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What is an exchange rate? What factors determine the exchange rate for the Australian dollar?

An exchange rate is the ratio at which a country’s currency exchanges for the currency of another country. Exchange rates are typically expressed as the foreign currency equivalent of one unit of domestic currency. The exchange rate between Australia and the United States for example was $A1.00 = $US0. , (as of 2.12.99). The exchange rate is determined by the demand for, and supply of, that currency in terms of other currencies.

The major trading countries of the world use a system of floating exchange rates. Under this system, exchange rates are determined by the free market forces of supply and demand. In other words, the rate moves freely in response to competitive market forces. Demand and supply are determined in terms of overseas currencies. Those who have foreign currency and want to buy dollars with it provide the demand for Australian dollars. These include overseas people who want to buy our exports, tourists coming here, overseas people wanting to lend money here, or buy shares or property here, overseas firms setting up branches here or expanding them, and those who pay us for various services, such as repay loans. Those who have Australian dollars and want to use them to buy foreign currencies provide the supply of Australia dollars. These include Australians who want to buy imports from overseas, Australian tourists going overseas, Australian banks and firms lending or investing money overseas, and Australians paying for various services from overseas, repaying loans and paying interest on loans.

There are a number of factors influencing the demand for Australia’s exports. Relative inflation rates are just one factor. To be competitive on international markets, a country’s exports must be at least as cheap as the same goods and services supplied by producers in other nations. Any change in domestic prices relative to those in other countries will alter the international competitiveness of local industries. If Australia experiences high inflation rates relative to other nations, exports will become more expensive and therefore less competitive. A currency depreciation occurs as the demand for the Australian dollar falls. An appreciation of Australia’s currency, will occur similarly if Australia has low inflation rates in comparison to other countries..

Changes in relative incomes also influence demand as the volume of imported goods purchased by consumers tends to vary directly with their level of income. As income levels increase, consumer demand for imported goods rises; and as income levels fall, consumer demand for imported goods decreases. Rising income levels in other countries relative to those in Australia cause an increase in demand for our exports and, thus and appreciation of the Australian dollar. The opposite occurs with a fall in other incomes.

Consumer preferences and tastes change over time. Naturally, any change in the preferences of overseas consumers for our exports affects our exchange rate. If overseas consumers preferences change in favour of Australian-made goods, then demand for our currency to pay for these goods increases. This, in turn, causes an appreciation of the Australian dollar, and vice-versa in preferences change against Australian.

Australia is host to much foreign investment. Any increase in capital inflow means an increase in the demand for Australian dollars and a currency appreciation, and a decrease would result in a depreciation. There are a number of factors affecting the volume of capital inflow into Australia. Firstly, the level of real interest rates in Australia relative to those in other countries is an important consideration to investors. An increase in real interest rates in Australia makes investment more attractive, but a fall will have the reverse effect. Secondly, the level of confidence in the Australian economy influences investment decisions by overseas investors. Lack of confidence in the Australian economy or pessimistic predictions as to its performance increase the perceived risk of investing here while optimism regarding the future direction of economic activity in Australia raises the expectations of overseas investors. These will lead to either a depreciation, or an appreciation in currency.

Speculation on foreign exchange markets occurs when currencies are bought and sold for the sole purpose of making a profit. Most speculation is based on expectations regarding the relative movements of exchange rates. Speculators base their forecasts on anything that affects the value of currencies – the performance of the current account, the signing of trade agreements, government economic policy decisions, political events, rumours, wars, and so on. This too make appreciate or depreciate Australia’s currency.

The supply of Australian dollars on foreign exchange markets depends primarily on the economic activities of Australian residents. Just as foreigners must pay for our exports with Australian dollars, we must use the relevant foreign currency to pay for imported goods. An increase in demand for imported goods by Australian consumers adds to the supply of Australian dollars, and the currency depreciates. On the other hand, a fall in demand for imported goods reduces the supply of Australian dollars, causing a currency appreciation.

High inflation rates in Australia relative to those of our major trading partners mean that imported goods are cheaper than domestically produced goods. As Australian consumers switch their demand from local goods to imports, the supply of Australian dollars increases and the currency depreciates. The reverse occurs with low inflation rates. A rise in the level of income in Australia relative to those in other countries leads to an increase in the demand for imported goods. A currency depreciation occurs as the supply of Australian dollars rises. On the other hand, a fall will result in a currency appreciation. As consumer preferences change in favour of foreign goods and services, the demand for imports increases. The supply of Australian dollars on foreign exchange markets also increases and the currency depreciates.

Capital outflow from Australia increases the supply of Australian dollars on foreign exchange markets as investors sell our currency to obtain the currency of the host nation. Any increase in capital outflow adds to the supply of Australian dollars, causing a currency depreciation, while a decrease in the level of capital outflow reduces the supply of Australian dollars and leads to a currency appreciation.

The value of the Australian dollar falls when speculators expect a future depreciation of our currency. As speculators sell their Australian dollars to avoid future losses, the present supply of our currency rises. The increase in supply causes the Australian currency to depreciate. The reverse occurs when the value of the Australian dollar is expected to increase in the future. In this case, speculators will hold their Australian dollars, effectively decreasing the supply, and causing the currency to appreciate.

As the forces affecting the value of our dollar are more dependent on profit and investment prospects than it is on our basic trade situation, our exchange rate is unstable. This affects the decisions of exporters and importers. From the point of view of our current account, our exchange rate has in some periods been too high and too unstable.

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