Exchange rates

CV - ER

- AUD mirrored falls in commodity prices - depreciated to lower of 0.57USD in March - lowest AUD in 18 years - fall in AUD may help to stimulate demand for X but no enough to counter overall fall in demand

2016 - 2018 - Appreciating TWI/AUD

- China began to grow again increased in D for both G+S X As commodity prices recovered during 2016-17 the AUD appreciated to USD 0.80 by the start of 2018. •Rising commodity prices due to strong surge of industrialisation and urbanisation → rising TOT : particularly iron ore and coal. With global D rising by more than global S →incrin Commodity prices →incrXPI → incrCR Increased overseas demand for Australian exports: •Commodities - as mining enters its production phase and stronger growth in China (higher than expected growth)→ incrCR •Services:Services industry, particularly education and tourism, had benefited from the previous period of the depreciated AUD (2013 - 2016) → incrCR

FOREX Market - Between USD and AUD

- FOREX Market between AUD and USD consists of two groups 1. those demanding USD; an Australian importer of US goods 2. those demanding AUD ; an American buyer of AUS goods

Why has the AUD depreciated since 2017?

- Falling IR differential (AUS irlower than many other countries) - Effects of a depreciation --> Rise in IC --> incX and decr PQM (affects CAD, real GDP)

Why is TWI better than single ER

- TWI often a better measure of general trends in the ER than any one single ER such as the USD - AUD could be rising against the USD but falling against other currencies - also if AUD appreciates against USD might be due to the US dollars weakness - TWI gives a general view on whether the AUD is rising or falling against all its trading partners

Relationship between ER and BOP

- The Trade Balance - The net Income Deficit - Foreign Investment (The Financial Account)

Effect on Trade Balance - Appreciation

- The price of Australian goods becomes more expensive in terms of foreign currency (more foreign currency required to purchase a given amount of AUD) therefore Australia's IC falls as FI look for cheaper goods somewhere else, leading to a fall in D for X's . - X recorded as credits, less credits recorded --> increase CAD • For Australians, M prices in other countries currency become cheaper in AUD terms, becomes more attractive, thus D for M's increases. - decrease trade balance, as debits greater than credits --> rise in CAD • Also effects, X and M of Services such as tourism as AUS becomes more expensive place to visit for overseas tourists, and AUS are encouraged to travel overseas as it it cheaper; the nation also becomes less attractive as an education services exporter • As a result X volumes decrease and M volumes increase (Net Exports fall) --> fall in Trade Surplus (or a rise in the Trade deficit) --> rise in CAD or fall in CAS. • A 10% appreciation reduces net exports by 8%

Macroeconomic Effects of an appreciating AUD

- The reverse of all of the above

Describe two causes of changes in the TWI

- commodity prices - ir differnetil

PQ: Using an appropriate diagram, outline the factors that may have caused a depreciation in Australia's exchange rate. (8 marks)

- commodity prices - slow growth of china - interest rate differential

BOP and Exchange rates

- country's exchange rate closely related to BOP - BOP records all international's transactions in G, S, Y, FA, FL - ER means by which these transactions are facilitated - fundamental factors underlying the value of a country ER are determined by the transactions in the BOP

Currency Pairings

- demand for USD is matched by supply of AUD, while demand for AUD is matched by a supply of USD. - currencies are paired --> whatever happens on one market will be mirrored in the other market. EG - AUS increase their imports from US, increase in supply of AUD and increase in demand for USD. The AUD will depreciate and the USD will appreciate EG - $A 1 = $US 0.76 --> $A 1 = $US 0.72 ($US 1 = $A 1.32) --> ($US 1 = $1.39) - So if the AUD has appreciated against the USD, then the USD has depreciated against the AUD; - as the $A depreciates, the $US appreciates

Commodity prices, trade and the AUD

- direct relationship CP and TB - relationship between the AUD and the TB- inverse - relationship between Commodity prices and the AUD

A decrease in demand for the AUD (due to a fall in credits) - graph

- fall in exports - fall in income from overseas - fall in capital inflow eg 1. fall in US Foreign investment 2. fall in income from US investments

A decrease in supply of the AUD (due to a fall in debits) - graph

- fall in imports - fall in income payments overseas - fall in capital outflow eg 1. fall in income payments to __ due to fall in interest rates 2. fall in AIA to US

