Supply and Demand Model of Foreign Exchange Rates
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 think that such actions would be a reasonable economic policy? Explain your answer.
With rise in the international trade, economies around the world are indulging itself into higher amount of trade. With rise in the international trade, it has become essential for the economies to calculate the value of their currency with respect to their currency. Foreign exchange rate of a nation refers to the monetary valuation of the country’s domestic currency with respect to the other currency value of other nation (Edwards 2015). Predicting foreign exchange rate is hard, however utilising simple supply and demand model, it can easily be explained.
Figure 1: Exchange rate determination with supply and demand model
Source: (Created by Author)
Considering the figure 1, it can be seen that there is demand and supply curve, which are being drawn depending upon the perceived demand of the AUD and the aggregate supply of AUD respectively (McNamara et al. 2016). Initial equilibrium occurs at point E, where the exchange rate is Ex0 and the demand of AUD is Q0. Now, if there is rise in the demand of the AUD in US market, then it will shift the demand curve from D0 to D1 and the new equilibrium occurs at E1, where the exchange rate is EX1 and demand of AUD is Q1. On the other hand if the demand of AUD falls from Q0 to Q2, then it will shift the demand curve to D2, position causing newer equilibrium at E2, where the exchange rate is EX2. Thus through demand and supply model, exchange rate can easily get determined.
Factors Affecting the AUD/USD Exchange Rate
Now, considering this it can be said that supply and demand model of foreign exchange can easily explain the various factor that affect the AUD in the foreign exchange market. Following are the essential influencer of the AUD/USD exchange rate:
- Interest rate – change in interest rate will change the foreign investment, which can alter the demand of AUD (Johnson 2017). With change in demand of AUD, exchange rate of AUD/USD will also change.
- Inflation – higher inflation can lead to depreciation of the AUD/USD exchange rate and the lower inflation can cause better investment prospect leading to currency appreciation on behalf of the AUD (Guofeng 2015).
- Government policies – if government takes expansionary fiscal or monetary policy or if it can take export promotion polices along with import substitution, then it will help to influence the demand of the AUD, leading to appreciation of the AUD in terms of USD (Melvin and Norrbin 2017).
Nominal exchange rate is the number of domestic currency required to attain one unit of foreign currency (Eichenbaum et al. 2017). According to the same source, with rise in nominal exchange rate of a domestic currency, purchasing power of the domestic population gets enhanced and if there is deterioration of the nominal exchange rate, then it will lead to fall in the purchasing power for the domestic population. On the other hand Trade Weighted Index measures the material rate of exchange depending upon the weighted average to the domestic trading with the foreign nation (Amiti et al. 2016). Higher TWI means, better trade has been participated between the two nations and a lower TWI apprehended that trading was not good and limited in nature (Nguyen 2016).
Figure 2: Nominal exchange rate of Australia
Source: (Reserve Bank of A0.ustralia 2018)
Considering the figure 2, it can be seen that there has been various flucutations in the Austrlain market over the from 2015 to 2017. During the last three years, nominal exhange rate of AUD was highest during May of 2015 and a second peak can be observed during the September of 2017. These rise in the nominal exhcnage rate higjlights that AUD has been substantially stron during these periods due to various reasons. However, during 2015, nominal exhcnage rate fell to its lowest point due to the recession in the US market and since then it has been rising upward (Mian and Sufi 2015).
Figure 3: TWI of Australia
Source: (Reserve Bank of Australia 2018)
Considering the figure TWI of the AUD can be perceived. From the figure it can be seen that AUD/USD conversion reached its highest point during 2015 May and in September 2017, highlighting good trading proposition between two countries. However, owing to inflation in the US market, TWI fell to its lowest point during September of 2015 and since then it has been rising towards as sustainable position, highlighting better AU-US trade prospect in future (Fabre 2016).
Given article highlights that there are various reasons that have been causing the rise in AUD compared to the USD, however it will not last long. The editor highlights that one of the major reason AUD appreciation is the recent slump in the USD due to the recession in the US market back in 2015. The article points out that in addition to the slump in US market, rise in the iron export in the US market from Australia has been facilitating the domestic economy to have better trade balance leading to exchange rate higher than the 80C USD for each AUD (Ismail 2018) . Additionally it has also pointed out that widening gap of the US and Australian interest rate is another driving force that has been leading to better situation for the AUD with respect to the USD. As the interest rate of the US is lower than the Australian interest rate, domestic market is attracting higher number of foreign investor leading to appreciation to their AUD (Summers 2014).
Recent Appreciation of the AUD
However, the same article asserts that this sudden rise in the AUD with respect to the USD is not sustainable in nature. One of the major reasons for asserting this is recent trend of the Chinese export to the US market. With rise in Chinese aggression in iron ore market in the US; Austrian market is yet to face depreciation of their currency (Brown 2015). In addition to this, the article highlights that Fed has recently raised their interest rate and once the US interest rate surpass the Australian interest rate, the boom in the foreign investment will be gone. Thus to conclude, the article stated that, Australian dollar’s recent appreciation is not sustainable, it’s just the outcome of the weakening USD (Ismail 2018).
