The Demand-Supply Framework of Foreign Exchange Market
Question:
Discuss about the Exchange Rates and Monetary Policy Uncertainty.
Exchange rate can be characterized as the price of the domestic currency or the currency of a nation stated in terms of the currency of a foreign country. In other words exchange rate can be held responsible for comparing a currency with the other in terms of their values. There different types of exchange rate regime such as the fixed, floating and pegged exchange rates and due to this it becomes difficult to determine the actual rate of exchange (Ferraro et al., 2015). Although, it can be stated that demand supply mechanism can be used to for the purpose of determining the exchange rate in the given scenario as this is identified as an efficient tool by many of the researchers. The aforementioned framework sometimes help to forecast the exchange rate expected to prevail in the next period as well. On an added notion it traces out different factors which in turn can affect and play a crucial role in determining the actual exchange rate (Engel et al., 2015). This specific report will focus on the Australian economy and how the value of AUD is obtained in the market of foreign exchange with the help of demand supply framework will be shown in the next few paragraphs management.
The figure above depicts the demand and supply framework of the foreign exchange market. Through this demand supply framework the exchange rate of a country can be determined. The export demand of a country determines the demand for currency and on the other hand, the supply is dependent over the demand for the importable in the domestic country (Engel, 2014). The demand curve is projected on the basis of the derived demand while the supply curve is projected on the basis of the overall aggregate demand for the importable. Now it can be observed that equilibrium is achieved where demand equals supply and at this point E the exchange rate is 80 C USD for a unit Australian Dollar. At this point the supply of the currency which is determined by the demand for importable in the domestic market is found to be represented by point Q. Now let us suppose that there is an increase in the demand for AUD and it moves from Q to Q1, the demand curve shifts upwards to the right to D1 as a result there is a increase in the rate of exchange for every unit of AUD in comparison to the initial equilibrium condition. On the other hand, when there is a fall in the quantity demanded the demand curve shift downwards to the left and a result of which the exchange rate further depreciates for each unit of the AUD.
As per the analysis it can be stated that exchange rate in a floating exchange rate regime is strictly determined by the interaction of demand and supply of currency and there are various factors which contributes to the fluctuations in this demand and supply factors (Cenedese et al., 2015). In brief these factors can be summarized as follows,
- Rate of inflation: An increase in the rate of inflation will lead to a depreciation in the AUD which will in turn shift the demand curve towards the left.
- Growth rate: If the demand for the export of goods and services produced in Australia increase due to an increased growth rate the exchange rate will be appreciated and shift the demand curve to the right (McCombie and Thirlwall, 2016).
- Plans implemented by government: Implementing a policy that supports promotion of exports and substitution of exports will help in appreciating the exchange rate of the country.
The exchange rate can be divided into two categories nominal exchange rate and real exchange rate. The nominal exchange rate can be defined as the units or amount of domestic currency needed for purchasing a single unit of the foreign currency (Jotikasthira et al., 2015). A fall in this variable is generally termed as the nominal appreciation of the currency and an increase on the other hand is termed as the nominal depreciation of the currency. On the contrary, the real exchange rate can be defined as the ratio of price level abroad to the price level prevailing in the domestic country.
Factors Contributing to the Fluctuations in Exchange Rate
The trade weighted index is generally used to estimate the effective value of the exchange rate of a country against a number of currencies. The significance of the other currencies used in this regard is reliant on the percentage of trade performed with those countries (Cavusgil et al., 2014). Generally the trade weighted index is calculated management
As depicted by the figure above the nominal exchange rate of has depicted rigorous fluctuations since the past three years. From the figure it is quite evident that a major fluctuation took place in the year 2015, because during the month of March, 2015 the Australian nominal exchange rate reached its peak point while during the month of September of the same year it reached rock bottom. The underlying reason behind this is the drastic fall in the demand for Australian goods and services. However, during 2017 it again started rising rapidly but suddenly fell down during the month of October. Presently an Australian Dollar can buy USD worth nearly .80.
From the TWI data also it is quite evident that it has depicted a fluctuating trend since the past few years. During the considered timeframe the TWI reached its lowest value during the month of October 2015 which resulted in a recession in the market of US while the highest TWI was achieved during 2017. On the basis of the magnitude of trade between Australia and US the TWI fluctuated, although the upward rising trend graph depicts increasing pattern of trade.
The key reason behind the fluctuating nature of the AUD. Along with this the market in United States has become saturated which resulted in a recession during 2015 due to which the demand for Australian goods and services declined drastically (Weale et al., 2015). However, in 2017, during the month of October the demand for Australian goods and services increased significantly which in turn increased the demand for the UAD.
As per the report provided it can easily be observed that there are numerous reasons behind the recent fluctuations in the AUD in contrast with the USD. The report traces out the fact that the key reason behind this fluctuation in the Australian exchange rate to USD is the rising price of the commodities like iron ore along with the slumps in USD (Neely, 2015). This as a result aggravated the exports of Australia increased the demand for Australian demand and in turn contributed towards the appreciation of the AUD in comparison to the USD. Along with this the report also stated the fact that the growth of AUD is not sustainable because of a constant rate of inflation and rising wages which is contributing towards the domestic economic growth of the country. On an added notion, the report also points out the fact that reducing the price of iron ore, reduction in the growth rate of Chinese economy coupled with the ever increasing interest gap between Australia and United States will again result in an exchange rate depreciation in Australia.
