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Forex Market Determination of AUD Exchange Rate

Question:

Discuss About The Exchange Rate Movements And The Australian?

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.

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 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.

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.

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 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.

Movements of AUD in Relation to USD


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 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.

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.

Driving Forces Behind AUD/USD Exchange Rate


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 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.

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 interest and must also take program regarding fiscal expansion from the accumulated fund (Taussig 2013). As a result, this will help to enhance the economic growth by overcoming this condition. Furthermore, the Australian government should also adopt import substitution method as well as quota system for stopping the deficit of net export. Although these plans might help to bring back the exchange rate of AUD from 72C to 80C USD for AUD, this might create adverse impact. For example, implementing import quota system might not be possible in AUSFTA pact between the nations. Additionally, increase in export promotion leads to appreciation in AUD, which again leads to increase in imports (Rios, McConnell and Brue 2013). Apart from this, domestic investment might increase if the government increases rate of interest and thus demand might fall owing to deficiency in liquidity in market.

Thus, Australia might bring back exchange rate to 80C USD per unit AUD with this above given plan. Moreover, the government should increase the development of infrastructure, then it be might be beneficial for the nation for increasing the exchange rate.

Conclusion

From the above report, it can be concluded that exchange rate fluctuates due to several activities in the economy. The demand-supply framework of the Australia’s exchange rate reflects that its market system is flexible. The TWD data also highlights that there has been fluctuations in AUD relative to that USD for the last few years. Increase in export of iron ore as well as US exchange rate and rise in product price are the main drivers that affect AUD/USD. The depreciation of Australian dollar has positive influence on the organization and thus local business benefits from this. In addition, the actions that Reserve Bank of Australia will take for bringing back exchange rate are- increasing rate of interest, reduction of wage rate and keeps inflation rate low.

References

Amiti, M., Itskhoki, O. and Konings, J., 2014. Importers, exporters, and exchange rate disconnect. American Economic Review, 104(7), pp.1942-78.

Berman, N., Martin, P. and Mayer, T., 2012. How do different exporters react to exchange rate changes?. The Quarterly Journal of Economics, 127(1), pp.437-492.

Bramble, T., 2015. The Australian economy after the mining boom. Red Flag.

Burstein, A. and Gopinath, G., 2014. International prices and exchange rates. In Handbook of International Economics (Vol. 4, pp. 391-451). Elsevier.

Chinn, M.D. and Wei, S.J., 2013. A faith-based initiative meets the evidence: does a flexible exchange rate regime really facilitate current account adjustment?. Review of Economics and Statistics, 95(1), pp.168-184.

Chowdhury, K., 2012. Modelling the dynamics, structural breaks and the determinants of the real exchange rate of Australia. Journal of International Financial Markets, Institutions and Money, 22(2), pp.343-358.

Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.

Gabaix, X. and Maggiori, M., 2015. International liquidity and exchange rate dynamics. The Quarterly Journal of Economics, 130(3), pp.1369-1420.

Gallo, C. and Fratello, A., 2014. The Forex market in practice: a computing approach for automated trading strategies. International Journal of Economics and Management Sciences (IJEMS), 3(2).

Ismail, N. (Conclusiontipped-to-slide-back-to-70-us-cents-20180129-h0pp8v.html [Accessed 16 Mar. 2018].

Lustig, H., Stathopoulos, A. and Verdelhan, A., 2016. Nominal exchange rate stationarity and long-term bond returns. Available at SSRN

Manalo, J., Perera, D. and Rees, D.M., 2015. Exchange rate movements and the Australian economy. Economic Modelling, 47, pp.53-62.

Mancini, L., Ranaldo, A. and Wrampelmeyer, J., 2013. Liquidity in the foreign exchange market: Measurement, commonality, and risk premiums. The Journal of Finance, 68(5), pp.1805-1841.

Rios, M.C., McConnell, C.R. and Brue, S.L., 2013. Economics: Principles, problems, and policies. McGraw-Hill.

Sloman, J., Norris, K. and Garrett, D., 2013. Principles of economics. Pearson Higher Education AU.

Taussig, F.W., 2013. Principles of economics (Vol. 2). Cosimo, Inc..

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