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Factors impacting the demand and supply of the Australian dollar

a. This section of the assignment takes into account the article “Is the Australian Dollar overvalued”, by Myriam Robin and tries to discuss the issues reflected in the article. Australia being one of the most dominant economies in the global framework, the dynamics of the Australian dollar, with respect to the international scenario, is a significant matter of concern among the economists, speculators and the governing authorities of the country as well as in the international framework (Smh.com.au, 2017).

According to the article, though the Reserve Bank of Australia posits that the performance of the domestic currency has been satisfying, there has been difference in opinion regarding this aspect as there has been a lot of speculation going on with respect to the dynamics in this value over time. However, an increase can be observed in the overall value of the domestic currency in the current year, when measured in terms of the American dollar and also the domestic currencies of China, Britain, European territory, Japan and Indonesia (Smh.com.au, 2017).

However, the studies with respect to the Westpac Model and also in the opinion of the currency strategist of NAB, show that there has not been a considerable appreciation in the value of the AUD, as has been shown by the opponents, which actually helped the country to come out of the post-boom period in the domestic mining industry. However, though there are conflicts regarding the direction of dynamics of the Australian currency in the recent period, there is an unanimous agreement on the fact that the value of the AUD with respect to the trade weight index has increased considerably in the recent period. This, in its turn, can be attributed to the rise in the country’s terms of trade (Beckmann and Czudaj 2017). As per another version of opinion, the change in the interest rate of the USA, provided that the rates in Australia are kept same, may lead to significant fluctuations in the dollar value of the country as in the contemporary economy, with expanding trade relations, the inter-linkage between the countries are increasing.

 b. Like any other economic variable, the value of the domestic currency of any economy, is determined by the demand and the supply of the same in the economy. The players in the demand and supply side of the currency markets are usually the international banks, companies, the speculators, and the investors who deal in the monetary market in the global scenario. According to the demand supply model of exchange rate, the same for an economy is determined by the demand and the supply of its domestic currency, which in turn is influenced by the factors like the inflation rate, rate of growth, rate of interest and the government framework (Frenkel and Johnson 2013).  

Figure 1: Determination of the equilibrium in the currency exchange rate

(Source: As created by the author)

In this context, the determination of the Australian dollar in the foreign exchange market can be explained. The exchange rate of the country, being kept at a floating level, is highly influenced by the demand and the supply dynamics in the country. The supply and the determination of the currency is also dependant on the policies and strategic intervention of the Reserve Bank of Australia (MacDonald and Stein 2012).

Determination of the equilibrium in the currency exchange rate

The demand for the domestic currency in the international foreign exchange market, depends on the factors which are as follows:

  • The demand for the commodities exported by Australia to other countries
  • The expansion of international commercial enterprises, which are setting up plants and operating units in the domestic geographical boundaries of the country
  • The foreign direct investments that the country receives from the other countries
  • The number of international tourists Australia attracts
  • The actions of the speculators and investors who buy and sell the Australian dollar according to the rise and fall in their value, the demand increasing with the expectation of a rise in the value in future (McLeay, Radia and Thomas 2014)

On the other hand, in the foreign exchange market, the supply of the Australian dollar is determined by:

  • The foreign exchange needed by the importers of the country
  • The asset demand for the Australian citizens in other countries
  • The expectations of the speculators and the private investors, the supply increasing with the expectation of a fall in the value of the Australian dollar in the near future (Parveen, Khan and Ismail 2012)

The interest rate prevailing in the global economic scenario and in the country itself, apart from the factors discussed above, also plays an important role in determining the value of the Australian dollar in the current economic framework (Diebold 2012).

c. The business activities of any country have a direct causal and effect relationship with the value of the domestic currency, prevailing at that particular period of time, in the country, which in its turn is determined by several domestic as well as international factors. With the trade and monetary relationships in the international scenario becoming more complex and interconnected, taking into account the movement of the domestic currency of any economy, with respect to some international and conventional yardstick, is important. This is because the performance of the country in the external and overall growth sector is highly attributed to this variable (Bussiere 2013).