It can be observed from the figure above that the initial equilibrium point was at E. After the increase in the level of export of the iron ore and US exchange rate slump the demand for AUD increased and as a result the Australian exchange rate appreciated and the equilibrium shifted to E1. Furthermore, it can be expected that if interest rate gap between Australia and US increases further the Australian exchange rate will depreciate and the equilibrium will be shifted to a new point E2.
Nominal Exchange Rate Fluctuations Over Time
The depreciation of the AUD will in turn make the imports more expensive which as a result will reduce the demand for imports. This is because a rise in the cost of imports will increase the cost of production. As a result firms will increase the price of its product. With an increased price the demand for the product will also reduce (Mueller et al., 2017). This process will continue until and unless the equilibrium is achieved through the interaction of supply and demand. Along with this a low value of the AUD compared to the USD will increase the cost of imports or reduce the demand for electrical machinery. On the other side of the spectrum the demand for exports will rise as the price of the exportable will fall. This in turn will improve the Balance of Payments of the country and thereby encourage economic growth.
As per the situation stated in the assignment it can easily be stated that the Government of Australia has various instruments through which it can manipulate the exchange rate to avail appreciation. Australia is highly endowed with minerals where this sector contributes up to 6.9% of the total GDP of the country (Julio and Yook, 2016). As the demand for Australian iron ore decreased worldwide since the past few years the Australian exchange rate has been affected adversely. In such a situation it can be recommended that the government should focus on designing and implementing some special export promotion plans which will especially focus on the United States economy. This will be able to increase the demand for Australian mining commodities and thereby increase the demand for AUD in the foreign countries. Hence it would be able to appreciate the AUD in comparison to the USD. Furthermore, the article has also mentioned the fact that there is an ever widening gap between the interest rates of the United States and Australia just because if the current sharp increase in the Fed rate. If this gap keeps on widening with the passage of time the foreign investors will start withdrawing their investments from the Australian economy and start endowing those investments in the US economy (Manalo et al., 2015). It will again result in a depreciation of the Australian exchange rate and appreciation of USD. Hence, it can be suggested that the Reserve Bank of Australia should implement some remedial measures to cope with the situation. The stagnancy in the inflation rate coupled with the increasing wage rate the Australian economy is slowing down gradually. In order to cope with such a condition the Reserve Bank of Australia should raise the rate of interest and take some expansionary fiscal policy in order to accumulate money within the economy (Baker et al., 2016). This is expected to provide the economy with the much needed boost for overcoming the stagflation. Then the government could be able to opt for import substitution and impose quota so as to control the export deficits.
These plans are efficient enough in increasing the demand for AUD and reestablishing the exchange rate at 80C USD for 1 AUD but it possesses some drawbacks. For instance export promotion will lead to an appreciation in the AUD and there will be an increase in the demand for importable. As the demand for importable increase net export will tend to go down and the economy will remain at the same situation.
Taking into account the benefits and drawbacks of the policy it can be stated the Australian government could be able to reestablish the exchange rate at 80c from 72c if the aforementioned plans are improvised effectively. However, if the government maintains appropriate balance between the interest rate and market liquidity it would be able to minimize the side effects. The infrastructural enhancement can also be promoted on the part of the government which will assist in enhancing the exchange rate (Neely, 2015).
Reference List
Baker, S.R., Bloom, N. and Davis, S.J., 2016. Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), pp.1593-1636.
Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.
Cenedese, G., Payne, R., Sarno, L. and Valente, G., 2015. What do stock markets tell us about exchange rates?. Review of Finance, 20(3), pp.1045-1080.
Engel, C., 2014. Exchange rates and interest parity. In Handbook of international economics (Vol. 4, pp. 453-522). Elsevier.
Engel, C., Mark, N.C. and West, K.D., 2015. Factor model forecasts of exchange rates. Econometric Reviews, 34(1-2), pp.32-55.
Ferraro, D., Rogoff, K. and Rossi, B., 2015. Can oil prices forecast exchange rates? An empirical analysis of the relationship between commodity prices and exchange rates. Journal of International Money and Finance, 54, pp.116-141.
Jotikasthira, C., Le, A. and Lundblad, C., 2015. Why do term structures in different currencies co-move?. Journal of Financial Economics, 115(1), pp.58-83.
Julio, B. and Yook, Y., 2016. Policy uncertainty, irreversibility, and cross-border flows of capital. Journal of International Economics, 103, pp.13-26.
Manalo, J., Perera, D. and Rees, D.M., 2015. Exchange rate movements and the Australian economy. Economic Modelling, 47, pp.53-62.
McCombie, J. and Thirlwall, A.P., 2016. Economic growth and the balance-of-payments constraint. Springer.
Mueller, P., TAHBAZ?SALEHI, A.L.I.R.E.Z.A. and Vedolin, A., 2017. Exchange rates and monetary policy uncertainty. The Journal of Finance, 72(3), pp.1213-1252.
Neely, C.J., 2015. Unconventional monetary policy had large international effects. Journal of Banking & Finance, 52, pp.101-111.
Reserve Bank of Australia. 2018. Historical Data | RBA. [Online] Available at: https://www.rba.gov.au/statistics/historical-data.html#exchange-rates [Accessed 20 Mar. 2018].
Weale, M., Blake, A., Christodoulakis, N., Meade, J.E. and Vines, D., 2015. Macroeconomic policy: inflation, wealth and the exchange rate (Vol. 8). Routledge.
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