Economics Assignment: Impact of Exchange Rates on Australian Economy

This economics assignment analyzes the foreign exchange rate, focusing on the AUD/USD. It begins by explaining the supply and demand framework for determining exchange rates, then explores factors influencing the Australian dollar's value. The assignment examines nominal exchange rates, t...Read More

Running head: ECONOMICS ASSIGNMENT
Economics assignment
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:.........................................................................................................................................6
Answer d:.........................................................................................................................................7
Answer e:.........................................................................................................................................8
Reference:......................................................................................................................................10

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Answer a:
Foreign exchange rate is one of the essential parts of shaping the international trade,
which stands for the value of domestic currency in terms of the monetary value of the foreign
currency (Cooper 2014). Among many supply and demand framework is the simplest
macroeconomic models that can effectively aid the economy to predict and determine the
exchange rate of the domestic currency compared to the foreign currency (Corazza and Malliaris
2015). It not only determines the value of foreign exchange rate of domestic currency against the
foreign currency, in addition to this, it aids to determine various key factors that can affect the
economy’s exchange rate (Gabaix and Maggiori 2015).
Figure 1, showcase the foreign exchange market demand and supply outline of a nation,
where the demand is perceived through the demand of export of a nation and the supply is
achieved through the importable demand of the domestic market (Caballero, Farhi and
Gourinchas 2016). Utilising the derived demand, AUD demand curve ‘D’ has been drawn and
aggregate demand of the importable has been utilised to draw the supply curve ‘S’. Now, if the
initial equilibrium occurs at E, then it can be seen that exchange rate of each unit of AUD is 80C
in terms of USD and the demand of the importable is represented through Q. Considering, a rise
in demand of the AUD from Q to Q1, it can be seen that there will be appreciation of the AUD.
At new equilibrium E1, exchange rate of each unit of AUD is 81C in terms of USD
(hypothetically). However, if there is fall in demand from Q to Q2, then the exchange rate will
fall to from initial equilibrium situation, where the exchange rate is determined at 77C USD for
every unit of AUD. Through this analysis it can be seen that demand and supply framework can
easily explain the relative price of domestic currency compared to the foreign currency and in
addition it can explain the factor too that influence the exchange rate (Knittel and Pindyck 2016).

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Figure 1: Exchange rate determination of Demand and Supply model
Source: (Created by Author)
According to the above mentioned analysis of AUD under the purview of supply and
demand, it can be said that there are various factors that can lead to alteration in the demand and
supply condition of the AUD, which can in turn lead to fluctuation in the exchange rate of AUD.
Key factors that can alter the foreign exchange rate of AUD are as follows:
 Interest rate – With rise in interest rate there will be higher inflow of foreign currency in
the Australian banks, which will lead to shift in the demand curve of Australian Dollar.
Rightward shift of the AUD carve will resulting in higher price of the domestic currency
in terms of USD (Ghosh et al. 2016).
 Inflation rate – with rise in inflation, there will be fall in demand of Australian dollar in
front of the US citizens. It will lead to shift the AUD leftward and the Australian
currency will be depreciated (Bussière et al. 2014).

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 Growth rate – better growth rate will lead to higher demand of AUD. Thus, with better
growth AUD exchange rate can get altered.
Answer b:
Nominal exchange rate is the value of domestic currency, which is required to buy a unit
of foreign currency (Eichenbaum et al. 2017). If there is rise in nominal exchange rate of a
nation’s currency, then it is acknowledged as the nominal appreciation of the domestic currency.
And in case of loss of purchasing power, there will be nominal depreciation. Trade Weighted
Index (TWI) on the other hand is the multilateral exchange rate which is calculated through
providing weighted average to magnitude of business with the partner country (Albuquerque et
al. 2015).
Considering the nominal exchange rate of Australia for last three years (figure 2) along
with the TWI o Australia for the same time frame (figure 3) it can be seen that there has been
various fluctuations. From figure 2, it can be seen that AUD was at its best compared to USD
during May of 2015; however, it fell sharply till November of the same year due to fall in the
demand of the Australian goods and services in the market of US. Next to this, AUD rose to a
moderate .76C USD for each unit of AUD during January of 2016 marking policy effectiveness
of the Australian government (Baumgartner 2016). Apparently from the figure 2, it can be seen
that there was a uplift of the US demand for the Australian goods and services along with this
and weakening USD has allowed the AUD to soar to the 80C USD for each unit of AUD.

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Figure 2: Nominal Exchange Rate of Australia
Source: (Reserve Bank of Australia, 2018)
Figure 3, highlights the same figure as it has been seen in the figure 2. TWI of AUD hit
its lowest during September of 2015 due to comparative fall in export to the US and it has been
rising since then. Though there has been fluctuation in TWI over the time, however it has
managed itself to remain steady. Presently with rise in demand of the Australian trade with US,
TWI is rising again and leading itself towards 80C USD for each unit of AUD (Engel 2016).
Figure 3: Trade Weighted Index of Australia
Source: (Reserve Bank of Australia, 2018)

