An Analysis of Exchange Rates and Trade

The assignment provides an overview of existing research on exchange rate dynamics and its impact on trade. It includes a list of relevant papers and articles, covering topics such as the sensitivity of Australian trade to exchange rates, monetary policy and exchange rate predictability, and the effect of currency depreciation on financial performance.

Running head: ECONOMICS FOR PROFESSIONALS
Economics for professionals
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Table of Contents
Answer a:.........................................................................................................................................2
Answer b:.........................................................................................................................................4
Answer c:.........................................................................................................................................6
Answer d:.........................................................................................................................................8
Answer e:.........................................................................................................................................9
Reference:......................................................................................................................................11

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Answer a:
21st century is the era of internationalisation, where countries are getting attached with
each other for mutual economic development (Altback and Wit 2015). For instance, Australia
being one of the developed nations performs substantial amount of trade with the countries like
UK, US and others (Cooper 2014). In order to shape the economy of the nations, international
trade, plays an important role through determining the level of future growth. Exchange rate, on
the other hand being the comparative value of domestic currency against the foreign currency
takes a vital role in order to determine the flow of international trade. When it comes to
Australia, then it can be seen that the country has a moderate exchange rate compared to the US
dollar that makes it one of the stable economy in the world(Gabaix and Maggiori 2015).
Determining the exchange rate is one of the toughest jobs due to eve evolving market
scenario, however, over the period researchers has came with various solution (Corazza and
Malliaris 2015). Among many, supply and demand framework can be considered as the simplest
yet effect tool to determine the foreign exchange rate market. (Gilpin 2016) According to the
given requirement for this task, below is the analysis of Australia – US exchange rate through
supply and demand framework as shown in figure 1:
The figure below highlights the demand and supply framework of Australian exchange
rate, where the demand curve “D” is drawn, which is based on the derived demand of the
Australian goods and services. On the other hand Supply curve “S” in figure 1, has been drawn
considering the importable aggregate demand (Caballero, Farhi and Gourinchas 2016). Let the
initial equilibrium takes place at point E, where the AUD/USD exchange rate is 80C USD
against every unit of AUD and the AUD demand is Q. Now if there is rise in the demand of the
AUD to the US citizens, then it will shift the demand curve D to rightward D1 position. At D1,

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equilibrium occurs at E1, where the AUDUSD is hypothetically as high as 81C USD for each
unit of AUD. On the flip side, if there is fall in the demand of AUD to the US citizens, then it
will lead to fall in demand from D to D2. At the new demand situation, equilibrium occurs at E2,
where AUD hypothetically fell to 77C USD for each unit of AUD. Thus, depending upon the
demand and supply framework, AUD/USD exchange can easily be explained as well the factors
that can alter the same (Jammazi et al. 2015)
Figure 1: determination of exchange rate through supply and demand model
Source: (Created by Author)
Considering the explanation of foreign exchange rate scenario of the Australia – US
trade, it can be stated that Australia is one of the developed nations that follows the flexible
market system (Wiedmann et al. 2015). Under various circumstances foreign exchange of
Australia can get altered and supply and demand can point those factors easily. Factors that can
lead to the fluctuation in the Australian dollar are as follows:

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 Inflation rate – with rise in inflation rate, there will be reduction in the demand of
Australian dollar to the US citizen. Lowered demand will lead to fall in exchange rate on
behalf of the Australia and it will cause depreciation of the Australian currency (Weale et
al. 2015).
 Interest rate – with change in the interest rate, there will be change in the foreign
investment in the Australian bank, which in turn can lead to alteration in the foreign
exchange of the Australian dollar. If the interest rate gets higher, then it would cost rise
in exchange rate of AUD in terms of USD (Engel 2014). On the other hand a fall in
interest rate will lead to depreciation of the AUD in terms of the USD.
 Growth rate – with better gross prospect Australia can have their AUD appreciated in
terms of the USD. Better growth will lead to rise in capability and stability of the nation
and it will reflect on the US investor’s mind too. With better growth prospect, Australia
can provide a positive outlook on the foreign investors, which will inherently appreciate
the AUD.
Answer b:
Nominal exchange rate can be acknowledged as the domestic currency number needed
have a unit of foreign currency (Eichenbaum et al. 2017). If there is rise in nominal exchange
rate, then it will lead to nominal depreciation and if there is fall then it will be nominal
appreciation. Trade Weighted Index (TWI) on the other hand is one of the the multilateral
exchange rate calculated through weighted average to domestic currency and foreign currencies
utilising the average trade values between two countries (Caselli et al. 2015).

