point from last year.

    The weight of the Chinese renminbi is now the highest in the index, having increased by 1 percentage point from the previous year and by 10 percentage points since 2000/01. The Japanese yen, which had received the highest weight since 1983/84, is now ranked second. The weight on the euro fell by ½ a percentage point and the weight on the US dollar fell by ¾ of a percentage point from the previous year.

    Source: Reserve Bank of Australia

  3. Factors affecting the demand for Australian dollars
    1. The demand for Australian exports

      When Australian goods and services are bought by overseas consumers, they need to convert their currency into Australian dollars to pay the exporters. Therefore, any increase in the demand for Australian exports, should increase the value of the Australian dollar.

      There are a number of factors that can influence the demand for exports:

      Tastes and preferences of overseas consumers for Australian exports

      A good example is the Australian tourism industry. During the 1990s a large growth in tourism meant an increase in the demand for Australian dollars. However, the events in the United States on 11 September 2001 reduced the number of tourists coming to Australia, and consequently, the demand for Australian dollars.

      Changes in world economic conditions

      Changes in the international business cycle can also affect the demand for Australian exports. The high levels of world economic growth during 2000 increased the demand for goods and services and the demand for Australian dollars. However the economic recession in 2001–2002 had the opposite effect on our major trading partners with the Australian dollar reaching lows of $US0.48 in March 2001, and $US0.49 in September 2001. The resources boom of 2007-2008 had a big impact on the value of the Australian dollar which gradually appreciated over this time as Australia sold more and more raw materials to major manufacturing nations such as China and Japan.

      International competitiveness

      To be competitive in the global market, Australia’s goods and services must be as cheap as its international competitors. If Australia’s inflation rates and costs are higher than its overseas competitors, our goods will be more expensive. High Australian inflation rates help cause a loss of export markets, reduce demand for Australian dollars, and force a depreciation of the Australian dollar.

      On the other hand, lower rates of inflation typically increase the demand for Australian exports, and appreciate the value of the Australian dollar.

    2. Capital inflow

      Foreign investors wishing to invest in Australia must exchange their own currency for Australian dollars. A number of factors may influence their investment decisions. For example, if Australian interest rates are relatively higher compared with overseas interest rates this will increase capital inflow and the demand for Australian dollars.

      The expectation of higher levels of domestic economic growth will also influence the size of the capital inflow and increase the demand for Australian dollars, causing a currency appreciation. On the other hand, a decline in the level of capital inflow may cause a fall in the demand for Australian dollars, resulting in a currency depreciation.

    3. Speculation

      Speculation occurs when currencies are bought and sold by foreign investors for the purpose of making a profit. If foreign investors expect the value of the Australian dollar to increase in the future, they may sell other currencies and buy Australian dollars. This would increase the demand for Australian dollars and put upward pressure on the exchange rate. Interestingly, around 98% of all global forex transactions are for speculative purposes only.

  4. Factors affecting the supply of Australian dollars

    Demand for imports

    Just as foreigners must pay for our exports with Australian dollars, we must pay overseas producers foreign currency for imported goods. If the Australian demand for imported goods and services increases, so does the supply of Australian dollars. The increase in supply of Australian dollars puts downward pressure on the value of the Australian dollar.

    The level of financial flows out of Australia

    An increase in capital outflow can occur as a result of higher interest repayments on overseas loans (net income transfers) or increased demand for foreign assets, such as shares and real estate by domestic Australians.

    This means that investors need to sell Australian dollars (increasing supply) in the forex markets to obtain other countries’ currencies. The increase in the supply of Australian dollars could cause a decrease (depreciation) in the value of the Australian dollar. The level of domestic interest rates and investor confidence in the Australian economy can also influence supply of Australian dollars.

    Inflation rates

    If there were high rates of inflation in Australia imported goods and services would be cheaper relative to domestically produced products. As consumers subsequently purchase increasing amounts of imported goods and services, the supply of Australian dollars in the forex market would increase, causing a decrease or depreciation in the value of the Australian dollar.

    Speculation

    If speculators lose confidence in the economy and feel that future values of the Australian dollar will be lower than present levels, a depreciation of the exchange rate can occur. This is because when speculators sell Australian currency to avoid future losses, the supply of dollars increases, putting downward pressure on the exchange rate.

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Review Exercises

Review exercise 1

Click to select the correct answers for the true/false questions.

Questions Answers
i) The forex market is used for the exchange of currencies to pay for exports and imports. True False
ii) Different foreign exchange markets exist around the world. True False
iii) More tourists coming to Australia will create an increase in supply of Australian dollars. True False
iv) The trade weighted index measures the Australian dollar against Australia’s main trading partners. True False
v) High domestic inflation rates will make imports cheaper and increase the demand for Australian dollars. True False
vi) If speculators lose confidence in the economy a depreciation in the value of the Australian dollar will occur. True False
vii) Lower rates of inflation increases the demand for Australian exports resulting in an appreciation of the Australian dollar. True False
viii) When business confidence in the Australian economy deteriorates capital outflow decreases. True False
ix) Speculation is the buying and selling of foreign currencies to make a profit. True False
x) The Australian dollar was floated in December 1993. True False

Answers

Review exercise 2

Explain following terms.

  1. Nominal exchange rate

    Answer

  2. International competitiveness

    Answer

  3. Trade weighted Index

    Answer

  4. “Real” exchange rate

    Answer

Review exercise 3

You are employed as a consultant for an international investment company. A new customer has asked you to explain how the following situations would affect the value of the Australian dollar.

  1. An international investor in New York has read some current information on an improvement in Australia’s terms of trade.

    Answer

  2. A recent World Bank report expects a rise in world economic growth during the next twelve months.

    Answer

  3. Current economic indicators point to a rise in the inflation rate in the Australian economy.

    Answer

  4. A newspaper report suggests a rise in the Australia’s interest rates relative to other countries.

    Answer

  5. News headline, “An improvement in Australia’s net foreign liabilities and current account deficit.”

    Answer

Extension Activity

Find out the current exchange rates for the $US, YEN, EURO and the TWI by accessing the Reserve Bank of Australia Daily Statistical Releases (external website) or at http://www.x-rates.com/ (external website)

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More

The Reserve Bank of Australia (external website) has a large number of articles located in Media Releases.

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