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Name Professor Course Date The Relationship between Exchange Rates and Commodity Prices, and Empirical Evidence on This Relationship for Australia Abstract There exists a dynamic and complex relationship between the exchange rate fluctuations and Australias commodity price movement. An evaluation of this relationship requires the consideration of parameter instability in order for a demonstration of the robust evidence. Exchange rates play an enormous role in predicting a countrys commodity price movements. The results are consistent with the current value association, which shows that the exchange rate relies on fundamental values, which include a core group of export commodities by Australia, and the global value of the commodity exports. Global commodity prices exist in exogenous nature to Australia, enabling the avoidance of issues that face related studies. In this case, the literature suggests that in case the commodity price market has thin and non-existence characteristics, the exchange rate can forecast future price movements. This means that there exists a relationship between the foreign exchange rates and the commodity prices in Australia. The paper relies on empirical, evidence to show this relationship.

Introduction This review relies on, empirical, evidence to illustrate that the exchange rate influences the price of commodities, future trends and trends in pricing. Australia relies on the production of primary goods in the agricultural and manufacturing segments of its economy. In this case, commodity price shocks in the event of instabilities in the foreign exchange will have crucial implications in the economic sector. According to the Dutch Disease, the main channel for commodity price shock affects a nations economic performance in the exchange rate. The dependence of the exchange market on trading terms has led to numerous studies; hence enormous volumes of literature on the issue (Cashin, Cespedes, & Sahay, 2003, p. 1). An analysis of the literature in the case of Australia shows that increases in the prices of commodities in Australia has an association with increases in the exchange rates. However, the analysis will be limited to the estimation of the exchange rates responsibilities to the commodity price. The review will not analyze the determination of the magnitudes of the exchange rate. This analysis will focus on five main structural features. The first lies on the exchange rates regime in Australia, the extent of openness of the financial sector in Australia, and the extent of export diversifications in Australia. It will also feature the commodities exported by Australia and the extent of trade openness. Comprehension of these factors provides immense insights into the connection between the rates and commodity prices (Chen, & Rogoff, 2002, p. 1). Australia has a complex exchange rate system and regime faced with issues such as the amount of open capital, and issues on the amount or concentration of export products. The choice of these factors depends on theoretical considerations.

This analysis is at a cross section of vital topics on the determinant of economic growth in Australia. The commodity prices instabilities may have shocks that will affect or influence economic performance. This happens because Australia has specialized exports in primary products. Structural factors such as financial openness and exchange rate regimes influence economic growth (Ellis, 2001, p. 5). Scarce empirical evidence exists on the determinants of the strengths of the exchange rate and commodity price relationship. Since the collapse of the Breton Wood and the wide spread adoption of elastic exchange arrangements by nations, there has been a growing interest by individuals on the field of exchange rates and its determination of commodity prices. This interest has intensified following the liberation of the capital markets, progression of global investment and trade and higher crossmarket returns. The past years have seen an accumulation of literature on exchange rate and its influence on commodity prices. Minimum fluctuations in the exchange rates have capabilities of influencing wealth creation, individuals wealth, governments policy and companys profitability, in addition to cultural attitudes (Clements, & Fry, 2006, p. 4). The widespread interests in the field has been supported by media coverage of capital markets in Australia, especially after the global collapse or melt down of financial institutions, and the instabilities in international commodities such as crude oil, which have immense capabilities of influencing the exchange rate. Studying the exchange rate and its relationship on commodity prices in Australia is logical because the Australian market has advanced, well developed, liberalized and transparent. Australia actively participates in foreign trade, and it has a reputation as a global commodity exporter. This offers an opportunity for evaluating the relationship between the exchange rate regimes and commodity prices (Ellis, 2001, p. 6). For conclusive and comprehensive coverage of

the topic, this review has sectional divisions. These include the background, theoretical consideration and data sections. The other crucial sections lie in the empirical analysis and conclusion. Background Information Equilibrium real exchange rate refers to the rate, which has the consistency with simultaneous achievement of equilibrium, both external and internal. Internal equilibrium refers to a situation in which non-tradable products clear the market, while external equilibrium refers to a situation in which current accounts retain sustainability. Real exchange rate misalignment refers to circumstances in which a gap exists in equilibrium and actual real exchange rates. This gap refers to a sustained departure from the real exchange rate and its long run equilibrium value. The real exchange rate should be capable of providing pointers and indications to the economic agents. Information or data on the degree of divergence of the exchange rates serves, as an indicator for the policy makers and market analysts, to ensure it does not affect the economy. Negative effects of the exchange rates on the economy could lead to the allocation of insufficient resources; hence the reduction or interference with a nations welfare (Gruen, & Kortian, 1996, p. 9). Misalignment of the exchange rate leads to an increase in economic instability, efficiency costs and distorts investment decision. A misalignment of the exchange rate, especially with overvaluation could hurt the export sector, or wipe out crucial economic sectors in Australia such as agriculture and mining. It also causes capital flight, which has optimal effects on the private sectors, but leads to substantial and magnified effects on the social welfare. Despite the fact that the exchange rate serves as an efficient pointer to the economy, the effects of the exchange rate on Australian commodity prices have not been studied deeply. This could be because of the challenging nature of estimating the effects of a misaligned exchange rate. This requires the