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Figure 2: Nominal Exchange Rate
Source: (Reserve Bank of Australia, 2018)
Nominal exchange rate of figure 2 highlights the real AUDUSD exchange rate scenario.
From the diagram it can be seen that there has been various ups and down in the nominal
exchange rate between the two countries. AUDUSD nominal exchange rate hit its lowest during
mid of 2015 due to recession in the US market (Jung and Kuester 2015). And next to this,
nominal exchange rate of Australia has been trying hard to stabilise itself. From the upward
sloping nominal exchange rate line it can be said that, present rise in iron ore demand and slump
in the USD is leading the AUD to rise.

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Figure 3: Trade Weighted Index
Source: (Reserve Bank of Australia, 2018)
Figure 3, highlights the TWI of the Australia that highlights over the time there has been
various fluctuations caused by the alteration in trade between two countries. During September
of the 2015, there has been lowest amount of trade between the Australia and US due to
recession in the US market and since then the trade has been rising between these two countries
(Deutsch 2015. Post recession of 2015, it can be seen that there has been a rise in the TWI and
presently with higher trade value between two countries TWI is tending towards a better future,
highlighted by upward sloping TWI in the figure 3.
Answer c:
Given article highlights various driving forces that can alter the AUD exchange rate in
terms of the USD. The article initially highlights that there is rise in the AUD in terms of the
USD, due to the recent slump in the USD (Ismail 2018). In addition to this recent rise in the
export of the Australian tech metals has enhanced the country’s exchange rate in terms of the
USD, however, once the mining boom is over and the USD get back to its strong position, then

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AUD will again slit back to the 70C bracket. In addition to this, the article has highlighted that
Australian mining market is facing boom, however soon Chinese iron industry boom will
constrain the same leading to fall in the AUD in terms of the USD (Gauvin and Rebillard 2015).
The report additionally highlighted that there is fall in the Fed rate, which is causing a reduction
in the investment in US banks, and a rise in investment of the Australian banks. Once the Fed
starts to raise the interest rate, it will dry up the AUDUSD exchange rate again, as asserted by the
given report.
Figure 4: Supply and demand diagram of AUD/USD
Source: (Created by author)
Considering the figure 4, it can be seen that hypothetically Australian exchange rate
demand and supply comes at equilibrium at point E, where the exchange rate is Ex and the
quantity demanded of the AUD is Q. Now if there is rise in interest rate or country face growth
due to expansionary fiscal policy, then it will lead to higher AUD demand to the US citizens.

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Higher demand will shift the initial demand curve D to D1 leading to rise in exchange rate from
Ex to Ex1. On the other hand, if the AUD gets depreciated in terms of the USD, then it will lead
to fall in the demand of the AUD, shown in the diagram by D2. At D2 demand curve, equilibrium
occurs at E2 point, where the exchange rate is Ex2. So, it is clear that factor explained in the given
article can easily be explained with the demand and supply framework of exchange rate
(Feenstra 2015).
Answer d:
If there is depreciation of one currency in terms of the other currency, then has both the
positive and dark side. For instance, if there is depreciation of the domestic currency in terms of
the foreign currency, then it would lead to better export for the domestic country (Cole and
Nightingale 2016). With lower price of the domestic goods and services, foreign individuals will
prefer to opt them at higher quantity, which in turn will lead to rise in the export and enhanced
Balance of Payment for the country (Gabaix and Maggiori 2015). On the other hand, domestic
investors or importer will face loss because there importable of buyable will become costlier
with depreciation of the domestic currency with respect to the foreign currency. Considering this
general economic framework of depreciation of domestic currency, being the manager of the
firm that import electrical machinery, it can be said that the firm will face loss. With AUD
became depreciated in terms of the USD, firm’s importable will become costlier, which will lead
them to rise price. With higher price demand will fall, which will force them to price rise again
(Mbogo 2015). The cycle will continue until there is equilibrium in demand and supply situation
takes place for the importable. Whatever the equilibrium is, with lower AUD in terms of USD,
importer will face loss and on the other hand here will be rise in export. Higher export will

