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Liquidity and Exchange Rate Dynamics

Question:

Discuss about the Liquidity and Exchange Rate Dynamics.

Answer:

Introduction:

The foreign exchange of a country refers to the valuation of the domestic currency of the concerned country in terms of countries of other countries. Over the years, different forms of systems and measurements have been developed in the global scenario for the purpose of determination of the valuation of the domestic currency of countries and the foreign exchange rates of the same (Chinn 2012). For example, there exit different systems including fixed, flexible as well as managed float ones for the purpose of determination of exchange rates in different countries, thereby making actual exchange rate determination a complex procedure. With globalization and the increasing integration of the economies in the international scenario, determination of exchange rates of different countries has become a vital necessity for establishing economic and industrial relations among the countries as well as for determining the economic and commercial prospects of the countries across the world (Noussair, Plott and Riezman 2013).

One of the most simple and comprehensive method of determining the exchange rate of the currency of a country is by using the demand supply framework, existing as one of the key conceptual frameworks in the domain of economics. Under this framework, the demand for a particular currency in international market and the supply of the same from the concerned country are compared in setting the value of the domestic currency in concern (Frenkel and Johnson 2013). The demand and supply framework of exchange rate determination helps the monetary authorities also to determine the future traits and dynamics of the exchange rates of the currency depending upon the market activities. Under this framework, the various factors affecting the dynamics in the value of the domestic currencies and their changes over time can also be taken into consideration, which in turn helps the monetary authorities to analyse and address any discrepancy in the same (Gabaix and Maggiori 2015).

Keeping this into consideration, the concerned section emphasizes on the economy of Australia and tries to analyse the way in which the exchange rate of the domestic currency of the country, Australian Dollar (AUD), is determined in the international Foreign exchange market (MacDonald and Stein 2012). This can be explained with the help of the following figure, which shows the dynamics in the demand and supply of currencies in the international foreign exchange market:

In the international market for foreign exchange, the demand for currency of a country is determined by the international export demand for the goods and services produced in the country whose currency is evaluated. On the other hand, the supply of the domestic currency of the same is determined by the total import demand of the country. The equilibrium exchange rate is determined at the point where the demand and the supply of the particular currency match each other (Imam et al. 2012). However, as shown in the above figure, if the demand for domestic currency of a country (in this case the currency being AUD), other things remaining the same, the demand curve shifts rightwards, from D0 to D1. The supply of the currency remaining the same, the foreign exchange rate increases from X0 to X1. On the other hand, when the demand for AUD falls, the demand curve shifts from D0 to D2, thereby decreasing the exchange rate from X0 to X2 (Mancini, Ranaldo and Wrampelmeyer 2013).

The exchange rate market in Australia being a flexible one, with the rate being determined by the demand and the supply forces, there are various exogenous factors, which considerably influence the demand and supply side dynamics of the AUD in the Forex market, thereby effecting the foreign exchange rate of the same (conventionally measured in terms of the US Dollar). These factors are discussed as follows:

  • Rate of interest- With an increase in the rate of interest in the money market of the country, domestic assets become more attractive to the foreign investors, thereby increasing the demand for AUD. This in turn shifts the demand curve for the same rightwards, thereby leading to an increase in the value of AUD in respect to USD.
  • Inflation- Increase in the overall price level decreases the value of the domestic value of the currency in terms of the USD (Cavusgil et al. 2014).
  • Government policy implications- To promote exports and decrease the imports in Australia, the government can deliberately decrease the value of AUD, thereby influencing the exchange rate.

There may also be other country specific factors apart from the above-mentioned ones which can influence the exchange rate of a currency of a country.

The nominal exchange rate of the currency of a country is the number of units of the domestic currency which the country needs to let go to attain one additional unit of the currency of any other country. There occurs depreciation in the nominal exchange rate of the currency of a country with the increase in the purchasing power and vice versa (Diebold 2012). The Trade Weight Index, on the other hand, of a country shows the material rate of exchange, which incorporates the weighted average of the domestic currency of the concerned country vis-à-vis that of any foreign currency, which is measured in terms of trade share of the country with the trading partners. The TWI also depends upon the business magnitude of the country with its different trading partners (Burstein and Gopinath 2014).

Keeping these measures into consideration, in the Australian economy, considerable fluctuations can be noticed in both nominal exchange rate as well as in the TWI, in the previous three years, which can be shown as follows:

From the above figure, it can be seen that there has been considerable amount of fluctuations in the nominal exchange rate in the country. The same being at its peak in March, 2015, came down considerably in the succeeding periods, owing to a fall in the demand for the commodities and services of the country. The rate rose again in mid-2017, with the rates falling after that.

Fluctuations can also be observed in the TWI of the country during that span of time, as is shown in the above figure. The index hitting a huge low in end 2015, in the recessionary situations in the US economy, recovered significantly, as can be seen from the increased value of the same in October 2017.

One of the factors explaining the fluctuations in both the nominal exchange rate of AUD as well as the country’s TWI is the presence of a weak USD. The recessionary situation in the US economy, during 2015 also led to market saturation and fall in the export demand of the Australian products. The crisis, however, withered away with time, which helped the exchange rate to gain back its impetus, as can be seen from the dynamics of the tow variables in 2017.

