Principles of Economics: The Impact of Exchange Rates on Businesses

This report delves into the fluctuations of the Australian dollar (AUD) exchange rate, examining its impact on business organizations and the broader economy. It analyzes the factors influencing the AUD/USD exchange rate within the Forex market using a demand-supply framework, exploring the impact of depreciation on firms and the actions taken by the Reserve Bank of Australia to stabilize the exchange rate. The report investigates the relationship between the AUD and USD, considering factors such as inflation, current account, interest rates, and government policies. It further discusses the effects of AUD depreciation on imports, exports, and the balance of payments, and the strategies employed by the Reserve Bank of Australia to manage the exchange rate, providing a comprehensive overview of the economic implications of these fluctuations. The report uses a case study approach, focusing on the AUD sliding back to 70 US cents, to illustrate the concepts and implications of the exchange rate dynamics.

Running head: PRINCIPLES OF ECONOMICS
PRINCIPLES OF ECONOMICS
Name of the Student
Name of the University
Author’s Note

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Executive Summary
The aim of this report is to highlight on the fluctuations of exchange rate and it affect on the
business organizations and economy. It also highlights on the factors affecting Australian
exchange rate and US dollar. This study also focuses on the impact of depreciation of Australian
dollar on the organizations. In addition, the impact of depreciation of AUD on the forms is also
explained in this study. The last section provides an overview on the actions taken by Reserve
Bank of Australia for stabilizing the exchange rate and its impact on the Australian economy.
The whole analysis has been done on the given case study.

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Table of Contents
Introduction......................................................................................................................................3
Answer a..........................................................................................................................................3
Answer b..........................................................................................................................................5
Answer c..........................................................................................................................................7
Answer d..........................................................................................................................................9
Answer e........................................................................................................................................10
Conclusion.....................................................................................................................................11
References......................................................................................................................................12

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Introduction
The present report highlights on the case study focusing on the Australian dollar sliding
back to 70 US cents. Based on this case study, the following questions are answered. The first
questions reflect on the determination of AUD exchange rate in the Forex market using the
demand and supply framework. The second question analyzes the movement of AUD in relation
to that of USD. The third question discusses about the driving forces that affect the AUD/USD
exchange rate. The fourth question elucidates on the influence of depreciation of Australian
dollar on the firm. The last question focuses on the actions taken by the Reserve Bank of
Australia for bringing the exchange rate back to US 80C AUD.
Answer a
Exchange rate refers to a specific nation currency in terms of foreign currency. The
demand –supply framework of determination of exchange rate indicates that equilibrium
exchange rate varies when some of the factors that impact demand as well as supply condition
varies. Unlike determination of price as well as quantity, the demand-supply model basically
guides authorities to forecast this exchange rate in the next period. In addition, it also aids to
trace different causes that impact the exchange rate of the nation and thereby directs
policymakers to measure the condition effectively. The determination of exchange rate of AUD
in the forex market has been described below.
The figure below represents the demand- supply model of the foreign exchange market in
which the demand of currencies has been attained through demand of export of the nation while
the supply has been determined through demand of its imports (Amiti, Itskhok and Konings

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2014, p.1970). The demand curve (DD) is drawn based on the derived demand whereas the
supply curve (SS) is drawn based on aggregate import goods demand. It has been assumed that
the equilibrium occurs at the point E* in which the exchange rate for per unit AUD is 80C USD.
However, at this point, the demand for the import goods in the Australian market is depicted by
Q. Now, if the demand for AUD increases from Q0 to Q1, the foreign exchange demand will
shift in the rightward direction from DD to DD1. This leads to increase in exchange rate to 81C
for per unit of AUD. On the contrary, if the demand of AUD decreases, the demand curve shifts
to leftward direction from DD to DD2. This in turn leads to decline in exchange rate to 77C USD
per unit of AUD from 80C USD per unit of AUD.

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AUD/USD
Quantity
D
D1
D D
D
D2
USD
80C/1AUD
USD
77C/1AUD
USD
81C/1AUD
S
S
E
E1
E2
QQ2 Q1
‘
Figure1: Demand- supply model of the foreign exchange market

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Source: (As created by author)
The above diagram of the demand-supply model of the exchange rate of Australia reflects
that the market system is flexible (Mancini, Ranaldo and Wrampelmeyer 2013, p. 1840) There
are several factors that lead to fluctuation of demand as well as supply of AUD, which are
explained below:
Rate of inflation- Low rate of inflation will exhibit increasing AUD value leading to
rightward shift of demand curve. On the other hand, higher inflation rate leads to
depreciation of AUD that shifts the demand curve to right.
Current Account of nation- Australia’s current account includes exports, debt, imports
and so on. Deficit in Australia’s current account owing to high spending in currency on
import goods than total earnings from export goods sale leads to depreciation. This in
turn shifts the demand curve to right.
Interest rate-Rise in rate of interest leads to appreciation of the AUD owing to increase in
demand of export of the products and services.
Plans of government- The government of Australia increases the demand of its currency
in the foreign market with increase in import substitution as well as export promotion.
This in turn leads to increase in the nation’s exchange rate.
Answer b
Trade weighted Index (TWI) refers to multilateral exchange rate, which is complied as
weighted average of domestic exchange rates with respect to foreign currencies. It is mainly used
as an economic indicator in order o compare exchange rate of the nation against their main
trading partner. In addition, it is highly useful between the Australian dollar and US dollar for

