Exchange Rates - a Link between the Prices of Goods and Services Produced in All Trading Nations - Assignment Example

Part A: “The critical thing about exchange rates is that they provide a direct link between the prices of goods and services produced in all trading nations of the world” Globalization has multiple characteristics. Undoubtedly, one of them is the growing exchange of goods and services across national borders. This means that capital is becoming internationally mobile, and countries are competing against each other with reference to their share of the business environment. The exchange practices are controlled by the exchange rate, that is the price of one currency in terms of another (World Bank, 2007), which affects the manner prices of goods and services vary on a day to day basis. Brauer (2003) studied exchange rates based on two questions: (1) whether countries set the prices of traded goods based solely on specific costs of production, and (2) whether the conditions in the pertinent target market or the global market also influence the setting of prices. The concept here is very important because is frequently observed on one hand that shocks arise due to shifts in nominal exchange rates or costs of production between countries, and on the other hand, there is a presumed law of one price that is expected to hold for identical goods around the world. Nevertheless, some adjustments have to be made as a result of imperfect homogeneity of goods (Brauer, 2003). Several factors influence the exchange rate equilibrium. The equilibrium exchange rate will shift over as demand and supply schedules change (Madura, 2009). The aspects that may cause currency demand and supply schedules to change are highlighted briefly in this paper. They include percentage change in the spot rate, change in the differential between the United States interest rate and a foreign country’s interest rate, change in government controls, and change in expectations of future exchange rates. Changes in relative inflation rates can influence international activity, which impacts the demand for and supply of currencies and thus influences exchange rates. For instance, assuming that firms in both Australia and the United States sell goods that can be used as substitutes for each other, a sudden jump in the United States inflation would cause an increase in demand for Australian goods by United States citizens. This would also imply and increase in demand for Australian dollars by citizens of the United States. Additionally, an inflation in the United States should reduce the demand for the United States goods in Australia, thus reducing the supply of Australian dollars for sale. When a depreciation or devaluation of the domestic currency occurs, it may stimulate an increase economic activity through an initial increase in the price of foreign goods in relation to home goods (Kandil, 2000, p.3). Hence, by increasing the international competitiveness of home industries, a depreciation in exchange rate diverts spending from foreign goods to domestic goods. Nevertheless, success of variations exchange rates and how they promote balance of trade depends on altering demand in the appropriate direction and amount, and the ability of the home economy to meet the additional demand by increasing supply of goods. In general, exchange rates are critical to international trade. They determine whether countries set the prices of their goods and services based on the local costs of production, or based on the trend of the world market. Part B: Analysis of Australia’s floating exchange rate Different countries apply different techniques to determine their exchange rate, which the price of one currency in terms of another (World Bank, 2007). The buying and selling of currencies is carried out in the foreign exchange market. With reference to Australia, the exchange rate is the price of one Australian dollar expressed in terms of another country’s currency (Reserve Bank of Australia, 2010). The main methods applied in determining this are a flexible or floating exchange and a fixed rate. This paper addresses the concept of floating exchange rate with a particular focus on Australia. It highlights how the country’s exchange rate has changed over the recent past ten years and the factors that have caused these changes. In doing this, issues that could have likely caused the changed in the floating exchange rate will be discussed based on evidence from existing literature. Overview of Australia’s floating exchange rate Australia is one of the countries that have diversified trade partners and are characterised by a high dependence on commodity exports. The country has also chosen to operate a floating exchange rate and its economy seems to be vibrant under these regimes (Mussa, 2000). Before delving into floating exchange rate, it is worthwhile to discuss exchange rate in general and note the implications that it has for Australia. According to the Reserve Bank of Australia (2010), the most common measures used to determine the exchange rate are the exchange rate of the Australian dollar against the United States dollar and the weighted trade index, whose acronym is WTI. Beginning with the first point, Australia’s exchange rate is determined by the status of the United States dollar because the trading of Australian dollars on the foreign exchange markets is mainly against the United States dollar. In addition, the Unites States dollar is the leading global medium of exchange. Revisiting the second point, the TWI does not imply a price in terms of a single currency, but rather a piece in terms of a collection of currencies. In most cases this is regarded a better measure of the genera trends in the exchange rate as compared to any other single