Economics Report: Analysis of Exchange Rate Fluctuations and Policies

This report examines the factors influencing the Australian dollar's exchange rate, including trade flows, capital flows, and interest rate differentials. It analyzes the movement of the trade-weighted index and the nominal exchange rate, highlighting the impact of the United States as a major trading partner. The report discusses the recent fluctuations of the Australian dollar, considering factors such as interest rate differentials, iron ore prices, and China's economic growth. It further explores the effects of currency depreciation on importers, exporters, and the overall economy, including the potential for inflation and wage growth. Finally, the report evaluates policy actions the Reserve Bank of Australia (RBA) could take to influence the currency's value, such as selling US assets, adjusting interest rates, and implementing anti-inflationary monetary policies, considering the potential impacts on economic growth and household debt.

Running Head: ECONOMICS FOR PROFESSIONALS
Economics for Professionals
Name of the Student
Name of the University
Author note

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Table of Contents
Answer a.....................................................................................................................................2
Answer b....................................................................................................................................4
Answer c.....................................................................................................................................5
Answer d....................................................................................................................................6
Answer e.....................................................................................................................................8
References................................................................................................................................10

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Answer a
Figure 1: Exchange rate determination in the forex market
(Source: as created by Author)
The forces of demand and supply of currency determine the price of Australian dollar
as against other currencies. DD curve shows the demand curve and SS curve shows the
supply curve. The equilibrium exchange rate is determined from intersection of the demand
and supply curve (Weale et al. 2015). The equilibrium point is E and the corresponding
exchange rate is P.
Factors influencing fluctuation of exchange rate
The demand supply condition in the forex market are related with macroeconomic
status of the nation and hence causes fluctuation in the exchange rate. These factors are as
follows
Trade flows

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Trade surplus defined as the excess of export over import increases the demand for
Australian dollar. This is because buyers in the overseas market demand Australian dollar to
purchase the export goods more. The increased demand pulls the exchange rate up. This
reflects a relatively weakening of currency. Opposite is the situation during a trade deficit.
That is when import exceeds export then there will be excess supply of Australian dollar
(Sarno 2016). The importers ill then required to supply Australian dollar in exchange of the
needed foreign currency to pay for the import. This creates a downward pressure and
exchange rate appreciates.
Flow of capital
Capital flow is a more important determinant of exchange rate. The investors,
financial institution, MNCs and rich individuals often transact more money than trade flows.
The capital flow depends on the interest rate differential among countries and hence influence
the movement of exchange rate.
Interest rate
Any change in the exchange rate influence the value of currency and exchange rate of
Australian dollar. A higher interest rate relative to other nations implies an increased demand
for country’s currency. This raise the relative strength of the currency.
Inflation rate
High inflation in the domestic market makes Australian exportable less competitive
by raising price of these goods. If this worsens current account balance, then there would be
depreciation of currency. With a small demand of export, import will become more price
attractive (Ramasamy and Abar 2015). This leads to a fall in demand for Australian dollar
and increase in dollar supply.

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Answer b
1-Jan-15
1-Mar-15
1-May-15
1-Jul-15
1-Sep-15
1-Nov-15
1-Jan-16
1-Mar-16
1-May-16
1-Jul-16
1-Sep-16
1-Nov-16
1-Jan-17
1-Mar-17
1-May-17
1-Jul-17
1-Sep-17
1-Nov-17
56
58
60
62
64
66
68
Trade Weighted Index
Figure 2: Movement of trade weighted index
(Source: quandl.com 2018)
The figure above shows movement of trade weighted index for Australia. The trade-weighted
index represents one form of effective exchange rate index. It is a weighted average of
multilateral exchange rate between domestic and foreign currency with weight being the
respective shares of each nation. Australia’s trade weighted index has declined from January
2015 to September 2015. This shows an appreciation of the overall exchange rate in
Australia. After that, the index has shown an upward trend in until January 2017. For the next
four months, the index again shows a downturn, and then it again increases and falls.