In this context, this portion of the assignment tries to analyze the dynamics in the value of the Australian dollar in the last three years, with respect to that of the domestic currency of the USA, the latter being the most widely used and conventional yardstick of measurement in this aspect: 

 

Figure 2: AUD/USD rate of exchange in the last three years

(Source: Rba.gov.au, 2017)

The above figure, as shown by the Reserve Bank of Australia, shows the fluctuations in the exchange rate of the Australian dollar with respect to the US dollar in the last three years. As can be seen from the same, the rate which prevailed at a considerably high level (nearly 0.95), during the first half of 2014, started depreciating after that. The value of the domestic currency reached a significant low as compared to that of the USD (less than 0.70), during the period of July 2015 and January 2016 (Ricci, MILESI?FERRETTI and Lee 2013). The rates have undergone moderated fluctuations post that period, though the range of variation remained more or less in between 0.70 to 0.80, with the value rising a little above 0.75 in the recent period. However, the rise in the value of the Australian dollar has not been significantly noticeable, according to the data provided by the Reserve Bank of Australia.

However, if measured in terms of the Trade Weight Index, the result is seen to be a bit different from what is seen above: 

Figure 3: Trade Weight Index of Australia (2014-2017)

(Source: Rba.gov.au, 2017)

The above figure shows the dynamics of the trade weight index of the country in the last few years. It is evident from the figure, that like that of the value of the domestic currency, the trade weight index also was high (72.5) during the late 2014 and early 2015. However, this fell drastically in the succeeding period. However, the recovery of the TWI, as can be seen from the above figure, was higher than that of the exchange rate, as the number rose from below 60 in July, 2015 to 67.5 percent in the recent period (Arvis et al. 2014).

Fluctuations in the AUD/USD exchange rate in the last three years

The currency of Australia, being kept at a floating framework, is highly sensitive to the demand and supply and the price levels prevailing in the commodity market internationally. The changes in the price levels of the commodities in the global framework indirectly indicate towards the growth pattern in the economy. As the past evidences suggests, the prices of the goods and services in the international market, especially of commodities like oil and iron ore directly influence the value of the Australian dollar. The recent fall in the value of oil and iron ore also led to a significant drop in the exchange rate of the Australian dollar which shows that the currency value in the concerned country moves in line with the dynamics in the global commodity price levels (Basher, Haug and Sadorsky 2012).

Apart from the above-discussed factors, the behavior of the Australian currency and the changes in its values are also determined by several exogenous factors like the value of the domestic currencies of other economies, which have links with the Australian economy. For instance, the negative conditions prevailing in the economy of Japan, in the recent period, lead to depreciation in the value of yen, which in turn led the investors to diversify their investments to Australian dollars, which in turn exerted an upward pressure in its value.

d. The overvaluation of domestic currency of an economy, in general, leads to a fall in the exports of that economy and an increase in the imports of the same country. In this context, the overvaluation of the Australian dollar is expected to affect the export of alcoholic beverages from Australia to the United States of America (Berman, Martin and Mayer 2012).

This shows that for an Australian alcoholic beverage producer, the overvaluation of the domestic currency will have effects on his or her level of revenue earned, due to the changes in the export demand of the product. However, the changes are subjected to the nature of the alcoholic beverage sold by the producer, as the demand and the elasticity of demand of these kinds of beverages in the USA, vary according to the nature of the beverages and the preferences of the citizens of the country.

In general, alcohol being a non-necessity commodity, the appreciation in the domestic currency makes the product more costly for the American citizens and thereby, the demand in general is expected to fall. However, the demand for beer in the USA is significantly higher than that of the demand for other kind of alcoholic beverages like wine or spirit. Accordingly, the degree of the decrease in the demand for the product of the alcohol producer in Australia, will vary with respect to what kind of beverage he is selling. However, due to an overall expected fall in the demand for Australian beverages because of the overvalued domestic currency, the revenue of the concerned Australian alcoholic beverage producer is expected to decline on the face of falling exports of his commodity (Glüzmann, Levy-Yeyati and Sturzenegger 2012).

