Demand and Supply of Australian Dollars in The Foreign Exchange Markets

What factors affect the demand and supply of Australian dollars in the foreign exchange markets? Distinguish between the possible causes and effects of a currency depreciation and a currency appreciation on the Australian economy. What forces have come into play, if any, in the past four months that have affected the value of the Australian dollar?

Exchange Rate: The rate at which one unit of domestic currency is exchanged for a given amount of foreign currency

A BRIEF HISTORY OF THE AUSTRALIAN DOLLARUntil 1971, the Australian dollar (AUD) was pegged to the British pound. This meant that the AUD rose or fell in line with the pound. In 1971, the AUD became pegged to the US dollar instead. These currencies were fixed currencies, which meant that the Australian currency would only change value when a major world currency also changed. This system lasted only until 1974 when the AUD became pegged to a trade-weighted selection of other currencies. This was still a fixed currency. In 1976 this selection of currencies became moveable. Small shifts were able to take place when needed. In 1983 the AUD became a floating currency. This means that the value of the dollar is determined by supply and demand. Initially, the Reserve Bank of Australia was not intended to intervene in the market however since then it has been deemed necessary for intervention to take place, usually to prop up the price.

FACTORS AFFECTING SUPPLY AND DEMAND OF AUSTRALIAN DOLLARSWith a floating exchange rate, such as Australias, supply and demand factors largely determine the dollars equilibrium price. The exchange rate is sensitive to changes in both demand and supply, which can cause changes in the equilibrium exchange rate. Another factor, which can affect the supply and demand of Australian dollars, is intervention in the market by the Reserve Bank of Australia.

DEMANDThe demand for Australias currency in the foreign exchange market (Forex) is a derived demand. It is derived from the demand for a countrys exports of goods and services and its assets.

In simple terms, people who may have a demand for the Australian dollar could include:

Foreigners wanting to purchase Australian exports

International tourists visiting Australia

International investors wishing to purchase Australian shares or property

International firms setting up branches or expanding in Australia

Speculators and investors who think the value of the Australian dollar will rise in hope of making a profit.

The demand for the Australian dollar will be affected by a number of factors. These factors are:

The Size of financial flows into Australia

The size of financial flows into Australia from investors who wish to invest in Australia and need to convert their currency into AUD will affect demand for the dollar. The level of capital inflow will be affected by the level of Australian interest rates relative to overseas interest rates as well as the level of confidence in the Australian economy. If Australia has relatively higher interest rates and stronger confidence, then this will encourage capital inflow and increase demand for the AUD. Using this theory, the Australian dollar at the present looks to be in a relatively strong position. Interest rates are beginning to rise (official interest rate has recently been risen 0.25 points to 4.5% and is expected to raise to 5.25% by September this year, with economic growth expected to be around 3.75% in 2002/03.) Also increasing the confidence in future economic growth is the recent budget. The 2002/03 budget released on 14th May 2002 was a deficit budget. This means that the government has spent more than it has earned. This is an injection of money into the Australian economy and will stimulate economic activity and growth.

Price Expectations

Expectations of a future appreciation of the AUD will increase the demand for the AUD by speculators as they expect to make a profit from buying the dollar now and selling at a later date at a higher price.

The Demand for Australian Exports

The demand for Australian exports varies for a variety of reasons. One reason is changes in commodity prices. Another is the terms of trade. These two variations tend to have an immediate impact on the AUD. A rise in commodity prices and an improvement in the terms of trade are generally expected to improve the Current Account Deficit (CAD). This will often result in an increase in the value of the AUD because of the expectation that the CAD will improve over the short to medium term.

The demand for Australian exports is also influenced by the level of international competition and the Australian inflation rate relative to other countries. If Australian firms are competitive in the world market and Australias inflation rate remains low, it means that Australias exports will be cheaper to foreigners, making them more attractive to buy.

Changes in world income levels will also influence the overseas demand for Australian exports. The demand for Australias commodity exports in particular are highly dependent on the levels of income of Australias trading partners. When the world economy is in a period of upturn, demand and prices for Australian exports will rise.

Also affecting world demand for Australian exports are simply the tastes and preferences of overseas consumers for Australian exports.

An increase in demand for Australian dollars generally causes the value of the currency to appreciate. A supply and demand curve is shown over the page, demonstrating an appreciation of the dollar.

SUPPLYThe supply of Australias currency is also derived. It is derived from the demand of Australias residents for foreign goods, services and assets.

People who could possibly create a supply of Australian dollars are:

Australians who want to buy imports from overseas

Australian tourists going overseas

Australian banks and firms lending or investing money overseas

Australians paying for various services from overseas such as repaying loans or paying interest on loans

Speculators and investors

The supply of Australian dollars will be affected by a number of factors. These factors are:

The size of financial flows out of Australia

The level of financial flows out of Australia will also be determined by the domestic interest rates relative to overseas as well as international confidence in Australia and other economies. If Australian interest rates are relatively lower and the confidence in the Australian economy has deteriorated, capital outflow will increase, thus increasing the supply of AUD. At the present, interest rates are at low levels, however they are expected to rise in the near future as economic confidence and growth are relatively high. This means there will not be a large increase in the supply of Australian dollars.

