Demand and Supply Model of Exchange Rate Determination
Questions:
1. Using a Demand and Supply model of exchange rate determination, briefly explain how the exchange rate of the AUD is determined in the forex market, and what factors influence fluctuations of it.
2. Using nominal exchange rate data and trade weighted index data from the Reserve Bank of Australia website (use monthly data for the last three years) and analyse the movement of the AUD relative to that of the USD using a graph. In your opinion what are the factors contributing to this behaviour of the AUD?
3. Summarise the main issues discussed in this article. Using the demand and supply framework discussed in part (a), show and explain how these main driving forces would impact the AUD/USD exchange rate..
4. Suppose you are a manager of an Australian firm which imports electrical machinery from the US.Some of the analysts interviewed in the article expect that the AUD/USD exchange rate is going to change from US 80C per AUD now to US 70C per AUD one year from now. Explain the impact of this depreciation of the Australian dollar on your firm. Thinking about the overall Australian economy, who will benefit and who will lose from such a depreciation?
5. Suppose that the AUD/USD exchange rate stabilises at around US 72C per AUD one year from now. What action could the Reserve Bank of Australia take in order to bring the exchange rate back to US 80C per AUD, and what side effects might this action have on the Australian economy? Do you
Foreign exchange rate is the price of the domestic currency in terms of the foreign currency (Gabaix and Maggiori 2015). Owing to various kind of exchange rate system, for instance, fixed and floating, it is hard to determine the actual exchange rate (Cooper 2014). However, with the rise in researches regarding foreign exchange new theories came in and one of them was demand and supply framework. Demand and Supply framework is one of the simplest economic tools that help to determine the foreign exchange rate easily. Unlike price and quantity determination, demand and supply framework guides the authorities to understand and predict the exchange rate of next period (Alichi and Benes 2015). Moreover, it helps to trace various reasons that influence the exchange rate of a country and guides the policymakers to gauge the situation efficiently. Considering the case of Australian currency, Australian Dollar (AUD) this report is aimed to analyse how the exchange rate of the AUD is determined in the Foreign Exchange (Forex) market.
Figure 1 represents the general demand and supply framework of the Forex market, where demand of the currencies is achieved through the export demand of a country and the supply is determined through the domestic demand of the importable (Canallero, Farhi and Gourinchas 2016). Demand curve (D) is drawn depending upon the derived demand and the supply curve (S) is drawn depending upon the aggregate demand of the importable (Gibson and Thirlwall 2016). Now, it is assumed that the equilibrium occurs at point E, where the exchange rate is 80C USD for each unit of AUD. At the equilibrium point demand of the importable in the domestic market of Australia is represented through the Q. Under this scenario, if there is rise in demand of the AUD from Q to Q1, then the demand of the foreign exchange will shift from D to D1, leading to rise in the exchange rate to81C (hypothetically) for each unit of AUD from the initial equilibrium situation. On the other hand, if there is reduction in demand of the AUD, then it will shift the demand curve left ward to the D2 from the initial D point, leading to fall in the exchange rate 77C USD for each unit of AUD from the initial 80C USD to each unit of AUD.
Factors Influencing Fluctuations of AUD Exchange Rate
Figure 1: Demand and Supply model of exchange rate determination
Source: (Created by Author)
Considering the above explained demand and supply framework of the Australian foreign exchange, it can be stated that it is a flexible market system, where the Forex rate is determined through the equilibrium of demand and supply (Manalo, Perera and Rees 2015). Various factors are responsible for the fluctuations of the demand and supply of the AUD. Some of them are as follow (Fernandes 2017):
- Inflation rate – rise in inflation will lead to depreciation of the AUD leading to leftward shift of the demand curve.
- Interest rate – rise in interest rate will lead to rise in demand of AUD leading to rightward shift of the demand curve and higher value of domestic currency with respect to the USD.
- Growth rate – with higher growth rate, AUD will be appreciated due to higher export demand of the Australian goods and services.
- Government plans – with rise in export promotion and import substitution, government of Australia can boost the demand of AUD in foreign market, leading to rise in the exchange rate for the country.
Nominal exchange rate is the number of domestic currency unit required to purchase a unit of foreign currency. With rise in the purchasing power it can be said that the domestic currency is having nominal depreciation and on the other hand if the variable decrease, then the situation can be termed as the nominal appreciation of the domestic currency (Lusting, Stathopoulos and Verdelham 2016). One the other hand Trade Weighted Index (TWI) is multilateral exchange rate with weighted average of domestic currencies versus currencies of foreign economy (Manalo, Perera and Rees 2015). It is calculated depending upon the share of trade with each trading partner and depending upon the magnitude of the business with the partner it can be import weighted, export weighted or even it can be total external weighted trade.
Now, considering the Australian nominal exchange rate and TWI for the last three years it can be seen that there are various fluctuations over the time. As depicted by the figure 2, there were various fluctuations during the year 2015, where the nominal exchange rate of AUD was at its peak during the month of March. However, during the same period, due to the fall in demand of the Australian goods and services, the nominal exchange rate fell to its lowest point leading the USD to become costlier with respect to the AUD. Over the period it went through various fluctuations and rose sharply during the July 2017, however it started to fall during again from the month of October. Within the taken timeframe, nominal exchange rate of AUD is presently floating at a rate of 80C USD with respect to the AUD.