An increase in demand for the AUD (due to an increase in credits) - graph

- increase in exports - increase in income from over seas - increase in capital inflow (FI) eg increase in demand for LNG from US

An increase in supply of the AUD (due to increase in debits) - graph

- increase in imports - increase in income payments over seas - increase in capital outflow eg increase demand for US cars

INCreased imports

- increase supply of AUD - depreciation

Macroeconomic effects list

- output - national income - aggregate demand - employment - inflation

Define exchange rates

- price of one currency in terms of another currency. - current rate US$0.70 - trend = depreciating - no target

J curve - The effects of changes in the exchange rate on the economy (J curve)

- representation of how the CA balance changes over time - the effect of currency depreciation on the trade deficit - J curve states that country trade deficit can worsen after depreciation but improve in the medium term Short term - CAD worsen from A to B - due to inelastic demand demand for M and X in the short term due to contracts - resulting in limtited decrease in M and limited increase in X as it takes time for buyers of exports to respond to price change - quantity of M and X will remain the same - therefore in short term if demand for our exporters isn't changing, yet we are receiving less for them --> worsen the CAD = less credit, more debit transactions = rise in CAD however - overtime CA moves from point B to C = improves - buyers of X will have more time to respond, and notice and take advantage of fact that AUS ER is low and X are cheaper - increase D for X, increase D outweighs falls in price --> increases credits --> falls in CAD

Currencies determined by forces of D and S

- the currencies being traded can be thought of as goods, with the price being determined by the forces of supply and demand → the greater demand for a good, the higher the price goes (appreciates) → the greater the supply, the lower the price (depreciates)

PQ: Use an appropriate model to demonstrate and explain how a simultaneous reduction in Australian IR and an increase in IR in the USA would affect the value of the AUD

- the interest rate differential is a key determinant of the ER - investors in interest bearing securities find economies with higher interest rates to be more desirable as this supples a higher rate of return - as such when Aus IR fall and USA Ir rise investors find the USA to be a more desirable environment for investment and move their funds out of the Australian economy - this results in a decrease in demand for AUD (shifting D curve left from D1 to D2) and also an increase in supply from S1 to S2. - as illustrated this results in a depreciation of the AUD from 0.71 to 0.68 - therefore the value of the AUD relative to the USD has decreased

TWI on a D/S Model

- use the normal ER model, with the X axis as Q (AUD) and the Y axis as TWI. - t replace AUD/USD with TWI EG - if there is an increase in FI --> incrCREDITS --> incrD for AUD --> appreciation of the TWI

Example - An American family choose to holiday in Australia.

1. Increased exports (CR) to USA 2. Credits increase 3. Increase in demand for AUD in the FOREX = rightward shift from D to D1. AUD appreciates Furthermore, this would also mean that the supply of USD in the FOREX is increasing, thus causing it to depreciate.

Example - An Australian car yard store imports stock from Japan.

1. Increased imports (DR) from Japan 2. Debits increase 3.Increase in supply of AUD in the FOREX = leftward shift from S to S1 AUD depreciates Furthermore, this would also mean that the demand for JPY in the FOREX is increasing, thus causing it to appreciate.

Aggregate Demand - depreciation

Aggregate Demand Rises • Remember AD (AE) = C + I +G + (X-M) - Net export component of aggregate demand is increasing - likewise if nation Y rising --> rise in C and I → firms spending more on investment and HH spending more on consumption → rise in AD

Increase Australias IR differential

An increase in Australia's i/r differential means that i/r's in Australia have increased relative to o/s - this will increase foreign investment (capital inflow) into Australia, - increasing the D($A) shown by shift right in the demand curve from D1 to D2 - appreciating the exchange rate.

Summary - Appreciation

Appreciation: Trade Balance : FALL -> Rise in CAD or Fall in CAS Net Income Deficit : Fall -> Fall in the CAD, rise in the CAS Foreign Investment: Fall -> Fall in the CAD, rise in the CAS

Effect on Foreign Investment Flows (Financial Account) - Appreciation

As the AUD appreciates •This may deter Foreign investors due to the relatively higher price of investing (in Foreign currency terms). Thus FI will fall --> fall in FA Surplus AND fall in NYD --> fall in CAD.