Price Expectations

Speculators and investors in the foreign exchange market who expect the value of the AUD to decrease will sell AUD so as to minimise losses. This will increase the supply of AUD and contribute to the anticipated depreciation.

The domestic demand for imports

Australian importers who buy from overseas need to sell AUD in order to obtain foreign currencies to pay for the imports. The level of domestic income will largely determine the demand for imports. When the domestic economy is growing, output employment and income are rising, so the demand for imports will also rise which will then increase the supply of AUD. If people have more income they may choose to purchase goods from overseas which are considered to have prestige.

The domestic inflation rate and competitiveness of domestic firms that are in competition with imports will also influence the level of demand for imports. If Australias domestic inflation rate is higher and its firms are relatively uncompetitive, then imports will be cheaper than products produced in Australia and demand for imports will rise.

Also, tastes and preferences of Australian consumers change over time, and an increase in the desirability of goods and services produced overseas will increase supply of AUD on the foreign exchange market.

When supply of the dollar increases, there is generally a depreciation of the value of the currency.

THE GOVERNMENT ROLE IN THE EXCHANGE RATEThe government can manage the Australian currency through the Reserve Bank of Australia (RBA). The RBA can intervene in the Foreign Exchange Market and can implement government policies designed to influence the value of the dollar.

Reserve Bank Intervention in the Forex Market

The Australian exchange rate is generally allowed to float cleanly, with market forces determining its value. However, from time to time, the RBA intervenes in the foreign exchange market to influence the value of the exchange rate, thus dirtying the float. Intervention may take place for a variety of reasons. They are:

1. If the exchange rate deviates too much from its smooth long-run equilibrium path, there can be adverse effects on economic conditions such as inflation, employment levels and Gross Domestic Product.

2. Intervention (as a buyer or seller of foreign exchange) may help to smooth the sentiment in the foreign exchange market resulting from excessive speculation.

3. RBA authorities may also intervene to prevent excessive depreciation (which could lead to higher input prices and inflation), or excessive appreciation (leading to higher export prices and a loss of international competitiveness) and buy time to re-evaluate economic policy.

Government Policies Relating to the Exchange Rate

Essentially, there are three policies that the Australian government (through the RBA) can do to try and affect the value of the exchange rate under a floating system:

The RBA can intervene directly in the force market as a buyer or seller of foreign exchange. This is usually done to smooth out the market to reduce what is deemed to be excessive volatility caused by misinformed speculation.

The RBA may intervene indirectly by changing the level of interest rates through its market operations. This will have the effect of altering the interest rate differential between Australia and the rest of the world. A rise in interest rates relative to overseas will encourage capital inflow and hence increase demand for the Australian dollar. This action might also be taken to prevent further depreciation of the Australian dollar. A fall in Australian interest rates will encourage capital outflow and increase the supply of Australian dollars relative to the demand. This action would prevent further appreciation of the Australian dollar.

The government may use a mix of macro-economic policies to increase or decrease the rate of economic growth in Australia relative to the rest of the world. Contractionary monetary, fiscal and industrial relations policies may reduce aggregate demand, including the demand for imports, thereby raising the value of the exchange rate. Alternatively, the use of expansionary macro-economic policy would be expected to boost aggregate demand, including the demand for imports relative to exports, raising economic growth, but lowering the exchange rate.

Direct intervention

Direct intervention by the RBA in the foreign exchange has potential implications for domestic liquidity. Intervention by the RBA can be sterilised to offset the effects on domestic liquidity and interest rates or unsterilised with intervention affecting domestic liquidity and interest rates.

Sterilisation occurs when the RBA offsets its foreign exchange market intervention by buying or selling the equivalent amount of government securities, leaving the monetary liabilities of the RBA unchanged.

Unsterilised foreign exchange market intervention involves no offsetting purchase or sale of government securities. An unsterilised sale or purchase of foreign currency will lead to a fall or rise in the money supply and a rise or fall in interest rates.

The RBA has always undertaken sterilised intervention. There are two means of doing this:

Buying Commonwealth Government Securities in its domestic operations

Arranging a foreign currency swap, by exchanging one currency for another in the current (Spot) market and agreeing to reverse the transaction at a future date at an agreed price or exchange rate (futures market)

Indirect intervention

Monetary policy initiatives are a more indirect way of influencing the exchange rate, and are rarely used for this purpose. If the government wishes to curb rapid depreciation, it may increase the demand for AUD by raising interest rates. Higher interest rates will attract more foreign savings, which must be converted into AUD. This will increase demand for AUD and put upward pressure on the exchange rate, however, this policy will generally only be effective for a limited time. It is unusual for the RBA to change interest rates in response to movements in the currency because the primary focus of its monetary policy decisions is to influence the domestic economy. Sometimes the exchange rate movements are so large that they may affect the stability of the economy or the level of inflation. An example of this happening occurred in April 2000. The RBA stated that one of the factors prompting it to raise interest rates was the depreciation of the Australian dollar, which was adding to inflationary pressures and putting low inflation at risk. This was the first time since 1986 when the RBA had openly adjusted interest rates in response to movements in the exchange rate.