Figure 2: Nominal Exchange Rate
Source: (Reserve Bank of Australia, 2018)
From the figure 3, TWI of the AUD can be seen, which represents high amount of fluctuation over the time. TWI hit its lowest value during October 2015 leading to recession in US market and the highest TWI can be seen during October 2017. Depending upon the trade magnitude between Australia and US, TWI fluctuated over the time; however, the upward line shows ever increasing business between two trading partners (Engel 2016).
Figure 3: Trade Weighted Index
Source: (Reserve Bank of Australia, 2018)
Weak USD is one of the main contributing factors of this behavior of AUD. Besides this, over the time US market become saturated, leading to recession during 2015 and it resulted in fall in demand of the Australian goods and services in the US market. However, since October 2017, demand of the Australian goods and services rose and interest rate in Australian market also enhanced, leading to rise in demand of the AUD (Tribe 2015). Thus, both the figure 2 and 3 represents uprising line diagram and tending towards better US-Australia business in future.
Analysis of AUD Relative to USD and Contributing Factors
According to the report mentioned in the assignment, it can be seen that various reasons are there for the recent fluctuation in the AUD with respect to the USD. The report highlights that, one of the main reason for the recent rise in AUD with respect to the USD is slump in USD and rising price of the commodities like ore of iron (Ismail, 2018). It has enhanced the Aussie export, leading to rise in demand of the AUD, which resulted in appreciation of the AUD with respect to the USD (Dai, Yu and Zhao 2018). However, the report has also suggested that, the AUD strength is not sustainable owing to the stagnant inflation rate and wages, which is containing the domestic economy growth of Australia. In addition to this, according to the Amundi, threats like reducing price of iron ore in world market, discernible reduction in growth of Chinese economy and rise in Fed hikes leading to widening interest gap between US and Australia (Ismail, 2018). Thus, the report expects that, soon the AUD will fall back below 70C USD, once the export with US falls and the US interest rate starts to surpass the Australian interest rate.
Figure 4: AUD/USD with Supply and demand diagram
Source: (Created by author)
Considering the initial equilibrium was at E point, where the exchange rate was Ex, figure 4, depicts the fluctuation of the Australian exchange rate. With rise in export of the iron-ore and slump in the US exchange rate, AUD faced higher demand D1, leading to rise in Ex1. However, if the factors like widening interest rate gap of the US and Australia, falling price of the iron-ore can be considered, then the demand is ought to fall to the D2. New equilibrium occurs at the point, where demand equates with the supply (Feenstra 2015). Thus, E2 is the new equilibrium point, where the exchange rate to Ex2.
With depreciation of the AUD, imports will be more expensive, which will lead to lower demand of the importable. With lower demand of the importable, the firm will increase the price of the commodity in order to make profit. With increased price, demand of the commodity will start to fall, which will again lead to rise in price (Gabaix and Maggiori 2015). The cycle will continue, until the equilibrium price and quantity is decided with the help of the supply and demand function of the commodity. With lower value of AUD with respect to the USD, importer of electrical machinery will face loss due to reduction in demand of the importable. On the other hand, depreciation will lead to rise in exports, because exportable will become cheaper with lower AUD/USD exchange rate. It will enhance the Balance of Payments and lead the economy to face growth (Mbogo 2015). Current account deficit will improve with depreciation of the AUD with respect to the USD and the trade between Australia and US will rise with lower exchange rate.
Considering the given conditions, it can be stated that there are various instruments, using which government of Australia can penetrate the exchange rate to avail appreciation. Australia is a mineral rich country, where more than 6.9% of the GDP comes from McLennan, Becken and Moyle 2017). With decrease in the demand of iron ore from Australia in the world economy, exchange rate of AUD has been decreasing as suggested by the given newspaper report. Thus, government can take export promotion plans with special focus on the US market, which can increase the demand of the Australian mining goods, leading to rise in demand of the AUD in the foreign countries (Groenewold 2017). It can efficiently appreciate the AUD with respect to the USD. Besides this, the newspaper report has mentioned that there is widening gap between the US interest rate and the Australian interest rate due to recent rise in the Fed rate. If the gap widens largely, then most of the foreign investors will withdraw their investment from the Australian economy and put it into the US economy. It will lead to fall in AUD exchange rate and rise in USD exchange rate. Thus, Reserve Bank of Australia needs to take actions in order to gauge the situation. With stagnant inflation and wage rate, domestic economy of Australia is gradually slowing down (Bramble 2015). In order to overcome this situation, Australian Reserve Bank need to rise their interest rate and government need to take fiscal expansion program from the accumulated money. It will provide much needed boost to the economy to overcome the stagnant inflation and wage rate situation. In addition to this, government can go for import substitution and bring in quota system for importable in order to stop the net export deficit.
Impact of Depreciation on an Australian Firm
Though these plans are effective to bring back the AUD exchange rate from 72C to 80C USD for each AUD, however it has various side effects. For instance, with rise in export promotion, AUD can get appreciated, which will lead to rise in importable (Wang 2016). With higher importable, net export will tend to fall and the economy will remain at same position. Besides this, once the government rise interest rate, domestic investment will rise, however demand will fall due to lack of liquidity in the market. Bringing in import quota is not possible in presence of the AUSFTA pact between two countries.
Considering both the pros and cons, it can be stated that, Australia can bring back the exchange rate to 80C USD for each AUD with the above mentioned plans, however, government need to take care of the side effects with caution. Maintain balance between market liquidity and interest rate will aid the government. If the government can enhance the infrastructural development, then it will beneficial for the economy to raise the exchange rate.
Reference:
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