On the other side of the market, the Australian demand for yen is determined by our need to pay for imports from Japan, and for any capital investment that we undertake there. We buy those yen by supplying Australian dollars in return. Thus the supply of dollars (mirrored by the demand for yen) is determined by our imports from Japan and our capital outflow to that country.
In summary, then, the demand for Australian dollars reflects the behaviour of our exports and capital inflow, while the supply of dollars reflects the behaviour of our imports and capital outflow. In other words, transactions on the foreign exchange market echo the international trade and financial transactions that are summarised in the balance of payments. Within the balance of payments, the relationship between our exports and imports of goods and services is captured by the balance of current account, while the relationship between capital inflow and capital outflow is captured by the balance of capital account. The activities of international currency speculators affect the exchange rate directly through their impact on capital flows.
The distinguishing characteristic of a floating exchange rate system is that the price of a currency adjusts automatically to whatever level is required to equate the supply of and demand for that currency, thereby clearing the market. The logic of the relationship between our international transactions and the supply and demand for currencies implies that this market-clearing, or 'equilibrium', price also produces automatic equilibrium in the balance of payments. 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. An analogous mechanism would operate to reduce the impact of an initial decline in Japanese investment in Australia. Both cases illustrate the role of exchange rate flexibility in insulating our economy to some degree against international economic instability. By the same reasoning, floating exchange rates also help to diminish the international transmission of our own domestic economic instability.
Economic Policy and The Balance of Payments
In a fixed exchange rate regime the need to manage the balance of payments often creates difficult conflicts with the government's domestic policy objectives. By ensuring automatic balance of payments equilibrium, floating exchange rates can liberate economic policy from this constraint, allowing the government to concentrate more easily on such internal issues as full employment and price stability. But we have noted earlier that balance of payments equilibrium means nothing more than that the current account and the capital account sum to zero. If, as in Australia's case, this state is achieved with a large and generally increasing current account deficit, matched by a correspondingly large and increasing capital account surplus, the government may be tempted to try to correct these tendencies. To this extent, balance of payments considerations may still compete with domestic considerations in the policy agenda (though whether they should do so is a matter of some controversy).
Relative Effectiveness of Monetary and Fiscal Policies
Relative to a fixed rate world, exchange rate flexibility increases the effectiveness of monetary policy, and diminishes the effectiveness of fiscal policy in regulating the economy. Suppose, for example, that there is a perceived need to stimulate the economy with a view to reducing unemployment.
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.
