How Are Exchange Rates Affecting Australia's Economy?

Exchange rates are the value of one currency with respect to another, for the purpose of conversion. They affect investment levels, via the cash rate and values of domestic assets; trades, via prices and the terms of trade (TOT); liabilities, via currency appreciation or depreciation and the valuation effect, and trades. Exchange rates are influenced by government policies in the short term and market forces in the long term. Since the Australian dollar (AUD) was floated in 1983 it has experienced an appreciating trend; however, in recent years the AUD has depreciated from its mining-boom highs due to expansionary monetary policy and weaker economic outlooks.
Prior to the 1980s, Australia’s exchange rate system was under a fixed system, whereby
the government determines the value of the currency in terms of a fixed value of another currency or a basket of currencies. In 1983, the exchange rate system began to operate under a floated system in which there is no government intervention and the value of the AUD is determined by market forces. For instance, an increase in supply of AUD depreciates the currency and an increase in demand appreciates the currency. Under a floated system, the exchange rate also correlates with the cash rate; an increase in the cash rate increase demand for AUD thus appreciating the currency, whilst a decrease in the cash rate also decreases supply, effectively depreciating the currency.
The demand and supply for AUD are foreign investment levels, expectations and trades.
Foreign investors must hold AUD to invest in Australia, thus high foreign investment levels results in high demand for AUD which appreciates the currency. Secondly, if people predict that the AUD will appreciate, then the demand for AUD increases and appreciates the currency; whereas the expectation that the AUD will depreciate will induce people to sell the currency, increasing supply of AUD and depreciating the currency. Moreover, demand for AUD will increase, appreciating the currency, when demand for exports increases and supply of AUD increases when the domestic demand for imports increases, depreciating the
currency.
The AUD appreciated relentlessly during the mining boom between the early 2000s and 2012 due to excessive demand for Australian minerals such as iron ore, particularly China. During this period, the terms of trade – the price of exports compared to imports – peaked historically high (2011). Economic instability in Europe and America, due to the sovereign debt crisis on fiscal cliff, also made the AUD a ‘safe haven’ investment which further drove its appreciation. High TOT, CAPEX and high exports lifted national income and the Balance of Goods and Services (BOGS) and Current Account Deficit (CAD) improved, resulting in economic growth. In effect, Australia’s external stability improved; that is, the economy was better equipped to service its foreign liabilities through its sustainable external accounts. However, the end of the mining boom, the May release of the Budget which forecasted bleak economic outlooks such as an increase in unemployment and decrease in GDP for the next couple of years, and the RBA’s expansionary monetary policy stance depreciated the currency.
A depreciation in the AUD initially decreases consumption, as the price of imports becomes more expensive. The lower AUD also reflects upon slowed growth in the Australian economy. Lower inflation, indicated by CPI which increase by 2.4% between June 2012 – 2013, compared to 2.5% between March 2012 – 2013, illustrates the lack of demand for goods and services. The lack of production translates over to high unemployment, which has been experiencing an increasing trend since 2011 and is currently 5.6%. In response to low economic activity and high unemployment, the RBA will lower the cash rate to increase money supply, decreasing borrowing and operational costs for businesses and consumers to encourage them to borrow and spend. Effectively, consumption increases.
Lower exchange rate increases capital investment from offshore into Australia because it is cheaper for foreigners to do so. The influx of capital inflows crowds out the domestic economy from private investment. In response, the government will implement microeconomic reforms and increase regulations to decrease the investments from offshore.
On the other hand, a lower AUD initially decreases financial investment since the low cash rate means less return for holding AUD, hence decreasing demand for the currency. Less financial investment decreases the KAS and CAD (since net foreign equity decreases). The RBA can increase the cash rate to shore up appreciate the AUD, just as India has been doing to appreciate the Rupee, and shore up investment. However, this has not been the case despite the RBA lowering the cash rate. Due to the interest rate differential between Australia (2.5%) and other currencies such as the JPY (0%), carry trades activity is high; that is, investors take advantage of the 0% borrowing cost to buy JPY and then sell the currency to buy the AUD and reap the benefits of the higher cash rate, hence appreciating the AUD. Moreover, USA’s decision to raise the debt ceiling and continue printing money under a 0% cash rate policy, thereby depreciating the USD, also appreciates the AUD. Hence, despite the RBA’s loosening monetary stance, the AUD has appreciated from below $US0.90 in August to $US0.97.
In addition, since a lower AUD signals slowed growth, the government will implement loosening fiscal policy, increasing expenditure to stimulate the economy. This results in a budget deficit, hence the government decreases its rate of expenditure. Again, this has not been the case in the Australian economy. Despite the RBA loosening monetary policy, the government has continued to tighten fiscal, defying economic fundamentals which dictate that the two policies should be executed with the same direction. This has had adverse implications on economic growth since cuts in government expenditure offsets any benefits from a lower cash rate, as reflected in increasing unemployment rates (5.6%), low inflation rate (2.4%), and 2.6% GDP which is below the 3% trend.
A deprecation in the AUD results in an increase in the demand for exports, since they are cheaper.
This improves the CAD and BOGS. As demand increases, the AUD appreciates, causing inflation in the domestic market. Hence, the RBA increases the cash rate to make exports more expensive, leading to a fall in demand and a fall in exports. Effectively, the CAD increases. In contrary, imports initially decrease because they are more expensive hence decreasing demand. However, the lack of imports in Australia will decrease competition in the market. Consumers then seek offshore for cheaper alternatives and businesses must seek offshore for capital, thus imports increase, damaging the CAD and
BOGS.
Policies available are only as effective as the way they have been executed. Therefore, there must be strong discipline imposed on the use of these policies in order to assure stability in exchange rates, maintain low unemployment levels and induce growth in the Australian economy.