Question

1. EXCHANGE RATES: AUSTRALIAN DOLLAR (AUD) [15 marks]
   1. Consider the following hypothetical (separate) events from December 2020 to December 2021:

1. Speculators are seriously concerned about long-term effects on the Australian economy of the coronavirus.
2. India and China increase their demand for Australia’s metals such as iron ore and lithium.
3. US Federal Reserve lowers the US cash rate from 1.50% to 0.50%, while the Reserve Bank of Australia raises its cash rate from 0.50% to 1.00%.

For each event, identify the specific factor and explain the likely effect on the price of the Australian Dollar (AUD) in the foreign exchange market. Use a relevant demand and supply for AUD diagram in each of your answers.

                                                                                               [9 marks]

1. b.Suppose in Australia the AUD in 2020 strongly depreciated against major currencies. Is there likely to be a contractionary or expansionary effect on the Australian economy from the depreciation of the AUD? Explain your answer.

                                                                                               [3 marks]

c) Discuss the likely effects a large appreciation of the AUD would have on: (i) consumers travelling overseas; (ii) wheat exporters; (iii) import-competing Australian firms such as manufactures. [3 marks]

Answer 1

a) i) Now, one reason behind the demand of a country's currency on the foreign exchange market is the belief or the expectations/ speculations that the value of the currency is about to increase due to a favourable or growth in that country's economy. However, if it is the opposite case as here, that speculators feel covid will impact Australian economy in the long run in an adverse way, i.e. the value of its currency will fall or weaken in future. This will increase the supply of the currency in the foreign exchange market as investors will be more willing to give it up and demand for AUD will fall as investors will not be interested to invest in such a currency. A typical trait of the foreign exchange market that both the supply and demand forces move at the same time, causing the exchange rate or price of the currency to move in the same direction but the quantity to move in opposite directions. Take a look at fig 1.

ii) Now, this situation indicates that there is an increase in the demand for Australia's metals i.e. an increase in the demand for exports. This implies that there is a higher demand for the currency. So, there will be a rise in demand and a fall in supply as investors wont be willing to give it up. This will lead to an increase in the price of the currency (AUD) or appreciation in the foreign exchange market. Take a look at fig 2.

iii) Now, lowering the cash rate implies a lower rate of return for investors and increasing the cash rate implies a higher rate of return for investors. In this case, as the Reserve bank of Australia has increased its cash rate, the rate of return in the country look relatively high. This will tend to attract funds from overseas. Also, as rates of return look low in a country, like in this case, US, the funds tend to flee to other countries, in this case Australia. So, more investors will demand AUD so that they can purchase interest bearing assets and fewer investors will be ready to supply AUD to the foreign exchange market. So, the rightward shift of demand and leftward shift of supply will give way to a new equilibrium at a higher exchange rate i.e. price of Australian currrency at almost the same quantity as before. Take a look at fig 3.

b) Now, if AUD has been strongly depreciated against the major currencies, these will lead to expensive imports and cheaper/competitive exports for Australia. So, Australia will tend to export more than it imports as other countries will find it cheaper to import from Australia. This will cause a trade surplus which will exert an expansionary effect on the economy. This means that just because the currency of Australia is weak, their domestic goods appear cheaper to other countries so they buy more of Australian goods. This increases the demand for Australian goods which could increase money supply, profit, increase the GDP as well as employment in the Australian economy. So, it is an expansionary effect.

c) Now, if AUD is highly appreciated, there is the opposite effect. The stronger currency leads to lesser exports, more imports and a resulting trade deficit. i) For consumers travelling overseas, the prices of Australian goods and services will seem very high or expensive now. So, it will be an adverse impact on their expenditure and spending.

ii) There will be an adverse impact on the wheat exports. As the currency is stronger, domestic goods will appear to be more expensive to consumers in other countries and they will demand less of it, i.e. less wheat. This will lower the demand for Australian wheat, leading to lower income and profits for the wheat exporters.

iii) Now, for import-competing Australian firms, i.e, firms or an industry which competes with imports in an economy. So, for such firms, its bad news, as a strong AUD implies that imports become cheaper. So, people will tend to purchase cheaper imported goods rather than expensive domestic goods.