Understanding Foreign Exchange Rate and its Determinants: An Analysis of AUD/USD Exchange Rate

This article provides an analysis of the AUD/USD exchange rate, its determinants, and the impact of currency depreciation on the Australian economy. It also suggests policies that can be implemented to stabilize the exchange rate. The article explains the supply and demand model of foreign exchange rate and highlights the essential influencers of the AUD/USD exchange rate. It also discusses the impact of nominal exchange rate and trade-weighted index on the economy. The article concludes that the recent appreciation of the AUD is not sustainable and suggests policies to stabilize the exchange rate.

Running head: ECONOMICS ASSIGNMENT
Economics assignment
Name of the student:
Name of the University:
Author note

1ECONOMICS ASSIGNMENT
Table of Contents
Answer a:.........................................................................................................................................2
Answer b:.........................................................................................................................................3
Answer c:.........................................................................................................................................5
Answer d:.........................................................................................................................................7
Answer e:.........................................................................................................................................8
Reference:......................................................................................................................................11

2ECONOMICS ASSIGNMENT
Answer a:
With rise in the international trade, economies around the world are indulging itself into
higher amount of trade. With rise in the international trade, it has become essential for the
economies to calculate the value of their currency with respect to their currency. Foreign
exchange rate of a nation refers to the monetary valuation of the country’s domestic currency
with respect to the other currency value of other nation (Edwards 2015). Predicting foreign
exchange rate is hard, however utilising simple supply and demand model, it can easily be
explained.
Figure 1: Exchange rate determination with supply and demand model
Source: (Created by Author)
Considering the figure 1, it can be seen that there is demand and supply curve, which are
being drawn depending upon the perceived demand of the AUD and the aggregate supply of
AUD respectively (McNamara et al. 2016). Initial equilibrium occurs at point E, where the

3ECONOMICS ASSIGNMENT
exchange rate is Ex0 and the demand of AUD is Q0. Now, if there is rise in the demand of the
AUD in US market, then it will shift the demand curve from D0 to D1 and the new equilibrium
occurs at E1, where the exchange rate is EX1 and demand of AUD is Q1. On the other hand if the
demand of AUD falls from Q0 to Q2, then it will shift the demand curve to D2, position causing
newer equilibrium at E2, where the exchange rate is EX2. Thus through demand and supply
model, exchange rate can easily get determined.
Now, considering this it can be said that supply and demand model of foreign exchange
can easily explain the various factor that affect the AUD in the foreign exchange market.
Following are the essential influencer of the AUD/USD exchange rate:
Interest rate – change in interest rate will change the foreign investment, which can alter
the demand of AUD (Johnson 2017). With change in demand of AUD, exchange rate of
AUD/USD will also change.
Inflation – higher inflation can lead to depreciation of the AUD/USD exchange rate and
the lower inflation can cause better investment prospect leading to currency appreciation
on behalf of the AUD (Guofeng 2015).
Government policies – if government takes expansionary fiscal or monetary policy or if
it can take export promotion polices along with import substitution, then it will help to
influence the demand of the AUD, leading to appreciation of the AUD in terms of USD
(Melvin and Norrbin 2017).
Answer b:
Nominal exchange rate is the number of domestic currency required to attain one unit of
foreign currency (Eichenbaum et al. 2017). According to the same source, with rise in nominal
exchange rate of a domestic currency, purchasing power of the domestic population gets

4ECONOMICS ASSIGNMENT
enhanced and if there is deterioration of the nominal exchange rate, then it will lead to fall in the
purchasing power for the domestic population. On the other hand Trade Weighted Index
measures the material rate of exchange depending upon the weighted average to the domestic
trading with the foreign nation (Amiti et al. 2016). Higher TWI means, better trade has been
participated between the two nations and a lower TWI apprehended that trading was not good
and limited in nature (Nguyen 2016).
Figure 2: Nominal exchange rate of Australia
Source: (Reserve Bank of A0.ustralia 2018)
Considering the figure 2, it can be seen that there has been various flucutations in the
Austrlain market over the from 2015 to 2017. During the last three years, nominal exhange rate
of AUD was highest during May of 2015 and a second peak can be observed during the
September of 2017. These rise in the nominal exhcnage rate higjlights that AUD has been
substantially stron during these periods due to various reasons. However, during 2015, nominal
exhcnage rate fell to its lowest point due to the recession in the US market and since then it has
been rising upward (Mian and Sufi 2015).