bilateral exchange rate, for instance that against the united states dollar, since the Australian dollar might be rising in relation to the united states dollar but declining against other world currencies. In such events, the TWI will show a clear measure of whether the value of the Australian currency is rising or declining on average (Reserve Bank of Australia, 2010). The floating exchange rate A floating exchange rate implies a mode of exchange in which the central bank of a country does not intervene in the foreign exchange market with a view to fix rate (Krugman, 2004). This means that the exchange rate is determined by market force depending on the supply and demand of a given currency (Reserve Bank of Australis 2010). The fixed exchange system was fixed by the Bretton Woods system but began to show signs of strain in the late 1960s. This lead to a recommendation by economist that countries allow the values of their currencies to be determined freely in the foreign exchange market. With the adoption of the floating exchange rate in 1973 by industrialized countries, it was perceived that this was a temporary measure to but was later adopted a permanent floating rate system. The floating exchange rate was and is viewed as a means of reducing conflicts between internal and eternal balance that arises as under the fixed exchange system (Krugman, 2004, p. 568). A country’s real exchange rate ultimately reflects the underlying economic conditions, regardless of whether nominal exchange rates are floating or fixed. Nevertheless, the adjustment mechanism is different, with modification in the domestic price levels being greater under a fixed exchange rate regime. Under a flexible exchange rate regime, the shift in the nominal exchange rate cushions some of the effects of the domestic price level, and can thus be viewed as a shock absorber. The main advantage of a flexible exchange rate system is that the nominal exchange rate can respond speedily to alterations in economic conditions. With the fixed exchange rate regime, changes to the point of domestic prices may take longer to occur. This may be particularly important when a real exchange rate depreciation is required (Odedokun, 1996; Kenwen, 2000; HM Treasury, 2005). Irrespective of whether or not the floating exchange rates of medium sized and large industrial countries are subject to significant neglect, exchange rates usually move regularly and often times quite substantially in reaction to market forces. Adjustments and interventions in monetary policy may be applied with a view to influencing exchange rates, but not with the intention or impact of defining de facto exchange rate standards. This is critical because real experience with fluctuations in exchange rates determined by markets informs market players of the realities of foreign exchange risk. As such, institutions have been compelled to adapt to the realities of the floating exchange rate system (Mussa, 2000, p.19). Shifts in the Australian dollar The two measures of determining the exchange rate (exchange rate of the Australian dollar against the United States dollar and WTI) sometimes move together but sometimes diverge. By applying a flexible or floating exchange rate regime, it means that the value of the Australian dollar changes recurrently, even by the minute. The market rate thus relies on the demand for and the supply of the Australian dollar in the forex market. The shift in the floating exchange rate of the Australian dollar based on the United States dollar is explained in figure 1. Figure 1 (Adapted from Kenen 2000) Under a flexible or floating exchange rate the value of a country’s currency changes frequently, even by the minute. The market rate will depend on the demand for, and supply of, that currency in the forex markets. The floating exchange rate regime that has existed in Australia since 1983 has largely been accepted as having been beneficial for the country. It advantages lie in the fact that Australia is a relatively small economy, and plausibly open and subject considerable shifts with reference to trade. Along this line, the floating exchange rate has acted as a buffer to external shocks, especially those that occur in terms of trade, enabling the economy to absorb them without developing large deflationary or inflationary pressures associated with the previous fixed exchange rate (Krugman, 2004). Since 1983, the exchange rate for Australia has been floated freely. But there have been occasional times of intervention by the Reserve Bank, although the Bank has never sought to fully fix the exchange rate by way of its intervention. This means that the Bank has been free to set domestic monetary conditions without having to deal at the same time with the impacts of capital flows through domestic monetary conditions. Many pressures have been imposed on the foreign exchange market, sometimes causing large significant movements in the exchange rate. The exchange rate has been affected by many factors, particularly terms of trade with reference to the export base of Australia. Exchange movements since the Australian dollar was floated have been driven in part by changes in real effective interest differentials. The strength of the Australian dollar is also supported by higher terms of trade in by both large exporters and primary commodities. Over the years, there has been a sharp increase in terms of trade due to increasing iron core, coal, and other mineral prices (Edison & Vitek, 2009). The trend in the exchange rate (Australian dollar versus US dollar) is shown in figure 1. Figure 1: Australia’s exchange rate trend (against the USD). The figures are based on approximate yearly averages Since the float began, shifts in the real exchange rate closely tracked those of