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1/1/2015
3/1/2015
5/1/2015
7/1/2015
9/1/2015
11/1/2015
1/1/2016
3/1/2016
5/1/2016
7/1/2016
9/1/2016
11/1/2016
1/1/2017
3/1/2017
5/1/2017
7/1/2017
9/1/2017
11/1/2017
0.6400
0.6600
0.6800
0.7000
0.7200
0.7400
0.7600
0.7800
0.8000
0.8200
Nominal Exchange rate
Figure 3: Movement of Nominal exchange rate
(Source: rba.gov.au 2018)
The nominal exchange rate between Australia and United State shows relative value
of Australian dollar against US dollar. The movement of nominal exchange rate is in almost
same as that of the trade weighted index. This is because United State is one of the major
trade partners of Australia. United State constitute accounts a higher trade share.
Consequently, in computation of trade-weighted index, United State has given a high
weightage (rba.gov.au 2018). This shows influence of United State in the exchange rate
determination of Australia. As a result, movement of these two indicators have a similar
pattern.
Answer c
The article summarizes recent movement of Australian dollar considering the possible
responsible factor behind fluctuation in the exchange rate. The Australian dollar has moved in
reverse. The interest rate differential is one factor that is pulling down the exchange rate. The
Federal Reserve is going on raising the interest rate while Reserve Bank of Australia has kept
the interest rate to a considerable low level in order to reduce the borrowing cost. The low

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interest rate has reduced the demand for Australian dollar as a mean of investment (Sarno
2016). The excess supply of Australian dollar is has driven down the value of the currency.
The AUD is likely to be exchanged at 70 US cents as against 80 cents in 12 months. The
rising price for iron ore have stimulated export outlook of Australia. However, the strength of
Australian dollar is not sustainable. The strong currency in medium term is not welcome in
Australia. There is possibility that RBA will leave the benchmark of keeping the interest rate
at the lower level of 1.5 percent because of debt burden followed by a stagnant wage growth.
The Australian dollar has climbed up to the highest level to 81.36 (smh.com.au 2018). The
strength of Australian’s dollar is not because of strength of domestic currency but because of
weakness of US dollar.
In the reversal show of exchange ratio, the most bearish group being open traders. The
payment to premium investors for selling Aussie against US dollar was approximately 50
basis point. It has recorded significant drop from the previous year’s value of 165 basis point.
Amundi Pioneer Asset Management that engages in overseas investment of around $US 88
billion also has undervalued Aussie. There are three likely factors responsible for Aussie
fluctuation –the declining prices of iron-ore, slow-down of china’s growth and widening
differential in interest favoring investment in United State. In Australia, return on 10 years
bonds over maturity Treasuries of with same tenure has declined to 23 basis point from 61
basis point (smh.com.au 2018). However, RBA is relatively reluctant and does not show
much care to pull up interest to strengthen currency.
Answer d
A change in US/AUD exchange rate from US 80C per AUD to US 70C per AUD
indicates a fall in relative price of AUD. The depreciation of Australian dollar with respect to
US dollar implies a weak position of AUD in the foreign exchange market. After currency

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depreciation, for every good imported from US to AUD, a higher price has to be paid. The
importers will be adversely effected from the weak currency position. The Australian firms
that imports electric machinery from US now faces a higher price for the imported
machinery. This in turn increase cost of the firm (Bruno and Shin 2016). The firm will try to
reduce its import demand from US as much as possible.
Under this situation, exporters will be benefitted. With depreciation of Australian
dollar, US residents now have to a pay a relatively lower price for Australian exports. This
raises the demand for Australian goods in the US market. The increases in export. A weak
currency may a prospective growth for the overall economy (Krugman 2014). With an
increase in export and fall in imports, net export balance is likely to improve. This increases
aggregate demand in the economy and leads to a higher price.
Figure 4: Effect of an increases in Aggregate demand
(Source: as created by Author)
Following a weak currency, there is an upward pressure on the price level both from
the demand side and cost side. The rise in aggregate demand tends to create a demand pull