5ECONOMICS ASSIGNMENT
Figure 3: TWI of Australia
Source: (Reserve Bank of Australia 2018)
Considering the figure TWI of the AUD can be perceived. From the figure it can be seen
that AUD/USD conversion reached its highest point during 2015 May and in September 2017,
highlighting good trading proposition between two countries. However, owing to inflation in the
US market, TWI fell to its lowest point during September of 2015 and since then it has been
rising towards as sustainable position, highlighting better AU-US trade prospect in future (Fabre
2016).
Answer c:
Given article highlights that there are various reasons that have been causing the rise in
AUD compared to the USD, however it will not last long. The editor highlights that one of the
major reason AUD appreciation is the recent slump in the USD due to the recession in the US
market back in 2015. The article points out that in addition to the slump in US market, rise in the
iron export in the US market from Australia has been facilitating the domestic economy to have
better trade balance leading to exchange rate higher than the 80C USD for each AUD (Ismail
2018) . Additionally it has also pointed out that widening gap of the US and Australian interest

6ECONOMICS ASSIGNMENT
rate is another driving force that has been leading to better situation for the AUD with respect to
the USD. As the interest rate of the US is lower than the Australian interest rate, domestic market
is attracting higher number of foreign investor leading to appreciation to their AUD (Summers
2014).
However, the same article asserts that this sudden rise in the AUD with respect to the
USD is not sustainable in nature. One of the major reasons for asserting this is recent trend of the
Chinese export to the US market. With rise in Chinese aggression in iron ore market in the US;
Austrian market is yet to face depreciation of their currency (Brown 2015). In addition to this,
the article highlights that Fed has recently raised their interest rate and once the US interest rate
surpass the Australian interest rate, the boom in the foreign investment will be gone. Thus to
conclude, the article stated that, Australian dollar’s recent appreciation is not sustainable, it’s just
the outcome of the weakening USD (Ismail 2018).
Figure 4: AUD/USD exchange rate dynamics through supply and demand model
Source: (Created by Author)

7ECONOMICS ASSIGNMENT
Now, if the present AUD situation has to be described through the demand and supply
framework, then it is important to consider the figure 4. From figure 4, it can be seen that present
equilibrium in exchange rate market occurs at point E, where the exchange rate is 80C USD with
respect to the each unit of AUD. Now if there is rise in exports from the Australian market to the
US, then it will lead to rise in the demand of the AUD, leading to shifting of the demand curve
from D to D1 (Stockhammer 2015). It will cause a currency appreciation for the AUD and the
exchange rate will be as high as 81C USD for every unit of AUD. However, as the given article
portray, there will be fall in export of the Australian market and the fall in interest gap will lead
to lower the foreign investment, which in turn will shift the demand curve of AUD from D to D2.
At new position of the AUD demand curve, equilibrium occurs at point E2, where the exchange
rate is as low as 77C USD for each unit of AUD or it can be worse. Thus with demand and
supply framework, present situation of the Australian market can easily get explained
(Armstrong et al. 2014).
Answer d:
Considering the given condition that from one year now AUD can get depreciated to 70C
USD for each unit of AUD from the present situation of 80C USD with respect to each unit of
AUD, then the condition will not be good for the importing firm. From the perspective of the
importing firm that import electrical machinery from US, it will face enhanced cost of
importable. With higher cost of importable, the importer will enhance their selling cost, leading
to a fall in the demand of the importable (Halpern et al. 2015). If there is fall in demand, then to
keep the profit same, the importer will again enhance its price or it can reduce the price. If the
importer enhances the price, then it will face additional drop in demand of the importable, and on
the other hand if the importer reduce the price, then it will have be able to cover only the fixed

8ECONOMICS ASSIGNMENT
cost of its business. Over the time, if the situation remains persistent, then being the manager of
the firm, it can be said that the firm will face loss and eventually it will exit the market. On other
hand, according to general economic theory, if there is currency depreciation, then it will aid the
economy to have higher foreign demand of their goods and services (Mbogo 2015). Considering
the Australian case of currency depreciation, it can be stated that with lowered price of the
foreign goods and services, US citizens will demand Australian goods and services in more
amount. This rise in demand will lead the demand of AUD to a better position, leading to higher
Balance of Trade compared to the present situation (Gabaix and Maggiori 2015). In addition to
this, once the AUD gets depreciated, then it will lead to fall in demand of the importable in
domestic market, which in turn will again lead the trade balance of the country to enhance. Thus
being the manager of the importing firm it can be stated that currency depreciation will be
costlier for the importing firm; however it will bring in positive result for the overall Australian
economy.
Answer e:
Considering the given condition, that Australian exchange rate stabilise at 72C USD
against each Australian dollar, if government of Australia wants to bring it back to the desired
80C USD for each USD, then monetary authority has to take necessary policies. In order to
gauge the present situation, currency appreciation is required, which needs the following policies
to be implemented:
Enhancing interest rate – interest rate is one of the key instruments that can lead to
currency appreciation or depreciation. If the Reserve Bank of Australia enhances the
interest rate, it will attract more foreign investor from US (Gantz 2016). With better