Effect on Foreign Investment Flows (Financial Account) - Depreciation

As the AUD depreciates •This will attract Foreign investors due to the relatively lower price of investing. Thus FI will rise --> rise in FA surplus AND rise in NYD as more AUD required to pay back interest, dividends --> more debits --> rise in CAD

Effect on Trade Balance - Depreciation

As the ER depreciates • The price of Australian goods become cheaper in foreign currency terms, cheaper for foreigns to purchase G+S from AUS, leading a rise in IC, goods more attractive and an increase in D for X's. • For Australians, M prices become more expensive thus D for M's decreases. • As a result, X volumes increase and M volumes decrease (Net exports rise) (more credits less debits) --> rise in Trade Surplus (or a fall in the Trade deficit) --> fall in CAD or rise in CAS. This is, however, considered a long term effect because we assume Xers and Mers have time to respond to the depreciation of the AUD.

Determining ER of AUD - Floating ER

Australia has had a floating ER since 1983. - floating ER is one whose value is determined by the market forces of D and S - equilibrium price will change whenever demand or supply curve shift Demand and Supply of the currency is determined by all transactions in the BOP - CREDITS affect Demand for the $A, while DEBITS affect Supply of the $A.

Explain the effects of a fall in the exchange rate on the balance of payments, firms and households in the Australian economy.

BALANCE OF PAYMENTS CA · Depreciation will increase competitiveness by lowering export prices & boosting exports while increasing import prices & reducing imports. · Positive impact on the tourism industry, services exports etc. A depreciation will (ceteris paribus) increase the trade balance. · Some students may talk of the J curve effect - elasticities may affect this process FA · Depreciation will reduce the price of Australian assets which will encourage foreign investment into Australia FIRMS · Exporting firms benefit - IC increases incr Dx increased profitability · Import firms suffer - due to higher import prices which may increase their costs e.g. higher petrol prices, imported inputs more expensive HOUSEHOLDS · S of L increases - as national income rises incr in S of L · Increased employment - as export sector grows

Commodity Prices

COMMODITY PRICES --> TOT movements. - The AUD is known as the 'commodity currency' . - Changes in commodity prices affect the XPI which affects the TOT . - There is a positive correlation between commodity prices and the ER --> CP rise, AUD rise •If Commodity prices rise (iron ore) ➔ XPI↑ (main exports) ➔ reflected in a rise in TOT ↑ ➔ caters paribus (same quantity earning more for them) ↑X income ➔ ↑ D for AUD (Aus exporters expect to be paid in AUD) ➔ appreciation •If Commodity prices fall ➔ XPI ↓ ➔ TOT ↓ ➔ ↓ X income ➔ ↓ D for AUD ➔ depreciation •Other changes in the TOT will also affect the ER. E.g. If TOT ↑➔rise in national income --> ↑ M payments (consumer and capital goods) ➔ ↑ S of AUD ➔ depreciation

Output - Appreciation

Contractionary effect on the Economy as production and therefore GDP will fall --> fall in EG Domestic firms (import competing). Imported overseas goods are now relatively cheaper (in AUD) than Australian goods and services so less competitive --> fall in D for domestic import competing goods --> fall in domestic production Exporting firms. - Fall in production as IC falls and less D for exported goods from overseas --> fall in domestic production

ER trends

Depreciated Jan 2018-March 2020 March 2020 appreciating - strong exports and increasing commodity prices = increasing TOT - weak domestic growth = decreased M debits - increased demand and decreasing supply AUD = appreciation

Macroeconomic Effects

Depreciating AUD = Expansionary (Expansionary effect on the Economy as production and therefore GDP will rise --> rise in EG) Appreciating AUD = Contractionary

Employment - depreciation

Employment Rises • demand for X's increases (due to increased IC) → rising production → increased demand for labour in order to produce jobs → fall in cyclical unemployment or rise in employment

a) Use the demand and supply model to illustrate a depreciation of the exchange rate. Explain THREE (3) factors that can cause an exchange rate depreciation. (10 marks)

FACTORS CAUSING A DEPRECIATION Any three factors. 2 marks each. Must be able to explain how the factor affects either the D($A) or S($A) · Decrease in commodity prices - this will decrease the value of Australia's exports & decrease D($A) · China (US or World) economy contracts - this will decrease demand for Australia's exports & decrease D($A) · Fall in Australia's interest rate differential - this will decrease foreign investment into Australia reducing D($A) & at the same time increase the outflow of capital decreasing the S($A)

