Demand and supply forces in forex market
Question:
Discuss about the Currency Depreciation and Emerging Market.
The forces of demand and supply of currency determine the price of Australian dollar as against other currencies. DD curve shows the demand curve and SS curve shows the supply curve. The equilibrium exchange rate is determined from intersection of the demand and supply curve (Weale et al. 2015). The equilibrium point is E and the corresponding exchange rate is P.
The demand supply condition in the forex market are related with macroeconomic status of the nation and hence causes fluctuation in the exchange rate. These factors are as follows
Trade surplus defined as the excess of export over import increases the demand for Australian dollar. This is because buyers in the overseas market demand Australian dollar to purchase the export goods more. The increased demand pulls the exchange rate up. This reflects a relatively weakening of currency. Opposite is the situation during a trade deficit. That is when import exceeds export then there will be excess supply of Australian dollar (Sarno 2016). The importers ill then required to supply Australian dollar in exchange of the needed foreign currency to pay for the import. This creates a downward pressure and exchange rate appreciates.
Capital flow is a more important determinant of exchange rate. The investors, financial institution, MNCs and rich individuals often transact more money than trade flows. The capital flow depends on the interest rate differential among countries and hence influence the movement of exchange rate.
Any change in the exchange rate influence the value of currency and exchange rate of Australian dollar. A higher interest rate relative to other nations implies an increased demand for country’s currency. This raise the relative strength of the currency.
High inflation in the domestic market makes Australian exportable less competitive by raising price of these goods. If this worsens current account balance, then there would be depreciation of currency. With a small demand of export, import will become more price attractive (Ramasamy and Abar 2015). This leads to a fall in demand for Australian dollar and increase in dollar supply.
The figure above shows movement of trade weighted index for Australia. The trade-weighted index represents one form of effective exchange rate index. It is a weighted average of multilateral exchange rate between domestic and foreign currency with weight being the respective shares of each nation. Australia’s trade weighted index has declined from January 2015 to September 2015. This shows an appreciation of the overall exchange rate in Australia. After that, the index has shown an upward trend in until January 2017. For the next four months, the index again shows a downturn, and then it again increases and falls.
The nominal exchange rate between Australia and United State shows relative value of Australian dollar against US dollar. The movement of nominal exchange rate is in almost same as that of the trade weighted index. This is because United State is one of the major trade partners of Australia. United State constitute accounts a higher trade share. Consequently, in computation of trade-weighted index, United State has given a high weightage (rba.gov.au 2018). This shows influence of United State in the exchange rate determination of Australia. As a result, movement of these two indicators have a similar pattern.
Factors influencing demand and supply of Australian dollar
The article summarizes recent movement of Australian dollar considering the possible responsible factor behind fluctuation in the exchange rate. The Australian dollar has moved in reverse. The interest rate differential is one factor that is pulling down the exchange rate. The Federal Reserve is going on raising the interest rate while Reserve Bank of Australia has kept the interest rate to a considerable low level in order to reduce the borrowing cost. The low interest rate has reduced the demand for Australian dollar as a mean of investment (Sarno 2016). The excess supply of Australian dollar is has driven down the value of the currency. The AUD is likely to be exchanged at 70 US cents as against 80 cents in 12 months. The rising price for iron ore have stimulated export outlook of Australia. However, the strength of Australian dollar is not sustainable. The strong currency in medium term is not welcome in Australia. There is possibility that RBA will leave the benchmark of keeping the interest rate at the lower level of 1.5 percent because of debt burden followed by a stagnant wage growth. The Australian dollar has climbed up to the highest level to 81.36 (smh.com.au 2018). The strength of Australian’s dollar is not because of strength of domestic currency but because of weakness of US dollar.
In the reversal show of exchange ratio, the most bearish group being open traders. The payment to premium investors for selling Aussie against US dollar was approximately 50 basis point. It has recorded significant drop from the previous year’s value of 165 basis point. Amundi Pioneer Asset Management that engages in overseas investment of around $US 88 billion also has undervalued Aussie. There are three likely factors responsible for Aussie fluctuation –the declining prices of iron-ore, slow-down of china’s growth and widening differential in interest favoring investment in United State. In Australia, return on 10 years bonds over maturity Treasuries of with same tenure has declined to 23 basis point from 61 basis point (smh.com.au 2018). However, RBA is relatively reluctant and does not show much care to pull up interest to strengthen currency.
A change in US/AUD exchange rate from US 80C per AUD to US 70C per AUD indicates a fall in relative price of AUD. The depreciation of Australian dollar with respect to US dollar implies a weak position of AUD in the foreign exchange market. After currency depreciation, for every good imported from US to AUD, a higher price has to be paid. The importers will be adversely effected from the weak currency position. The Australian firms that imports electric machinery from US now faces a higher price for the imported machinery. This in turn increase cost of the firm (Bruno and Shin 2016). The firm will try to reduce its import demand from US as much as possible.
