Joseph Rossi

Explain (cause and effect) how movements in the Australian dollar, particularly Australias recent depreciation,
can affect the performance of the Australian economy.

Australias exchange rate refers to the bilateral price of Australias currency in

terms of another economys currency. The value of the Australian dollar ($A) may
also be measured multilaterally against a number of weighted foreign currencies
of major trading partners according to their significance to Australias trade flows
by the Trade Weighted Index (TWI). Since the floating of the $A in 1983, from the
managed flexible peg, its value has been subject to fluctuations determined by
the price mechanism in foreign exchange (forex) markets. As all trade and
financial relationships are mediated by exchange rates, movements in the value
of the $A have a significant impact on Australias economic objectives, principally
economic growth and external stability. From mid-2009 to mid-2013, the $A
steadily appreciated, mainly owing to demand factors, particularly the mining
boom and Chinas strong economic growth and inelastic demand for Australian
products. However, owing to a gradual reversal of these trends since, Australias
currency has depreciated against most of its major trading partners, below parity
with the USD (0.73) and Euro (0.64).
The recent depreciation of the $A has been a corollary of a decrease in demand
for $A and an increase in supply of $A. Demand for $A is represented by those
who want to buy $A. A decrease in demand is shown by a left shift of the demand
curve, decreasing equilibrium quantity, Q to Q 1, and the equilibrium exchange
rate, P to P1 (see diagram below). An increase in demand would be shown by a
shift right in the demand curve, reflecting an appreciation.
Exchange rate

P
P1

Q1 due
Q to a decrease
Quantityinof $A
Diagram 1: Depreciation
demand

Demand for $A is affected by the size of financial flows into Australia from
foreign investors who wish to invest in Australia and need to convert their
currency to $A. Australias lower than previous interest rate differential in
comparison to other advanced economies has made Australia a less attractive
location for foreign savings, resulting in capital flight. In January 2011, the cash
rate was 4.75%, much higher than the US, 0.25%, and the Eurozone, 1.00%. Now
Australias cash rate is 2.00%, the US remains stable and is predicted to
increase, and the Eurozone only dropping slightly, 0.05%. The depreciation was
exacerbated by falling demand for commodities owing to the decline in the
mining boom, reflected in the general fall in commodity prices ( -20% in 2014),
such as iron ore (-45%), thermal coal (-20%), and Brent oil (-44%), which
Australia export in large quantities. Australias decreased export volumes is
further a repercussion of global economic conditions, particularly Chinas
decreased economic growth, 10.5% in 2010-11 to 7.4% in 2014-15. This also
reflects Australias decreased international competitiveness, as evidenced in

Joseph Rossi
Australias comparatively higher inflation rate, 1.5% in 2014-15, compared to the
US, 0.2%, and the Eurozone, -0.1%. Demand for exports are also influenced by
overseas consumers change in tastes and preferences. The use of quantitative
easing in the US, Japan and the Eurozone has supported economic growth,
increasing consumer demand and keeping the $A higher than forecast.
Supply for $A is represented by those who want to sell $A. An increase in supply
is shown by a right shift of the supply curve, increasing equilibrium quantity, Q to
Q1, and decreasing the equilibrium exchange rate, P to P 1 (see diagram below). A
decrease in supply would be shown by a shift left in the supply curve, reflecting
an appreciation.
Exchange rate

P
P1

Q Q1
Quantity of $A
Diagram 2: Depreciation due to an increase
in supply

Supply of $A is affected by the size of financial flows out of Australia by

Australians who wish to invest overseas, and has increased owing to the lower
interest rate differential. Greater availability of investment opportunities
overseas, increased domestic demand for imports, due to higher domestic
income, changes in domestic consumers tastes and preferences and/or
decreased competitiveness of domestic firms, can increase supply. The slowdown
in the mining boom has increased profits leaving Australia and decreased
investment, also increasing supply. As 95% of daily forex transactions are
speculator driven, speculators are also capable of changing both demand and
supply. During the appreciation period, the positive speculation on the $A due to
increased terms of trade (TOT) weakened Australias international
competitiveness of non-commodity exports (Dutch Disease). Australias close to
target economic growth, 2%, has maintained investor confidence, cushioning
against a large devaluing in the $A, unlike that in the GFC, highlighted by the
drop in exchanged derivatives, falling from $77 trillion in 2008 to $58 trillion in
2009.
A depreciation in the exchange rate has an expansionary effect on economic
activity in the medium term by changing the relative price of exports to imports
(decreasing the TOT from a peak of 132 in September 2011 to 85.7 in June
2015). By decreasing the value of the $A in terms of other currencies, Australias
exports become cheaper on world markets. Foreign investors would find it less
expensive to import and invest in Australia, causing an increase in Australias
export volumes and increased foreign direct and portfolio investment, supporting
Australias production, and so economic growth. This further should lead to a
structural reallocation in the tradeable goods sector as resources are reallocated
in production, improving the competitiveness of firms. This will benefit the
Australian economy, maintaining economic growth despite a decline in the

Joseph Rossi
mining boom. Increasing prices for imports should discourage import spending
and encourage domestic producers to purchase locally produced goods and
services. The impacts of an uncompetitive economy were clear in the sustained
appreciation of the $A, causing many firms to close, unable to compete, such as
the Australian car industry, increasing structural unemployment.
However, a depreciation reduces a consumers purchasing power due to
increased import prices. If consumers are unaffected by the depreciation,
imported (t5tand demand-pull) inflation will occur. The fall in world oil prices
though is expected to more than offset the upward pressure on prices, resulting
in a sustained inflation rate. In the September quarter 2014, the direct effects of
the exchange rate depreciation added about 0.5% to the prices of tradeable
goods. Overseas travel is also more expensive for Australians. The converse is
also true, that it will be cheaper for foreigners to come to Australia, potentially
increasing economic growth and employment.
Movements in the value of the $A impact the CAD. The recent depreciation
should improve Australias CAD in the medium term via the BOGS, owing to
increased export volumes and decreased import volumes, B to C. In the short
term though, a trade deficit occurs, A to B, as exporters receive lower revenue
for a given quantity of exports and import spending rises for a given quantity of
imports. The graphical representation is known as the J-curve. Australias fall
from 78.4 in April 2013 to 64.1 in April 2015 in the TWI helped increase the
deficit on the BOGS, -$10.5 bn in 2012-13 to -$15.7 bn in 2014-15, and the CAD,
-3.2% of GDP to -4.0% of GDP in the same period.
C

A
B

Diagram 3: J-curve
effect

A depreciation increases the value of foreign assets in terms of $A (the valuation

effect). The $A value of foreign income earned on Australias investments abroad
will therefore rise, increasing net primary income (NPY) inflows, and decreasing
NPY outflows for return on foreign investment in Australia, improving Australias
external balance. By this same principle though, the $A value level of foreign
debt borrowed in foreign currency will rise in terms of $A. However, 80% of
Australias debt is denominated in the $A, so, the net foreign liabilities section of
the balance of payments will only rise slightly owing to increased debt servicing
costs (NPY outflows). Foreign debt held in foreign currency always exposes a
country to a debt trap scenario. This partially explains Australias rise in net
foreign debt to $955 bn in 2014-15, reaching a new cyclical high of 60% of
annual GDP. If the CAD rises too high, Australias AAA credit rating may be
reduced.

Joseph Rossi
The recent depreciation in the value of the Australian dollar has had a significant
impact on Australias economic performance, holistically supporting economic
growth and external balance, a shift away from what was considered an
overvalued currency.