Foreign Investment Flows

FI FLOWS - due to: • Perceived safety of Australia - Historically AUS safe place for investment - Foreign investors will be attracted to invest in Australia if it is considered a relatively safe destination for investment, Australia has a AAA sovereign credit rating so is considered a safe destination ➔ ↑ in FI (incrK inflow) ➔↑ Credits ➔ ↑D for AUD ➔ appreciation. • Profit opportunities in Australia - Foreign investors will be attracted to a country that offers high profit opportunities e.g. during mining boom ➔ ↑ in FI (incrK inflow) ➔↑ Credits ➔ ↑D for AUD ➔ appreciation • FI flows will also vary depending on profit opportunities of other countries. If higher then FI to Australia will decline

Aggregate demand - Appreciation

Fall - Fall in National Income will lead to a fall in C and I thus a fall in Agg Demand. - Net Exports also falling - Remember : AE = AD = C + I + G + (X-M)

Inflation - Appreciation

Fall Three reasons: - As National Y falls so do wages and employment thus decreasing spending. As agg demand falls --> demand pull disinflation - AT the same time, an appr reduces the price of overseas goods to domestic producers who may use imported goods as production inputs --> cost push disinflation. - Lower priced imports (In AUD terms) feed into the CPI

Employment - Appreciation

Fall - As demand for X's decreases due to reduced IC therefore less labour is required to produce the goods and services (cyclical unemployment) but if appreciation prolonged will cause structural UE in sectors that are uncompetitive. - For example, import competing sectors may not be able to compete effectively so may lose business (e.g. demise of the manufacturing sector - car and steel industries)

National Y - Appreciation

Fall Due to decrease in X volumes and increase in M volumes --> fall in X income and rise in M payments --> fall in net exports which will lead to a fall in National Y.

Credits and debits

Fall in credits --> fall in Demand for AUS --> depreciation Increase in credits --> rise in D for AUD --> appreciation Fall in debits --> fall of supply of AUD --> appreciation Rise in debits --> increase in supply of AUD --> deprecation

Depreciations

Fall in the value of one currency in terms of another currency Can be caused by; • a decrease in demand for the AUD or; • an increase in supply of the AUD

FOREX Market

Foreign Exchange Market - market where the currencies of different countries are bought and sold. - Foreign exchange is the currency of another country that is needed to carry out international transactions Valued at over $4 trillion per day, 1000 of currencies are exchanged every day.

Discuss the longer term impacts of a depreciation in the Australian Dollar on households and firms in the Australian Economy.

Households: · Increased standard of living - as depreciation --> incr in Int Comp --> incr in D x --> incr in X income --> incr in national Y --> consumers are able to purchase more G and S --> incr in S of L · Increased employment - as X porters incr output to meet growing D so they require more labour incr in employment. Also import competing will incr output creating N opportunities. · Increase in inflation - demand pull inflation as national Y rises, cost push inflation as price of imports increases, M prices feed into the CPI Firms: · Exporting firms - benefit as X goods are more competitive on international markets --> incr D x --> incr X income --> incr in profitability · Import competing firms - benefit as imports are now more expensive, thus their domestic competitiveness increases --> increased output --> incr profitability · Mining companies will increase their revenue if payments are made in foreign currency. · Service firms will benefit as they become more competitive --> incr in Service X's · Domestic firms who rely on imported production inputs will lose as their costs increase fall in profitability

Factors affecting / influencing Australia's Exchange Rate

However the 4 main factors are: • Commodity Prices • Relative interest rates (the IR differential) • Export demand (Overseas Economic Growth) • FI flows

Relative Interest Rates

INTEREST RATE DIFFERENTIAL (RELATIVE INTEREST RATES)- - difference between Australia's interest rate and overseas interest rates. - interest is a return on FI - Causes movement in FI, particularly Portfolio Investment which is short term and speculative - Foreign investors will shift funds into and out of countries in order to gain the benefit of the highest interest rates on offer to maximise return •If Australia's Ir rises (compared to overseas interest rates) ➔ Ir differential rises ➔ attract FI and incrK inflow into Australian economy ➔↑ Credits in financial account ➔ ↑D for AUD ➔ appreciation. •If overseas Ir rises (compared to Australian interest rates) or Aus IR drops more than overseas ➔ Ir differential falls ➔ become less attractive as a place to invest ↓ in FI ➔ ↓ Credits ➔↓ D for AUD ➔ depreciation. - Also when depreciation occurs, some Forigen investor will take their money out of the current AUS investments - will lead to increased K outflow (as foreign investors move their capital from Australia to other countries ➔ ↑ Debits ➔ ↑ S of AUD ➔ depreciation