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inflation while increase in import price by making imported raw materials more expensive
creates a cost push inflation (Chow et al. 2016).
As Australian export now becomes more competitive in the international market,
current account balance may improve with increase in export earnings (Bruno and Shin
2016). There is a possibility of wage growth in Australian economy following currency
depreciation. However, the real wage might fall because of a higher price level.
Answer e
An increase in AUD/USD exchange rate from US 72C per AUD to US 80C per AUD
involve the policy actions for currency evaluation by Reserve Bank of Australia. In order to
increase strength of a currency Reserve Bank of Australia can take the following policies
Sell US assets and buy own currency
One way to increase value of the currency is to sold the treasury bills of US holds by
Australian government in US and bring the proceed back to Australia. This will increase
supply of US dollar and demand for Australian dollar (Brzoza-Brzezina, Kolasa and
Makarski 2017). This in turn will cause a depreciation of US dollar and appreciation of
Australian dollar.
Interest rate
Currently RBA has set the interest rate to a relatively low level. An increase in
interest rate helps to strengthen the currency as investors have a high prospective return from
investment in the country.
Economic policies

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RBA should take anti-inflationary monetary policy to promote a relatively strong
currency. The anti-inflationary monetary policies include an increase in interest rate, cutting
down the money supply and other contractionary policies (Hofmann, Shim and Shin 2016).
Such policies though strengthen the currency value but in the long run, it adversely affects
growth of the nation. A high interest rate by increasing the cost of borrowing discourages
investment. A reduction in productive investment in turn causes a decline in growth rate. The
anti-inflationary measures again discourage production (Turner, 2014). Moreover, a relatively
strong currency reduces aggregate demand by lowering export and increasing export.
Whether currency evaluation is a reasonable economic policies or not that depend on
the state of macro-economic condition. Increase in interest rate is one policy to make
currency to evaluate. The economy where low interest rate leads to increasing debt of the
household, rising interest rate above the low benchmark can be a reasonable policy. For
example, the historically low interest rate in Australia has pushed up household debt
following a stagnant wage growth (Hofmann, Shim and Shin 2016). Additionally, low
interest rate has channeled most investment in the property market. Therefore, RBA at this
stage should increase its interest rate. However, this should be done up to a certain limit as
strong currency may adversely influence growth by lowering export and investment.

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References
Bruno, V. and Shin, H.S., 2016. Currency depreciation and emerging market corporate
distress.
Brzoza-Brzezina, M., Kolasa, M. and Makarski, K., 2017. Monetary and macroprudential
policy with foreign currency loans. Journal of Macroeconomics, 54, pp.352-372.
Chow, M.J.T., Jaumotte, M.F., Park, M.S.G. and Zhang, M.Y.S., 2016. Spillovers from
dollar appreciation. International Monetary Fund.
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 22 Mar. 2018].
Krugman, P., 2014. Currency regimes, capital flows, and crises. IMF Economic
Review, 62(4), pp.470-493.
Quandl.com. (2018). Quandl. [online] Available at:
https://www.quandl.com/data/RBA/FXRTWI-Australian-Dollar-Trade-weighted-Index
[Accessed 22 Mar. 2018].
Ramasamy, R. and Abar, S.K., 2015. Influence of macroeconomic variables on exchange
rates. Journal of economics, Business and Management, 3(2), pp.276-281.
Reserve Bank of Australia. (2018). Historical Data | RBA. [online] Available at:
https://www.rba.gov.au/statistics/historical-data.html [Accessed 22 Mar. 2018].
Sarno, L., 2016. Exchange rate economics. Institute for Capacity Development.

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Turner, P., 2014. The global long-term interest rate, financial risks and policy choices in
EMEs.
Weale, M., Blake, A., Christodoulakis, N., Meade, J.E. and Vines, D., 2015. Macroeconomic
policy: inflation, wealth and the exchange rate (Vol. 8). Routledge.