Under this situation, exporters will be benefitted. With depreciation of Australian dollar, US residents now have to a pay a relatively lower price for Australian exports. This raises the demand for Australian goods in the US market. The increases in export. A weak currency may a prospective growth for the overall economy (Krugman 2014). With an increase in export and fall in imports, net export balance is likely to improve. This increases aggregate demand in the economy and leads to a higher price.
Movement of trade-weighted index and nominal exchange rate
Following a weak currency, there is an upward pressure on the price level both from the demand side and cost side. The rise in aggregate demand tends to create a demand pull inflation while increase in import price by making imported raw materials more expensive creates a cost push inflation (Chow et al. 2016).
As Australian export now becomes more competitive in the international market, current account balance may improve with increase in export earnings (Bruno and Shin 2016). There is a possibility of wage growth in Australian economy following currency depreciation. However, the real wage might fall because of a higher price level.
An increase in AUD/USD exchange rate from US 72C per AUD to US 80C per AUD involve the policy actions for currency evaluation by Reserve Bank of Australia. In order to increase strength of a currency Reserve Bank of Australia can take the following policies
One way to increase value of the currency is to sold the treasury bills of US holds by Australian government in US and bring the proceed back to Australia. This will increase supply of US dollar and demand for Australian dollar (Brzoza-Brzezina, Kolasa and Makarski 2017). This in turn will cause a depreciation of US dollar and appreciation of Australian dollar.
Currently RBA has set the interest rate to a relatively low level. An increase in interest rate helps to strengthen the currency as investors have a high prospective return from investment in the country.
RBA should take anti-inflationary monetary policy to promote a relatively strong currency. The anti-inflationary monetary policies include an increase in interest rate, cutting down the money supply and other contractionary policies (Hofmann, Shim and Shin 2016).
Such policies though strengthen the currency value but in the long run, it adversely affects growth of the nation. A high interest rate by increasing the cost of borrowing discourages investment. A reduction in productive investment in turn causes a decline in growth rate. The anti-inflationary measures again discourage production (Turner, 2014). Moreover, a relatively strong currency reduces aggregate demand by lowering export and increasing export.
Whether currency evaluation is a reasonable economic policies or not that depend on the state of macro-economic condition. Increase in interest rate is one policy to make currency to evaluate. The economy where low interest rate leads to increasing debt of the household, rising interest rate above the low benchmark can be a reasonable policy. For example, the historically low interest rate in Australia has pushed up household debt following a stagnant wage growth (Hofmann, Shim and Shin 2016). Additionally, low interest rate has channeled most investment in the property market. Therefore, RBA at this stage should increase its interest rate. However, this should be done up to a certain limit as strong currency may adversely influence growth by lowering export and investment.
References
Bruno, V. and Shin, H.S., 2016. Currency depreciation and emerging market corporate distress.
Brzoza-Brzezina, M., Kolasa, M. and Makarski, K., 2017. Monetary and macroprudential policy with foreign currency loans. Journal of Macroeconomics, 54, pp.352-372.
Chow, M.J.T., Jaumotte, M.F., Park, M.S.G. and Zhang, M.Y.S., 2016. Spillovers from dollar appreciation. International Monetary Fund.
Hofmann, B., Shim, I. and Shin, H., 2016. Sovereign yields and the risk-taking channel of currency appreciation.
Ismail, N. (2018). Australian dollar tipped to slide back to 70 US cents. [online] The Sydney Morning Herald. Available at: https://www.smh.com.au/business/investments/australian-dollar-tipped-to-slide-back-to-70-us-cents-20180129-h0pp8v.html [Accessed 22 Mar. 2018].
Krugman, P., 2014. Currency regimes, capital flows, and crises. IMF Economic Review, 62(4), pp.470-493.
Quandl.com. (2018). Quandl. [online] Available at: https://www.quandl.com/data/RBA/FXRTWI-Australian-Dollar-Trade-weighted-Index [Accessed 22 Mar. 2018].
Ramasamy, R. and Abar, S.K., 2015. Influence of macroeconomic variables on exchange rates. Journal of economics, Business and Management, 3(2), pp.276-281.
Reserve Bank of Australia. (2018). Historical Data | RBA. [online] Available at: https://www.rba.gov.au/statistics/historical-data.html [Accessed 22 Mar. 2018].
Sarno, L., 2016. Exchange rate economics. Institute for Capacity Development.
Turner, P., 2014. The global long-term interest rate, financial risks and policy choices in EMEs.
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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