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Figure 2, and Figure 3, both highlights that foreign exchange rate of AUD is rising in
terms of the USD since 2015. This rise has been christened from various sources and among
them most important is the weakening USD. According xxx, under the floating exchange rate
system, if a currency gets weaker compared to the other, then it inherently makes the other
currency stronger compared to itself. Utilising this phenomenon, it can be said that though there
is very little rise in demand of the AUD, weakening USD is allowing the Australian dollar to
rise. On the other hand it can also been seen that there is very little rise in demand of Australian
tech metals in US market that has aided the AUD to have some upward boost. This rise in
demand has caused the AUD to rise against USD leading to better AU-US business situation in
future.
Answer c:
Given report highlights various reasons for the rise in AUD compared to USD. According
to the given article, recent slump in the USD is one of the main reasons that lead to rise in
Australian dollar compared to the USD (Ismail, 2018). Besides this, rising price of iron ore is
another key element that has lead to rise in the AUD. However, according to the given report,
Australian dollar appreciation is not sustainable owing to the stagnant inflation rate of the
country as well as persistent labour wage rate. In addition to this, Hong et al. (2017), argues that
it has been seen that recently there is a fall in demand of Australian iron due to rise in Chinese
export promotion as well as Fed hikes are amongst the key factors that leading to rise in interest
gap between the two countries. The report concludes with the idea that AUD will fall back to
70C USD soon, once the US interest rate outshine the prevailing bank interest rate of Australia
(Arteta et al. 2015).

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Figure 4: Representation of AUD/USD exchange rate with Supply and demand
Source: (Created by author)
In order to explain the effect of the abovementioned driving force on the AUD considers
the Figure 4. Point E highlights the present equilibrium situation of the country, where exchange
rate is Ex. With rise in the demand of Australian iron ore and enhancement in the Fed rate gap,
demand of AUD shifts from D to D1, which caused in a rise in exchange rate from Ex to Ex1
(Feenstra 2015). Once there will be fall in demand of the AUD, demand curve D1 will shift to D2,
making new equilibrium E2, where the exchange rate is Ex2, which is much lower than the initial
equilibrium.
Answer d:
If the AUD is going to cheaper compared to the USD one year from now, then it will
hamper the country’s economy positively. On the other hand, being the manager of an Australian
firm, it can be said that the firm will face loss with weak AUD compared to the USD. According

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to the general economic theory, if there is depreciation of one currency, then importable will be
expensive compared to the present situation (Cole and Nightingale 2016). In addition to this,
higher price of the importable will lead to rise in the price of the importable, which will force the
aggregate demand of the importable to fall. With falling demand, price will rise again and the
cycle will continue until there is balance between the demand and supply of the importable
(Friedman 2017). Considering the company that imports electric machinery from the US, it can
be said as a manager of the firm, that it will face loss. With stronger USD, the firm will fail to
import as much as goods that it is importing now. With lesser importable, the firm will raise the
price to keep the profit intact, which will in turn lead to fall in the demand (Galbraith 2015).
With lower demand firm will face loss, however, it will raise the price again to cover the
Average Variable Cost. Further deterioration in demand will take place with rising price and the
cycle will continue until equilibrium is established between the supply and demand of the
electrical machinery.
On the other hand with weaker AUD, there will high demand of the Australian goods and
services in the US market (Dwyer et al. 2016). With higher export, Australia will have better
trading proposition, which will enhance the Balance of Trade of Australia as well as, with higher
trade, TWI of Australia-US will be better off.
Answer e:
If the government wants to enhance the AUD/USD exchange rate from 72C USD to 80C
USD, then there are various plans. Australia is growing at 6.9% annual growth rate and a large
portion of its GDP comes from the mining sector (Nakamura et al. 2017). There has been
substantial drop in Australian mining good in US market during past few years. Presently with
rise in demand of tech metals, mining trade with US is rising and utilising this situation

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Australian government can use export promotion and enhance its exchange rate through
increased trade with US (Irwin 2015). On the other hand there is large gap in Australian and US
interest rest, which is leading to fall in foreign investment in the Australian banks. Thus if the
Australian Reserve Bank can enhance its interest rate, then there will substantial rise in US
investment in Australian banks, leading to rise in AUD compared to USD (Calomiris et al.
2016). Next to this, import substitution can be handy if the Australian government want to
restrict the importable that hurt the Balance of Payment of the country largely.
Bringing in AUD/USD exchange rate from 72C USD to 80C, has both the bright and dark side.
If the government of Australia need to promote growth, then it would be require for the
government to implement the aforementioned policies so that the country can have stronger
AUD compared to the USD. With stronger AUD, the country can enhance its trade balance and
let the trading participating as an engine of country’s economic growth. On the other hand, with
stronger AUD, imports will raise leading to deterioration of the Australian trade balance
(Hofman et al. 2016). Moreover, import quota is not possible under the AUSFTA pact between
these two trade participating countries (Gantz 2016). Besides this, once the AUD gets
appreciated through raising the interest rate, it will dry up the market leading to fall in aggregate
demand. Thus it can be said that, government can use these actions to gauge the deteriorating
AUD, however it need to be aware of the side effect (Blanchard et al. 2016). Proper balance
between interest rate and market liquidity and import substitution can be helpful for the
Australian government.

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Reference:
Albuquerque, R., Ramadorai, T. and Watugala, S.W., 2015. Trade credit and cross-country
predictable firm returns. Journal of Financial Economics, 115(3), pp.592-613.
Arteta, C., Kose, M.A., Ohnsorge, F. and Stocker, M., 2015. The Coming US Interest Rate
Tightening Cycle: Smooth Sailing or Stormy Waters?.
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Eichenbaum, M., Johannsen, B.K. and Rebelo, S., 2017. Monetary policy and the predictability
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