THE EFFECTS OF EXCHANGE RATE MOVEMENTSBoth depreciation and appreciation of the value of the Australian dollar have negative and positive effects. If depreciation occurs it raises the domestic price of foreign goods as well as reducing the foreign price of exports. If appreciation occurs, it lowers the domestic price of foreign goods and raises the foreign price of exports.

DEPRECIATIONThe depreciation of Australias currency has a number of positive effects. They are:

In the long term, a depreciation of the exchange rate enhances the competitiveness of the tradable goods sector (producers that compete with exports and imports) by making Australian goods and services cheaper and thus more competitive relating to the same goods and services produced overseas. This will help to raise export income and reduce import expenditure. Overall this will help to improve the Current Account Deficit (CAD). This theory is known as the theory of the J Curve.

A depreciation may encourage higher levels of capital inflow into Australia as domestic assets become cheaper relative to their foreign counter-parts. This can help to reduce the level of foreign debt and increase foreign equity investment in Australia.

A depreciation can lead to a structural change in the make-up of the Australian economy e.g. a shift to the manufacturing and services export industries.

Along with the above-mentioned positive effects, there are also negative effects. These are:

A depreciation of the currency can raise the cost of imports and reduce the price of exports in the short term. This can lead to lower export volume income from the sale of a given volume of exports and raise the cost of a given volume of imports. Lower export income and higher import expenditure in the short term will increase the size of the CAD.

A depreciation can often lead to a higher inflation rate. This will occur if monetary policy is unable to contain inflationary expectations. Since the 1990s micro-economic policies have been adopted to smooth out inflation and make the economy more flexible when dealing with large currency shocks such as the 1997 Asian crisis. Examples of these policies include enterprise bargaining and the national competition policy.

An immediate impact of a depreciation in the dollar is to increase the value of the part of the net foreign debt to which the value of the AUD has depreciated against. e.g. If the AUD depreciates against the then the section of foreign debt to USA will increase in value.

A depreciation of the AUD will raise the debt-servicing ratio. The debt-servicing ratio is the interest repayments as a percentage of exports. Higher interest repayments can lead to a higher net income deficit and increase the size of the CAD

A large depreciation could lead the RBA indirect intervention to support the exchange rate by raising interest rates. This can lead to lower economic growth and investment thus reducing employment and domestic confidence levels.

APPRECIATIONAs with depreciation, appreciation has both negative and positive effects. Some of the positive effects include:

And appreciation of the exchange rate lowers the costs of imports and increases the price of exports in the short-term. This can lead to a higher export income and lower export expenditure. This will lead to a reduction in the size of the CAD.

Appreciation may lead to lower domestic inflation rates due to the lower import prices. This should raise the real income of consumers who can then in return increase standards of living by being able to purchase a variety of imports at a cheaper price.

An appreciation will reduce the value of the section of foreign debt to which the currency has appreciated. If the value of the AUD rises relative to , Australias foreign debt to the USA will decrease.

An appreciation will reduce the debt-servicing ratio. Lower interest repayments can lead to a higher net income deficit and decrease the size of the CAD.

The negative effects of an appreciation of the currency are as followed:

In the long term it will decrease the competitiveness of Australian producers in the tradable goods sector. Australias goods and services will become less price competitive and therefore less attractive to overseas buyers. The CAD would increase if this were to occur.

An appreciation could lead to higher levels of capital outflow from Australia. This is because Australian assets become more expensive and less attractive relative to goods and services produced overseas. This would decrease foreign equity investment in Australia.

It could lead to higher unemployment rates as those industries that export restructure in an attempt to remain internationally competitive.

A dramatic appreciation might lead to a RBA indirect intervention to support the exchange rate by lowering interest rates to reduce the demand for Australian dollars. This could lead to high levels of economic growth and investment, causing domestic inflation levels to rise.

RECENT TRENDS IN THE AUSTRALIAN DOLLARIn recent months, the Australian dollar has generally been making an upward climb. The trend seems set to continue. Four months ago, the AUD was trading at .51715 (18/2/2002). Today it is trading at .54795. The exchange rate is currently seen to be relatively undervalued due to the strength of the American dollar. The Sydney Morning Heralds Economic Editor, Ross Gittins, says that the American dollar is vastly overvalued and the Australian dollar undervalued. He says this is an imbalance and that the thing about imbalances is that theyre unsustainable: eventually they have to be, and will be, corrected one way or the other. It could be for this reason that the Australian dollar is starting to gain momentum and increase in value against all other major currencies, particularly the .

Other reasons for the appreciation of the Australian dollar include the recent economic figures posted by the government showing Australia to be in a strong economic position, the recent budget deficit and the anticipated rise of interest rates.