* Year unknown
One can explain movements in the international currency market in much the same way. When demand for an Australian good increases the price of the good rises. Here the "good" is the Australian dollar and the price of the good is its exchange rate. (CHASS)
As demand for Australian dollars increases, the price of Australian dollars rises. Since the price can be viewed as the exchange rate we can thus say that, as the demand for Australian dollars rises the exchange rate increases. An increase in the exchange rate is also called an appreciation of the exchange rate. (CHASS)
So again, what would cause a change in the demand for Australian dollars, or in other words what causes the demand curve to shift? This can have multiple causes, the most important being:
- Level of exports and imports
- World commodity prices
- Level of economic activity
- Australia’s inflation rate
Imports and exports
Consider the situation where Australian businesses sell Australian commodities to the British. Imagine the situation from the perspective of British businesses. They buy Australian goods and they have to pay Australian businesses in Australian dollars. Where will they get the Australian dollars to do so? The British use the Pound Sterling and the Australians use the AUD. So what they are forced to do is visit banks and purchase Australian dollars. Where will these banks then go to get Australian dollars? The international currency market. (CHASS)
When the British banks demand Australian dollars on the currency market, this implies there is a greater demand for Australian dollars. This will, in turn, cause a shift in the demand curve to the right, increasing the value of the Australian dollar. (CHASS)
On the flipside, however, if British businesses were to sell goods to Australia, domestic buyers would be seeking Pound Sterling. Australian banks would then visit the international currency market and sell Australian dollars for Pound Sterling. By selling Australian dollars, these banks are effectively increasing the supply of Australian Dollars on the international currency market. Consequently, this would lead to a rightward movement in the supply curve of Australian dollars, leading to a depreciation in the value of the currency. (CHASS)
Since 2000, slow declines in Australia’s exports against growths in imports have not been a very positive sign for the Australian dollar. Whilst it has not realistically, this has had the effect of decreasing the value of the Australian dollar. Record Current Account Deficits have also not boded well for the AUD, which has maintained its strength through other factors (discussed hereunder). Arguably, however, the Dollar’s strength in spite of this suggests that it may have been even stronger with a more solid import/export foundation. (RBA 2003)
World Commodity Prices
World commodity prices are determined by the market conditions of demand and supply on a global level. For example, if nuclear war was to break out worldwide and global demand for gas masks increased, the world price for gas masks would increase too, relative to the increase in demand. Similarly, if world supply of a particular good increases, its world price would decrease. (Alcorn 2003)
Contrary to what one might expect, fluctuations in world commodity prices can have great influence of the Australian exchange rate. Because Australia is a nation that specialises very much in the agricultural sector of its economy, a fall in world commodity prices for rural commodities would adversely affect our economy. This would occur because rural commodities form the bulk of Australia’s exports, and would result in a depreciation of the AUD. (Alcorn 2003)
Over the past 3 years, commodity prices have taken a bit of a tumble. World commodity prices have slumped somewhat in general, but have, in some individual aspects, grown. Whilst world commodity prices of base metals (another of Australia’s major exports) have decreased slightly over the past 3 years, this decrease has been offset by a slight increase in the world prices of rural goods. Whilst even these prices have dropped recently, the general trend over the past 3 years has been upward moving, and has been very positive for both the Australian economy (through greater economic growth as a result of more valuable exports) and the Australian exchange rate. (RBA 2003)
Level of Economic Activity
Increased level of economic activity within Australia’s borders has the result of increasing demand for imports. This occurs as a result of increased consumption spending and to provide essential producer requirements for expanding sectors of the Australian economy. An increase in the level of imports will, as already explained, lead to a desire to purchase foreign currencies, causing an influx of AUDs on the international currency market – this increase in supply will, in turn, lower the value of the AUD. Reduced economic activity, however, has the opposite effect, dampening the demand for imports, thereby assisting in strengthening the AUD. (Alcorn 2003)
Similarly, the level of Australian exports is dependent on demand abroad. For example, increased economic activity in America may entice American consumers to purchase more Australian exports, thus raising the amount of Australian exports. Likewise, a slowing down of foreign economies will decrease the demand for Australian export items, having a negative effect on our exchange rate. (Alcorn 2003)
In Australia, over the past 2 years, we have seen a sharp decline in real GDP (gross domestic product) which can be attributed in part to one of the worst droughts Australia has seen in many years. This decrease in economic growth has led to a strengthening in the AUD, and has offset fears that low foreign growth rates will cause a sharp decrease in Australian exports, and hence the AUD. (RBA 2003)
Australia’s Inflation Rate
A nation’s (Australia’s) rate of inflation in relation to other nations’ inflation rates is a vital consideration in determining the value of that nation’s currency. If, for example, Australia’s interest is much higher than that of its trading partners, this will reduce the competitiveness of the Australian economy in the international marketplace. As a result of a higher CPI and hence relatively high prices, demand for Australian exports will be reduced. This will, again, decrease demand for and the value of the AUD. Over and above this, higher domestic prices will force consumers to seek commodity substitutes, which will, in many cases, be imports. A double-whammy effect can therefore be noted, as not only will demand for Australian exports decrease, but foreign imports will increase as well. This has the effect of both lowering demand for the AUD whilst increase the supply of it – not a very positive situation. (Alcorn’s Notes 2003)
Unfortunately, the situation mentioned above is the very grim situation facing Australian economists even to this day. At present point, Australian interest rates sit well above their trading partners, at around 4.75%. Other major countries around the world have the following, comparatively lower interest rates:
United Kingdom 3.75%
Canada 3.25%
European Union 2.5%
United States 1.25%
Clearly, Australia’s high interest rate leaves something to be desired in comparison to these other first world interest rates. One can hardly expect Australia to be competitive with America with an interest rate almost 4 times as large as it. This is, without a doubt, the most weakening factor of the Australian economy, and is the greatest threat to its exchange rate at present. (RBA 2003)