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Economics of the Foreign Exchange Market.

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Introduction

An exchange rate is simply the price of one currency in terms of another. The process by which that price is determined depends on the particular exchange rate mechanism adopted. In a floating rate system, the exchange rate is determined directly by market forces, and is liable to fluctuate continually, as dictated by changing market conditions. In a 'fixed', or managed rate system, the authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such a system often seems appealing to those who are troubled by the uncertainties of the present, highly volatile, floating rate environment. But the choice of exchange rate regime involves considerations that extend beyond the stability or otherwise of currency prices. This will become clearer after an examination of some fundamentals of the foreign exchange market. Economics of the Foreign Exchange Market In a floating exchange rate regime the price of the dollar, like any other market-determined price, depends on the relevant forces of supply and demand. But what are the relevant forces of supply and demand in the foreign exchange market? To try to answer this question, let us consider, for illustration, the factors that determine the relationship between the Australian dollar and the Japanese yen. ...read more.

Middle

That is, the balance of current account (whether positive, negative, or zero) must be precisely offset by the balance (negative, positive, or zero) of the capital account. Under floating exchange rates these outcomes are achieved automatically without the need for government intervention. By contrast, under fixed exchange rates balance of payments equilibrium is not the normal condition. These characteristics of the floating exchange rate mechanism have important implications both for the nature of our relationship with the global environment, and for the policy options available to the authorities in managing the economy. Let us now consider some of these. International Transmission of Economic Stability A flexible exchange rate acts as a kind of shock absorber that helps to insulate us against overseas disturbances. This is because the relationship between our international transactions and the foreign exchange market runs in both directions. Let us suppose, for example, that recession in the Japanese economy leads to a decline in the demand for Australian exports. In itself, this will tend to reduce economic activity in Australia. But this tendency will be offset by an associated depreciation of the dollar, which will induce an expansion of exports, a contraction of imports, and perhaps an increase in net capital inflow, all of which will help to cushion the Australian economy against recession. ...read more.

Conclusion

The appropriate monetary policy action is for the Reserve Bank to reduce interest rates. This causes a depreciation of the dollar, which in turn encourages exports, discourages imports, and increases net capital inflow. These exchange rate effects tend to reinforce any initial expansionary impulse resulting from the change in monetary policy. It can be shown, by contrast, that where the exchange rate is fixed monetary policy is quite ineffective. Indeed the logic of a fixed exchange rate system essentially precludes the conduct of an independent monetary policy. This was a primary reason for the Australian government's decision to float the Australian dollar in 1983. In the case of fiscal policy, the conventional prescription is for an increase in the government budget deficit. The associated upward pressure on interest rates induces an appreciation of the dollar, which in turn discourages exports, encourages imports, and reduces net capital inflow. These exchange rate effects on our international transactions weaken aggregate demand in Australia and accordingly tend to offset any expansionary effects of the government's fiscal program. By contrast, with a fixed exchange rate these adverse secondary effects are precluded, and fiscal policy is likely to be correspondingly more effective. These considerations help to explain why fiscal policy has come to be overshadowed by an increased reliance on monetary policy as the primary instrument of macroeconomic stabilisation. ...read more.

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