terms of trade. In recent years, terms of trade have recovered tremendously, leading to a stronger exchange rate that is widely recognized as part of the adjustment process to variations in external conditions (Bank for International Settlements, 2009). Relative interest rates, confidence and expectations have also impacted the exchange rate. In particular, two occasions are memorable to impacted capital flows. For instance, in 1997, following the Asian crisis, demand for Australia’s exports, most of which went to Asia, was anticipated to drop sharply. In addition, terms of trade declined with weak commodity prices. This means that Australian commodities looked less attractive, and the flight of funds caused the exchange rate to go down sharply. In the same period, there was concern about the impacts of depreciation on inflation. Nevertheless, these turned have not much significant impacts since 2000 as shown by the curves in figure 1. In the period between 2000 and 2002, the Australian dollar slumped against the US dollar. This was caused by an increase in imports, which created an ongoing shortfall in the current account, which is the measure of the balance between exports and imports. In the period between 2003 and 2005, and increase in the prices of gold from Australia saw the value of the dollar appreciate, exchanging at 1.552114 and 1.304993 (average) in 2003 and 2005 respectively. There was a further strengthening of the Australian dollar against the US dollar between 2006 and 2007 due to an increase in Australian exports, mainly agricultural and livestock produce. However, this was cut short by uncertainties caused by the global financial crisis in 2008, a trend that continued into 2009 (figure 1). Terms of trade have had significant impacts on Australia, floating exchange rate. For instance, an increase in terms of trade due to a rise in the prices of common commodities offers and expansionary impulse to the economy as a result of an increase income. The increased demand for inputs due to the export sector causes an inflationary pressure. An increase in the exchange rate counteracts the influences to some extent by way of causing a substitution of domestic demand towards imported services and goods. Nevertheless, the strength of the relationship varies with time. According to the Reserve Bank of Australia (2010), the strong increase in commodity prices commenced in 2002 and boosted terms of trade, as well being associated with a rise in the real TWI. Even then, the rise was can be realized to have been less than what might have been expected going by the historical relationship. As of the period between 2007 and 2009, the terms of trade and have moved closely together, thus stabilizing the floating exchange rate. In 2007, the elevated volatility as well as uncertainty of the global economy saw movements in the Australian dollar, influenced by the appetite of risk in the market. Increased perceptions of risk in addition to the appetite for riskier assets undoubtedly caused a flight quality by financiers and an appreciation of other currencies like the United States dollar. This strategy caused the Australian dollar to appreciate on positive aspects about foreign and global developments while depreciating on negative aspects in the era of the global financial crisis. The elevated market volatility and uncertainty about the global economy from 2007 saw movements in the Australian dollar also be influenced by risk appetite in the market. Heightened perceptions of risk and a reduction in the appetite for riskier assets arguably generated a flight to quality by investors and an appreciation of reserve currencies like the US dollar. This mechanism saw the Australian dollar appreciate on positive news about foreign and global developments and depreciate on negative news during the crisis. References Kandil, M. (2000) The Asymmetric Effects of Exchange Rate Fluctuations: Theory and Evidence from Developing Countries, Issues 2000-2184, International Monetary Fund, New York. World Bank (2007) World Development Indicators 2007 (11th edition), World Bank Publications, New York. Brauer, H. (2003) The Real Exchange Rate and Prices of Traded Goods in OECD Countries, Springer, New York. Krugman, P. R.(2004) International economics: theory and policy (6th edition), Online, http://books.google.co.ke/books?id=L5DaCeXtNq0C&dq=floating+exchange+rate&client=firefox-a&source=gbs_navlinks_s (accessed 3 May 2010). Odedokun, M.O. (1996) Monetary model of black market exchange rate determination: evidence from African countries, Journal of Economic Studies, 23(4): 31-49. Kenen, P.B. (2000) Fixed versus floating exchange rates, Cato Journal, 20(1): 109-113. Reserve Bank of Australia (2010). The Exchange Rate and the Reserve Bank’s Role in the Foreign Exchange Market, http://www.rba.gov.au/mkt-operations/foreign-exchg-mkt.html (accessed 3 May 2010). Mussa, M. (2000) Exchange rate regimes in an increasingly integrated world economy, International Monetary Fund, New York. HM Treasury 2005, The exchange rate and macroeconomic adjustment. EMU study. Madura J. (2009) International financial management (Abridged edition), Cengage Learning, New York. Bank for International Settlements (2009) Australia's experience with capital flows under difficult exchange rate regimes, http://www.bis.org/publ/cgfs33rba.pdf (accessed 6th May 2010). Reserve Bank of Australia (2010) The Exchange Rate and the Reserve Bank’s Role in the Foreign Exchange Market, http://www.rba.gov.au/mkt-operations/foreign-exchg-mkt.html (accessed 6th May 2010). Edison, H & Vitek, F. (2009) Australia and New Zealand Exchange Rates: A Quantitative Assessment, IMF Working Paper WP/09/7, http://www.imf.org/external/pubs/ft/wp/2009/wp0907.pdf (accessed 6th May 2010). Read More