Trade weight index of Australia

The overvaluation of the domestic currency in general is expected to facilitate the imports in the Australian economy as buying products from the other countries become cheaper due to the comparative devaluation of the foreign currency. On the other hand, the overvaluation of the domestic currencies have negative implications on the overall exports of the country as the goods and services exported by Australia becomes relatively expensive for the other countries. Thus, the overvaluation of the Australian dollar has direct implications (both positive as well as negative) on the external and trade sector of the country.

e. The market rate of exchange of the Australian dollar being prevailing at US 76C, to bring it down to US 72C, the Reserve Bank of Australia has to devaluate the domestic currency and keep it at a devaluated level. This can be done by several measures, involving the releasing of more of the domestic currency in the market. Money printing, dumping the currency in the international foreign exchange market can facilitate the decrease in the value of the domestic currency. This can be done, in its turn, by increasing the amount of imports in the country and decreasing the level of exports by imposing taxes and quantity capping on the exports of the country. This in its turn, is expected to supply the currency to abroad as the consumers are forced to buy foreign commodities with the cash (Oreiro, Basilio and Souza 2014).

The devaluating process can have both positive and negative implications on the domestic economy as a whole. The decrease in the value of the domestic currency facilitates exports on one hand and decreases imports on the other as imports become comparatively costly. The decrease in the value of the domestic currency leads to an increase in the aggregate demand but on the other hand also can lead  to increase in the inflationary pressure (Schulmeister 2013). 

References

Arvis, J.F., Saslavsky, D., Ojala, L., Shepherd, B., Busch, C. and Raj, A., 2014. Connecting to compete 2014: trade logistics in the global economy--the logistics performance index and its indicators.

Basher, S.A., Haug, A.A. and Sadorsky, P., 2012. Oil prices, exchange rates and emerging stock markets. Energy Economics, 34(1), pp.227-240.

Beckmann, J. and Czudaj, R., 2017. Exchange rate expectations and economic policy uncertainty. European Journal of Political Economy, 47, pp.148-162.

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.

Bussiere, M., 2013. Exchange Rate Pass?through to Trade Prices: The Role of Nonlinearities and Asymmetries. Oxford Bulletin of Economics and Statistics, 75(5), pp.731-758.

Diebold, F.X., 2012. Empirical modeling of exchange rate dynamics (Vol. 303). Springer Science & Business Media.

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

Glüzmann, P.A., Levy-Yeyati, E. and Sturzenegger, F., 2012. Exchange rate undervaluation and economic growth: Díaz Alejandro (1965) revisited. Economics Letters, 117(3), pp.666-672.

MacDonald, R. and Stein, J.L. eds., 2012. Equilibrium exchange rates (Vol. 69). Springer Science & Business Media.

McLeay, M., Radia, A. and Thomas, R., 2014. Money creation in the modern economy.

Oreiro, J.L., Basilio, F.A. and Souza, G.J., 2014. Effects of overvaluation and exchange rate volatility over industrial investment: empirical evidence and economic policy proposals for Brazil. Revista de Economia Política, 34(3), pp.347-369.

Parveen, S., Khan, A.Q. and Ismail, M., 2012. Analysis of the factors affecting exchange rate variability in Pakistan. Academic Research International, 2(3), p.670.

Rba.gov.au (2017). Exchange Rates | RBA. [online] Reserve Bank of Australia. Available at:

https://www.rba.gov.au/statistics/frequency/exchange-rates.html [Accessed 6 Oct. 2017].

Ricci, L.A., MILESI?FERRETTI, G.I.A.N. and Lee, J., 2013. Real Exchange Rates and Fundamentals: A Cross?Country Perspective. Journal of Money, Credit and Banking, 45(5), pp.845-865.

Schulmeister, S., 2013. Currency speculation and dollar fluctuations. PSL Quarterly Review, 41(167).

Smh.com.au, M. (2017). Is the Australian dollar overvalued?. [online] The Sydney Morning Herald. Available at:

https://www.smh.com.au/business/markets/currencies/is-the-australian-dollar-overvalued-20170210-gu9wl7.html [Accessed 6 Oct. 2017].

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