Figure 4: AUD/USD exchange rate dynamics through supply and demand model
Source: (Created by Author)
Now, if the present AUD situation has to be described through the demand and supply framework, then it is important to consider the figure 4. From figure 4, it can be seen that present equilibrium in exchange rate market occurs at point E, where the exchange rate is 80C USD with respect to the each unit of AUD. Now if there is rise in exports from the Australian market to the US, then it will lead to rise in the demand of the AUD, leading to shifting of the demand curve from D to D1 (Stockhammer 2015). It will cause a currency appreciation for the AUD and the exchange rate will be as high as 81C USD for every unit of AUD. However, as the given article portray, there will be fall in export of the Australian market and the fall in interest gap will lead to lower the foreign investment, which in turn will shift the demand curve of AUD from D to D2. At new position of the AUD demand curve, equilibrium occurs at point E2, where the exchange rate is as low as 77C USD for each unit of AUD or it can be worse. Thus with demand and supply framework, present situation of the Australian market can easily get explained (Armstrong et al. 2014).
Considering the given condition that from one year now AUD can get depreciated to 70C USD for each unit of AUD from the present situation of 80C USD with respect to each unit of AUD, then the condition will not be good for the importing firm. From the perspective of the importing firm that import electrical machinery from US, it will face enhanced cost of importable. With higher cost of importable, the importer will enhance their selling cost, leading to a fall in the demand of the importable (Halpern et al. 2015). If there is fall in demand, then to keep the profit same, the importer will again enhance its price or it can reduce the price. If the importer enhances the price, then it will face additional drop in demand of the importable, and on the other hand if the importer reduce the price, then it will have be able to cover only the fixed cost of its business. Over the time, if the situation remains persistent, then being the manager of the firm, it can be said that the firm will face loss and eventually it will exit the market. On other hand, according to general economic theory, if there is currency depreciation, then it will aid the economy to have higher foreign demand of their goods and services (Mbogo 2015). Considering the Australian case of currency depreciation, it can be stated that with lowered price of the foreign goods and services, US citizens will demand Australian goods and services in more amount. This rise in demand will lead the demand of AUD to a better position, leading to higher Balance of Trade compared to the present situation (Gabaix and Maggiori 2015). In addition to this, once the AUD gets depreciated, then it will lead to fall in demand of the importable in domestic market, which in turn will again lead the trade balance of the country to enhance. Thus being the manager of the importing firm it can be stated that currency depreciation will be costlier for the importing firm; however it will bring in positive result for the overall Australian economy.
Impact of Currency Depreciation
Considering the given condition, that Australian exchange rate stabilise at 72C USD against each Australian dollar, if government of Australia wants to bring it back to the desired 80C USD for each USD, then monetary authority has to take necessary policies. In order to gauge the present situation, currency appreciation is required, which needs the following policies to be implemented:
- Enhancing interest rate – interest rate is one of the key instruments that can lead to currency appreciation or depreciation. If the Reserve Bank of Australia enhances the interest rate, it will attract more foreign investor from US (Gantz 2016). With better investment prospect demand of AUD will rise it will lead the domestic currency to get appreciated.
- Reducing inflation – Reducing inflation can act as the effective stimuli to the Australian dollar to get appreciated. With reducing price level, there will be higher aggregate demand, which will lead to higher requirement for the domestic currency. With higher demand AUD will have appreciation and lead it to desired position.
- Buying back AUD –If the Australian government buy back their own currency, and sell foreign exchange in order to enhance the value of their domestic currency, then it will lead the demand of AUD to a higher situation (Calomiris et al. 2016). With demand raising higher, Australian dollar will become costlier with respect to the USD.
Though it is good to see that through aforementioned policies government of Australia can easily bring back the deteriorating AUD from 72C USD to 80C USD, however, when it comes to reasonability of these policies then it is subjective. Currency appreciation has both the positive and dark side, because it can lead to better trade balance, and on the other hand dry up the liquidity in the market leading to fall in aggregate demand. For instance, if the government of Australia enhance the interest rate, then it will attract more amount of domestic investment too, apart from the foreign investment. With higher amount of domestic investment, there will be fall in the liquidity in the market and the aggregate demand will also tends to fall. With fall in aggregate demand market will face inflation again. Additionally, if domestic currency gets appreciated, then it will lead to higher import, while crowding out the positive effect of currency appreciation. Australia and US is under AUSFTS act, thus it cannot imply import quota (Hofman et al. 2016). The only way to deal with the rising import due to currency appreciation is the import substitution, for which technological enhancement, R&D is required that will need another additional cost.
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