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enhance the Australian balance of payment, which will ultimately lead to better off to the
Australian economy.
Answer e:
If the Australian dollar stabilise around 72C USD for each AUD, then various corrective
measure can be taken by the Australian reserve bank to bring the AUD back to the 80C mark.
Australian economy is growing at a stable 6.9% annual growth rate, however recent reduction in
the Australian iron ore demand is leading to fall in the AUD in terms of the USD (Weale et al.
2015). This has effectively reduced the AUD exchange rate because Australian mining sector
provide a substantial part to its GDP. In addition to this, it has been seen from the given article,
there is a widening gap in Australian and US interest rate (Ismail 2018). With interest
augmentation of the Fed by US, Australia can soon loss some amount of foreign investment,
which will lead to fall in AUD exchange rate (Hofman et al. 2016). Thus as the corrective
measurement to bring he AUD to 80C USD, Australian government need to utilise the tech
metals export boom and additionally go for the export promotion. It will constrain the Chinese
iron ore boom and help the Australian iron ore to insert into the US market . Next to this,
Reserve Bank of Australia needs to enhance the interest rate, which will lead to rise in AUD
through higher foreign investment.
Above mentioned steps can certainly bring in the AUD to its desired position, however
when it comes to the reasonability of the policies, then it is subjective in nature. As mentioned by
the Gantz (2016), there is both good and bad side of domestic currency appreciation in terms of
the foreign currency. For instance, if the AUD gets appreciated, then it will lead to rise in the
import, which in turn will cause a reduction in Balance of Payments of the country. Moreover,
Australia under the AUSFTA pact cannot bring in import substitution to gauge the rise in import

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from the US. In addition to this if the Reserve Bank of Australia takes steps to enhance the
interest rate, then it will lead to fall in market liquidity, which will further escalate into reduced
demand (Bramble 2015). Thus, it is highly questionable, that whether the aforementioned
strategies can be a reasonable economic policy or not. However, if the Australian government
can take corrective measure in the form of import substitution, technology generation and export
promotion, then it will certainly make the above mentioned strategies an effective policy for
appreciating the AUD in terms of the USD.

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Reference:
Altbach, P.G. and De Wit, H., 2015. Internationalization and global tension: Lessons from
history. Journal of studies in international education, 19(1), pp.4-10.
Bramble, T., 2015. The Australian economy after the mining boom. Red Flag.
Caballero, R.J., Farhi, E. and Gourinchas, P.O., 2016. Safe asset scarcity and aggregate
demand. American Economic Review, 106(5), pp.513-18.
Caselli, F., Koren, M., Lisicky, M. and Tenreyro, S., 2015. Diversification through trade (No.
w21498). National Bureau of Economic Research.
Cole, D. and Nightingale, S., 2016. Sensitivity of Australian trade to the exchange rate. Reserve
Bank of Australia Bulletin, pp.13-20.
Cooper, R.N., 2014. Exchange rate choices.
Corazza, M. and Malliaris, A.T.G., 2015. Multi-fractality in foreign currency markets.
Deutsch, K.W., 2015. Political Community and the North American Area. Princeton University
Press.
Eichenbaum, M., Johannsen, B.K. and Rebelo, S., 2017. Monetary policy and the predictability
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Eichenbaum, M., Johannsen, B.K. and Rebelo, S., 2017. Monetary policy and the predictability
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Engel, C., 2014. Exchange rates and interest parity. In Handbook of international
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Fernandes, K. (2017). Macroeconomic Factors Causing Variations in the Exchange Rate of the
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Gabaix, X. and Maggiori, M., 2015. International liquidity and exchange rate dynamics. The
Quarterly Journal of Economics, 130(3), pp.1369-1420.
Gantz, D.A., 2016. Increasing the Host State's Regulatory Flexibility Under FTA Investment
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Gauvin, L. and Rebillard, C., 2015. Towards Recoupling? Assessing the Global Impact of a
Chinese Hard Landing Through Trade and Commodity Price Channels.
Gilpin, R., 2016. The political economy of international relations. Princeton University Press.
Hofmann, B., Shim, I. and Shin, H., 2016. Sovereign yields and the risk-taking channel of
currency appreciation.
Ismail, N. (2018). Australian dollar tipped to slide back to 70 US cents. [online] The Sydney
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tipped-to-slide-back-to-70-us-cents-20180129-h0pp8v.html [Accessed 26 Mar. 2018].
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Wiedmann, T.O., Schandl, H., Lenzen, M., Moran, D., Suh, S., West, J. and Kanemoto, K.,
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