Effects of a Depreciation on Firms

Import competing Firms (Australian manufacturing and services sector) • Imported goods from overseas become more expensive →rising demand for domestically produced goods →increased production and profits in these industries Exporting Firms (mining sector) •Rise in IC → rise in demand →rise in production and profits eg mining, tourism, education more attractive to overseas buyers --> more IC --> rise in D Other Firms •May lose from the increased price of imported capital equipment which are now more expensive → increased costs → reduced profit

Inflation - depreciation

Inflation Rises • As National Y rises so does employment and wages → rising spending →demand pull inflation • Rising cost of imported goods → feed into the CPI → cost push inflation • Rising cost of imported capital goods for firms → rising costs of production for producers → pass onto consumers in the form of higher prices --> cost push inflation

PQ: Discuss the effects of this movement in the exchange rate on international trade, businesses and Australia's macro economy. (12 marks)

International trade - Dep increases IC - export prices fall = increase - M prices rise = decrease - higher import prices discourage household and firms to M - CAD fall as trade balance improves Businesses - benefits to export industries due to lower $AUD - benefits to service industries ie tourism and education - increased consumer spending on M competing industries - negative impact on businesses that rely on imports (higher input costs) Macroeconomy - Dep will have expansionary affect - increase NX --> increase AD - higher inflation - higher employment - capital imports become more expensive - increasing debt servicing costs

2008 - 2012 - Appreciating TWI/AUD

MINING BOOM. - TWI reached a peak of 85 in real terms and AUD reached a peak of $1.10 in USD in May 2011. (highest In history) • Growth in east Asia therefore demanding X --> Commodity prices rose → large rise in TOT - Commodities Boom. AUD known as the 'Commodity currency'. Commodity prices rose due to massive boom in China (industrialisation, with 10.4% GDP 2001 - 2011) →rise CR • Widening IR differential - Aust IR higher than overseas IR → higher return on investment --> rise in portfolio I into Australia (Aust IR 3.5 %, US 0%) →rise CR • Rise in FI - Australia viewed as safe, stable destination for FI. AAA rating (low risk), low levels of sovereign debt and high profitability (particularly in mining sector who wished to explandproduction) →incrFI → incrCR. Also Australia's SI Gap widened →incrFI (particularly driven by mining industry). Australia offered profit opportunities to foreigners →rise in FDI • Overseas growth - high levels of demand for Aust exports from East Asia and particularly China - incrD for exports → incrCR •Domestic growth rising - would lead to a rise in M spending (K and consumer goods) →rise in DR --> rise in SOL

National Y - depreciating

National Income Rises as depreciation generates income • Increased X and decreased M → rise in X income and a fall in M payments → rise in net exports overall → rise in national income as a result - Exporters are earning more

Output - depreciating

OUTPUT Rises From both: • Domestic firms are now relatively cheaper in AUD than overseas imports for domestic consumers → rise in demand for domestic import competing goods → rise in domestic production in import competing firms. • Exporting firms are now more internationally competitive because their G&S are now relatively cheaper in foreign currency → rise in demand from overseas → rise in domestic production

Export Demand and Import demand

Overseas Growth ➔ - stimulates demand for X - demand for X is most impacted by overseas eg China growing strongly - ↑ D for X ➔ ↑ X Credits ➔ ↑ D for AUD as AuS exportors expected to be payed in AUD ➔ appreciation and vice versa Domestic Growth ➔ - stimulates demand for imports from other countries - If AUS growing strongly, confidence is high, UE low, income rising, business growing and investing - ↑D for capital and consumer M ➔ ↑ M Debits ➔ (pay overseas producers in their currency, supply AUD on foreign market,↑S of AUD ➔ depreciation and vice versa

1. Calculate the AUD value of a good from another country, using its ER

Question- If $A 1 = $US 0.77 how much would a good costing USD 100 be in AUD? Answer- 100 / 0.77 = $A 130.