This section of the assignment takes reference of the report and shows that there are several factors working behind the fluctuation of the domestic currency of Australia in comparison to USD. Of these the key reason, is the recent slump in the US dollars and a simultaneous increase in the price of commodities like iron ore and other, which has resulted in a hike in the exports from Australia to the USA, thereby leading to an increase in the value of AUD with respect to currency of the USA (Ismail 2018).

However, this rise in the AUD value, as per the assertions of the concerned report is not expected to be long term sustainable. The report attributes this assertion to the stagnation of the wage rates and price level dynamics in the economy of Australia. This, clubbed with the fall in the price of iron ore in the international scenario, the fluctuations in the economic growth of China as well as the rise in the interest rate of the USA, are expected to contribute negatively to the sustainability of the high value of AUD (Manalo, Perera and Rees 2015). The value of the same is expected to fall below that of 70c, with the fall in the exports and the rise in the rate of interest in the USA, which can be shown with the help of the demand supply framework as follows:

As is evident from the above figure, with the slump in USD and the rise in the Australian exports, the demand for AUD is expected to increase, thereby shifting the demand curve from D0 to D1. This in turn shifts the equilibrium from E0 to E1, thereby hiking the exchange rate to X1. However, with the factors like fall in the iron ore price as well as the increase in the interest rate gap between the USA and Australia, the demand for AUD is expected to fall. If the magnitude of fall surpasses that of the initial rise, then the equilibrium is expected to shift to E2, thereby leading to a fall in the exchange rate (X2) (Rossi 2013).

An expected fall in the value of the AUD, in one year, from 80C per AUD to 70C per AUD is expected to make the imports in Australia from that of the USA more expensive. Keeping this into consideration, the Australian firm, which imports electrical machineries from that of the USA is expected to suffer as their imports, which includes the materials required for production of their commodities or services will become costlier. This in turn will force the firm to increase the price of their products owing to a rise in the overall cost of production of the same. The demand for the commodity is expected to fall, thereby hampering the concerned company to a considerable extent.

However, with the fall in the value of the domestic currency the overall exports of the country is expected to increase as the goods and services produced and exported from Australia will become cheaper for countries like that of the USA (Amiti, Itskhoki and Konings 2014). Thus, from the overall perspective, the fall in the value of AUD with respect to USD is expected to have mixed impacts on the economy of the country as the companies which export their products or services will be benefited while those importing commodities and substances from the USA will suffer considerably.

Given that the exchange rate is stabilized at US 72C per AUD, to bring the same back to 80C per AUD, the monetary authority has to take policies of currency appreciation, which include the following:

  1. a) Increase in interest rate- By increasing the rate of interest the country can make their assets more attractive for foreign investors, which in turn will increase the demand for the AUD in the international market, thereby increasing the value of the same.
  2. b) Buying their own currency- The government of the country often buys their own currency and sell foreign exchange assets in order to increase the value of their domestic currency.
  3. c) By reducing inflation- By reducing the overall price level of the economy, the government can also attract more of investors in their economy, thereby increasing the demand for their domestic currency which can help in increasing the value of the same (Caglayan and Demir 2014).

By taking the policy of appreciation of the domestic currency in the country, the government of Australia can help in facilitating in more imports as well as greater inflow of foreign direct investments from all parts of the world. The increase in the ease of importing can help those companies in Australia who need to import raw materials, labour resources and technologies for their production. The increase in the value of the domestic currency in Australia can also benefit the country by decreasing the overall level of inflation in the same (Manalo, Perera and Rees 2015). However, on the other hand, the appreciation of AUD can create problems in the aspects of exporting goods and services of the domestic goods and services, by making exports costly, thereby hurting the growth and prospects of the industries of the country. Thus, the policy of currency appreciation can have both positive and negative implications on the economy of Australia, depending upon the magnitude of which the government of the country needs to take the policy.

References

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

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

Caglayan, M. and Demir, F., 2014. Firm productivity, exchange rate movements, sources of finance, and export orientation. World Development, 54, pp.204-219.

Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.

Chinn, M., 2012. Macro approaches to foreign exchange determination. Handbook of exchange rates, pp.45-71.

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.

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

Imam, T., Tickle, K., Ahmed, A. and Guo, W., 2012. Linear relationship between the AUD/USD exchange rate and the respective stock market indices: A computational finance perspective. Intelligent Systems in Accounting, Finance and Management, 19(1), pp.19-42.

Ismail, N. (2018). Australian dollar tipped to slide back to 70 US cents. [online] The Sydney Morning Herald. Available at: https://www.smh.com.au/business/investments/australian-dollar-tipped-to-slide-back-to-70-us-cents-20180129-h0pp8v.html [Accessed 3 Mar. 2018].

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

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.

Noussair, C.N., Plott, C.R. and Riezman, R.G., 2013. The principles of exchange rate determination in an international finance experiment. In International Trade Agreements and Political Economy (pp. 329-368).

Reserve Bank of Australia. (2018). Historical Data | RBA. [online] Available at: http://www.rba.gov.au/statistics/historical-data.html#exchange-rates [Accessed 3 Mar. 2018].

Rossi, B., 2013. Exchange rate predictability. Journal of economic literature, 51(4), pp.1063-1119.

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