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estimating changes in competitiveness owing to movements in exchange rate (Burstein and
Gopinath 2014, p.395). On the other hand, nominal exchange rate refers to the total number of
unit of domestic currency, which can purchase foreign currency unit. However, decline in this
variable refers to nominal appreciation of currency while increase in this variable refers to as
nominal depreciation of currency.
For over the past three years, there have been several fluctuations in nominal exchange
rate of Australia and TWI. From the figure below, it can be seen that in the year 2015, there was
several fluctuations and thus reflects that the nominal exchange rate of Australia’s currency was
at peak at March (Lustig, Stathopoulos and Verdelhan 2016). Furthermore, during this period,
the nominal exchange rate declined to lowest point owing to decline in demand for products and
services in Australia. This in turn increases the cost of USD as compared to AUD. During the
month of July 2017, it rose at high rate but declined again from October of the same year.
However, recent evidences reflect that nominal exchange rate of AUD has been currently
floating at the rate of 80C USD as compared to AUD.
Figure 2: Nominal Exchange rate

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Source: (As created by author)
The figure of TWI of AUD highlights that there has huge fluctuations over the last few
decades. In the year 2015, the TWI had resulted lowest value, which in turn lead to recession in
the US market. But in the year 2017, the TWI value recorded the highest. Therefore, TWI
fluctuated during the last three years based on the trade magnitude between US and Australia. In
addition, weak US dollar has been one of the major factors of behavior of AUD. As the US
market had become saturated over the years, it lead to recession in the year 2015, which in turn
resulted into decrease in demand of products and services of Australia in US market (Sloman,
Norris and Garrett 2013). Hence, since the year 2017, the demand for products and services and
rate of interest in Australia increases, which in turn lead to increase in AUD demand. However,
from the above two figures, it can be seen that there has been increasing trend, which signifies
that there will be better business between US and Australia in future.
Figure 3: Trade Weighted Index (TWI)
Source: (As created by author)

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Answer c
The given article reflects that there have been several reasons for the current fluctuation
in AUD as compared to USD. The study also highlights that the major reason behind increase in
AUD in respect of USD is increasing price of goods and droop in export of USD. However, this
has increased the export of Australia leading to increase in AUD demand (Manalo, Perera, and
Rees 2015, p.60). As a result, there has been appreciation of AUD in comparison with USD. In
fact, the strength of AUD is not highly sustainable due to rigid wages as well as inflation rate of
this nation. Furthermore, some threats also occurs such as decrease in iron ore price in global
market, decrease in Chinese economy’s growth and increasing gap between Australia and US. In
addition, it has been predicted that the AUD will again decline to 70 C USD when the interest
rate of US begins to surpass interest rate of Australia and export with US declines.
The figure below portrays variation in Australian exchange rate with the help of demand
and supply (Frenkel and Johnson 2013). Increase in export of iron ore as well as US exchange
rate slump leads to rise in exchange rate from Ex to Ex1 as AUD faced rise in demand. Therefore,
if the gap in rate of interest increases between US and Australia and declining price of iron ore is
considered, then demand will decline to D2. However, new equilibrium occurs at E2 in which
the exchange rate is Ex2.

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S
D
D1
D2
Quantity
Exchange rate
Ex
Ex1
Ex22
E1
E
E2
QQ2 Q1
Figure 4: AUD/USD with demand-supply diagram
Source: (Author’s Creation)
Answer d
Imports will become highly expensive with the depreciation of AUD, which again might
lead to lower demand of import goods. However, with less importable demand, the enterprise
will increase commodity price for making profit. This increase in price of goods leads to decline
in demand for product, which again leads to increase in price (Gabaix and Maggiori 2015, p.
1375). This cycle continues until equilibrium quantity as well as price is attained. In addition,
low AUD value in respect of USD, the importer of electric machinery might face huge loss
owing to reduction in importable demand. On the contrary, depreciation will also lead to increase
in export as the exported goods become cheaper with decline in AUD/USD exchange rate. This

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in turn will increase the BOP (Balance of Payment) and increase in economic growth. Moreover,
deficit in current account with also increase with AUD depreciation as compared to USD. Hence,
the terms of trade between US will enhance with decrease in exchange rate. Considering the
overall Australian economy, the exporters of the products are the main ones who enjoy the
benefits of lower Australian dollar (Berman, Martin and Mayer 2012, p.449) However, the local
business might find competitive edge over the import goods, which in turn generally becomes
highly expensive.
Answer e
By taking into account the given situation, it can be said that there are several instruments
that the government of Australia might enter the exchange rate in order to gain appreciation.
From the newspaper report, it can be seen that exchange rate of Australian dollar has been
declining owing to decline in iron ore demand from Australia (Chowdhury 2012, p. 345). In
addition, the government of this nation can take plans regarding export promotion by focusing on
the US market that in turn might enhance the demand of mining products in Australia. This in
turn might lead to increase in AUD demand in the foreign nations. However, this might
appreciate AUD in comparison with USD. The given article also highlights that there has been
increasing gap of rate in interest between Australia and US owing to increase in the Federal rate.
Suppose if the gap increases hugely, then it is expected some of the international investors will
make investment in the US economy instead of making it in Australian economy (Ismail 2018).
This in turn might lead to decline in exchange rate of AUD and increase in exchange rate in
USD. In order to bring back the exchange rate, the Reserve Bank of Australia should take some
actions. The Australian economy is slowing down owing to sluggish wage rate and inflation rate.
For overcoming this condition, the Reserve Bank of Australia should increase their rate of