2. Work out the reciprocal if only given one side of a currency pairing

Question- If $A1 = $US 0.83 , what does $US 1 equal to in AUD? Answer- The easy way is to just divide 1 by 0.83, thus $US 1 = $A 1.20

Appreciations

Rise in the value of one currency relative to another currency Can be caused by; - an increase in demand for the AUD - a decrease in supply of the AUD

2013 - 2016 - Depreciating TWI/AUD

SLOWDOWN IN MINING BOOM AND SLOWDOWN IN CONSTRUCTION PHASE OF THE MINING BOOM. TWI fell 35% from previous high, USD rate fell to 0.70 by early 2016. • China development and growth striating to slow --> Commodity prices fell →Fall in TOT →decrCR •Narrowing IR differential - Aust IR fell (govt attempt to stimulate spending in the economy) and US rates started to increase as the US economy grew post GFC →incrCapital outflows as portfolio I leaves Australia → incrDR + less FI into Aust → decrCR. •Fall in FI - rest of the world now more stable, particularly US →incrin capital outflows → incrDB. Also as mining moves from investment to production phases (mining I down 41% from its peak, business I down 21% from its peak) →decrCR • Overseas growth slowing -particularly China and East Asia, less D for Australian commodity X's and uncertainty about Aust growth prospects → decrCr • Strengthening of other key currencies - USD and EUR have been appreciating as these economies grow →depreciation of AUD in terms of other currencies •Domestic growth falling - would lead to a fall in M spending (K and consumer goods) →fall in DR

Since 2018... Depreciating trends

Since 2018 the TWI/AUD has continued to depreciate. This has occurred despite a rise in the Terms of Trade over this period. Mainly due to: • 2018-2019 Continued narrowing of IR differential - due to improved financial conditions overseas offering higher interest rates. - AUS downturn recent years, under performing, Ir on hold for 31 months - For instance, in October 2018 the Australian cash rate was 1.5%, where as the US cash rate was 2.25% - a difference of 75 basis points (look invest US not AUS) →incrDR + less FI into Australia → decrCR • 2020- Many countries offering negative rates, and some of the lowest rates in history Aus 0.25% , it is very difficult to determine the effect these changes will have on FI. - Ir globally low; investors may look past nominal figure and to safety and security of Investment --> leading to investment in AUS •Weak domestic growth - - economy under perfuming, growth under target rate - fall in M spending (K and consumer goods) → fall in DR leads terms of trade in positive •Commodity prices -even though still strong, tightened barriers to trade in countries and states due to CV might lead to a fall in D → decrCR •Global uncertainty (China/USA trade war, BREXIT, Coronavirus) - less D for Australian commodity X's and uncertainty about Aust growth prospects → decrCr . Also will potentially result in less FI into Australia → decrCr .

Effects of a Depreciation on Households

Standard of living • Imported goods from overseas become more expensive which reduces consumer spending and purchasing power → cannot afford to consume as many goods --> HH demand for imports will fall →fall in standard of living. • However, as national Y rises due to rising X revenue, so HH income will rise and are able to purchase more→ rise in S of L - overall effect is defendant on particular households, spending, industries or sector employed in etc.. Rise in inflation - reduced purchasing power for fixed income earners • redistribution and output effects of high inflation e.g. fixed income earners lose, borrowers win etc - demand pull inflation as national Y rises, cost push inflation as price of imports increases, M prices feed into the CPI Rising employment • Greater job opportunities from X industries doing well → transfers into whole economy with higher wages if got lower UE and higher D for labour

Australias TWI

The TWI has a direct relationship with the AUD. - AUD appreciates, TWI increases - However, as the index is made up of a basket of currencies, the swings are less significant.

Trade Weighted Index

The TWI is an index which measures the value of a country's currency in relation to a basket of 19 currencies weighted according to the value of trade flows with Australia. - currently 60 (depreciating) - provides a measure of whether the AUD is rising or falling an average against the currencies of Australis trading partner - a more accurate reflection of demand and supply of currency than more common measures such as USD currencies - currencies of trading partners such as Yuan, Yen, USD, NZ dollar and Euro are included and weighted in the construction of the index - Weights adjusted each year based on changing importance to Australia - if Australia's TWI increases --> AUD getting stronger against its main training partners.