9ECONOMICS ASSIGNMENT
investment prospect demand of AUD will rise it will lead the domestic currency to get
appreciated.
Reducing inflation – Reducing inflation can act as the effective stimuli to the Australian
dollar to get appreciated. With reducing price level, there will be higher aggregate
demand, which will lead to higher requirement for the domestic currency. With higher
demand AUD will have appreciation and lead it to desired position.
Buying back AUD –If the Australian government buy back their own currency, and sell
foreign exchange in order to enhance the value of their domestic currency, then it will
lead the demand of AUD to a higher situation (Calomiris et al. 2016). With demand
raising higher, Australian dollar will become costlier with respect to the USD.
Though it is good to see that through aforementioned policies government of Australia
can easily bring back the deteriorating AUD from 72C USD to 80C USD, however, when it
comes to reasonability of these policies then it is subjective. Currency appreciation has both the
positive and dark side, because it can lead to better trade balance, and on the other hand dry up
the liquidity in the market leading to fall in aggregate demand. For instance, if the government of
Australia enhance the interest rate, then it will attract more amount of domestic investment too,
apart from the foreign investment. With higher amount of domestic investment, there will be fall
in the liquidity in the market and the aggregate demand will also tends to fall. With fall in
aggregate demand market will face inflation again. Additionally, if domestic currency gets
appreciated, then it will lead to higher import, while crowding out the positive effect of currency
appreciation. Australia and US is under AUSFTS act, thus it cannot imply import quota (Hofman
et al. 2016). The only way to deal with the rising import due to currency appreciation is the

10ECONOMICS ASSIGNMENT
import substitution, for which technological enhancement, R&D is required that will need
another additional cost.

11ECONOMICS ASSIGNMENT
Reference:
Amiti, M., Itskhoki, O. and Konings, J., 2016. International shocks and domestic prices: how
large are strategic complementarities? (No. w22119). National Bureau of Economic Research.
Armstrong, G., Adam, S., Denize, S. and Kotler, P., 2014. Principles of marketing. Pearson
Australia.
Brown, B., 2015. A Guide to Surviving the Plague of Market Irrationality. In A Global Monetary
Plague (pp. 197-228). Palgrave Macmillan, London.
Calomiris, C.W., Flandreau, M. and Laeven, L., 2016. Political foundations of the lender of last
resort: A global historical narrative. Journal of Financial Intermediation, 28, pp.48-65.
Edwards, S., 2015. Monetary policy independence under flexible exchange rates: an
illusion?. The World Economy, 38(5), pp.773-787.
Eichenbaum, M., Johannsen, B.K. and Rebelo, S., 2017. Monetary policy and the predictability
of nominal exchange rates (No. w23158). National Bureau of Economic Research.
Fabre, G., 2016. The Twilight of ‘Chimerica’? China and the Collapse of the American Model.
In Current Issues in Economic Integration (pp. 69-90). Routledge.
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
Chapters: US Approaches Under NAFTA, the AUSFTA and the TPP.
Guofeng, S., 2015. Foreign Exchange Market. In Financial Reforms in Modern China (pp. 133-
175). Palgrave Macmillan, New York.
Halpern, L., Koren, M. and Szeidl, A., 2015. Imported inputs and productivity. American
Economic Review, 105(12), pp.3660-3703.

12ECONOMICS ASSIGNMENT
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
Morning Herald. Available at: https://www.smh.com.au/business/investments/australian-dollar-
tipped-to-slide-back-to-70-us-cents-20180129-h0pp8v.html [Accessed 26 Mar. 2018].
Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.
Mbogo, M.M., 2015. The effect of currency depreciation on financial performance: a study of
manufacturing and allied companies listed on the Nairobi Securities Exchange (Doctoral
dissertation, United States International University Africa).
McNamara, J., Rowcliffe, M., Cowlishaw, G., Alexander, J.S., Ntiamoa-Baidu, Y., Brenya, A.
and Milner-Gulland, E.J., 2016. Characterising wildlife trade market supply-demand
dynamics. PloS one, 11(9), p.e0162972.
Melvin, M. and Norrbin, S., 2017. International money and finance. Academic Press.
Mian, A. and Sufi, A., 2015. House of debt: How they (and you) caused the Great Recession,
and how we can prevent it from happening again. University of Chicago Press.
Nguyen, L., 2016. Should the Reserve Bank worry about the exchange rate?.
Reserve Bank of Australia. (2018). Historical Data | RBA. [online] Available at:
http://www.rba.gov.au/statistics/historical-data.html#exchange-rates [Accessed 3 Mar. 2018].
Stockhammer, E., 2015. Rising inequality as a cause of the present crisis. Cambridge Journal of
Economics, 39(3), pp.935-958.
Summers, L.H., 2014. US economic prospects: Secular stagnation, hysteresis, and the zero lower
bound. Business Economics, 49(2), pp.65-73.