Effect on Net Income Deficit - Appreciation

The income payments and debt servicing payments to foreigners need to be paid in foreign currency. As the AUD appreciates • The AUD has increased its purchasing power and LESS AUD are required to purchase a given amount of foreign currency to make the income payments to foreigners (interest, profits and dividends) • Therefore, an appreciation reduces the debit transaction recorded in the primary income account • Thus the NYD falls and the CAD falls.

Effect on Net Income Deficit - depreciation

The income payments and debt servicing payments to foreigners need to be paid in foreign currency. As the AUD depreciates • The AUD has decreased its purchasing power and MORE AUD are required to purchase a given amount of foreign currency to make the income payments to foreigners (interest, profits and dividends) • Therefore, a depreciation increases the debit transaction recorded in the primary income account • Thus the NYD rises and the CAD rises.

PQ: The Commodity price index and the AUD are usually positively related. Explain where this is evident in the graph and why

The main reason is the AUD is dependent also affected by changes in the interest rate differential between Australia & the US. During this period Australia's i/rs were falling relative to the US which reduced demand for AUD & counteracted the effect of rising commodity prices.

Effects of a Depreciation on Overseas Sector (BOP)

Trade Balance (BOGS) rises assuming in more elastic demand in longterm → fall in CAD • Above can be shown using 'J curve' model BUT • Net income deficit higher because due to depreciating dollar it takes more AUD to convert foreign currencies to pay off debts (due to rise in debt servicing costs) →rise in the CAD • FI will rise more IC (investments are cheaper) →rise in net income deficit in the future →rise in the CAD OVERALL EFFECT ON THE CAD WILL DEPEND ON THE STRENGTH OF THE TWO EFFECTS

Summary - depreciation

Trade Balance : RISE -> Fall in CAD or rise in CAS Net Income Deficit : Rise -> Rise in the CAD, fall in the CAS Foreign Investment: Rise -> Rise in the CAD, fall in the CAS

Appreciation

a rise in the value of one currency in terms of another currency EG - $A1 = $US 0.63 changes to $A1 = $US 0.66 so the AUD has appreciated (or can now buy more/exchange for more USD).

Depreciation

fall in the value of one currency in terms of another currency e.g. $A1 = $US 0.66 changes to $A 1 = $US 0.63 so the AUD has depreciated (or can now buy less/exchange for less USD)

Decrease price of commodities

i. A decrease in commodity prices will decrease the value of Australia's commodity exports (iron ore, coal etc) - which will decrease the D($A) on the FOREX shown by shift left from D1 to D2, as less money required to exchange - depreciate the exchange rate

PQ: Use a model to explain two reasons for the decrease in Trade Weighted Index.

· Acceptable reasons for decrease in TWI (4): - Fall in Ir differential (àfall in capital inflow, rise in K outflow àdecr D AUD, incr S AUD) - lower FI as overseas economies provide more opportunity as they begin to grow (àfall in K inflow àdecr D AUD) - overseas growth slowing due to trade wars (decr X àdecr D AUD) strengthening of other key currencies (àdepr of AUD) Model = decrease in the D or increase in S AUD

Effects of a Depreciation on Government Sector

• Higher X → X industries paying higher company tax to govt --> increased company tax revenue • Higher Incomes → consumers are earning more paying more tax --> higher income tax revenue • Less UE → less welfare spending Overall government is earning more and spending less therefore budget is going to be looking healthier If the expansionary impact of the Depreciation is large enough it may require govt ennact Fiscal Policy --> needs to be sustainable period of economic growth

An alternative way of looking at effects is to discuss the impacts on the main sectors of the economy:

• Households • Firms • Overseas Sector • Government

Supply of the $A is determined by

• Imports of Goods and Services • Income payments overseas • K outflow (AIA) --> OUTFLOW OF FUNDS

Short term vs Long term effects of a depreciating dollar on the trade balance

•The discussion in the last slides assumes that demand for our X and M is elastic •However, in the short term pre-existing trade contracts actually make demand of both M and X quite inelastic •As a result of this the opposite effect on the trade balance occurs in short term •This theory is called the J curve and is illustrated and can be illustrated in a diagram

So Demand for the $A is determined by

•X of Goods and Services •Income from overseas •K inflow (FI into Australia) --> INFLOW OF FUNDS