determination of the equilibrium exchange rate and evaluation of the degree of divergence of the actual exchange rate from the equilibrium exchange rate. The methods for estimating the equilibrium exchange rate have undergone advances through the introduction of econometrics tools such as co integration, unit roots and vector auto regression. Australia, as a commodity-exporting nation, faces large volumes of trade fluctuations, which could render the nations real exchange rate to be volatile. Increased unpredictability with the real exchange rate could result to harmful effects on the economy. This could be through its negative effects on private agents and their ability to make investment decisions (Makin, 1997, p. 6). Australia being a leading global exporter in various products and materials is not an exception to these exposures of the volatilities of the real exchange rate. Economists have attempted to demonstrate and model movements in the real exchange rate without much success. Meese and Rogoff suggested linear structural exchange rate tools failed in accurate forecasting for both real and equilibrium real exchange rate. In case the real rates follow a random trend, innovations to the real rates may persist, providing impetus for the time series to fluctuate without bound. This contradicts the theory of Purchasing Power Parity (RBA, 1998, p. 7). According to this theory, constant equilibrium levels exist, which enable the exchange rate to converge. Therefore, the foreign currencies should have similar purchasing powers. Accordingly, the PPP has continuously proved to be a fragile model of the real rate long run because recent studies show and emphasize the time varying nature of the real exchange rate. Theoretical Considerations In the Australian context, long run determinants of the real rate exist, and they have their emphasis on differentials in sector productivity, government spending and cumulated imbalances

in current accounts. Other crucial drivers of the long run deviations include interest rate differentials. Recent studies by Chen et al. (2008) applying quarterly information found that exchange rates of exporting countries have immense forecasting potentials for the prices of the export commodity. Therefore, the currency market provides price efficient and useful information on future price activities. As a result, the exchange rates have forward lean information beyond the price reflected on the commodity price. Literature studying this relationship began with the Exchange Rate Puzzle by MeeseRogoff. This states that principles-based currency estimate models cannot outdo random walk benchmarks. Therefore, the puzzle suggests that economic fundamentals relationships exist. Other literature after the introduction of the puzzle contradicts the fundamentals in the puzzle. Previous studies on the relationship cite three explanations to the commodity-currency relationship. The Sticky Price Model points that price for commodities increases leading to inflationary pressure on the exporting countrys wages, exchange rate and non-traded goods prices (Sanidas, 2005, p. 9). However, non-traded goods prices and wages have upward sticky, leading to an increase in the commodity price, which will influence the countrys exchange rate. The appreciation of the currency results to the restoration of the efficient relative price existing between the non-traded and traded goods. The Portfolio Balance Model indicates that the exporting countrys exchange rate depends in foreign determined assets demand and supply fluctuations. Therefore, an increase in the commodity price results to balances in payment surplus and increases in a foreign holding by Australian dollar. These factors lead to increases in the demand for the Australian dollar; hence, positive currency returns. The third explanation points the relationship between the commodity and currency to proxy exogenous shocks. According to this explanation, the price of the

commodity changes the proxy exogenous shocks in the exporting country trading terms (Simpson, 2003, p. 6). The trading terms then result to shifts in the demand for the Australian dollar, which leads to increases in the exchange rate in the exporters market. The currency commodity association can be explained using the changes in macroeconomic expectations. These expectations embed in the currency returns incorporated in the price of the commodity. This is possible because of the forward-looking nature of the exchange rate, as the commodity prices have short-term demand and supply imbalance. In these expectations, economic frameworks embed in currency returns that contain information concerning the exporters capacity to satisfy supply expectations (Swift, 2001, p. 9). Consequently, expectations concerning the commodity conditions in the future can result to hoarding and hedging behaviors, resulting to commodity price changes in Australia. These models assume economic agents to adjust their holdings of commodities based on business activities. Additionally, economic agents have the capabilities of grasping incoming currency or commodity information and accurately interpreting the information on the grounds of their business conditions. Though these actions hold over enormous periods, it is crucial to consider the ability of actions to manage one-day frequencies. This review examines the commodity and exchange rate relationship using the restriction based causality and the rolling, out-of-sample foretelling methodology. In light of the attained information and data, it is crucial to suggest that economic expectations data should add to the currency returns in Australias terms of trade, which embed in the commodity returns (Bluedorn, Snudden, Pan, 2012, p. 129). The real rate in Australia can be described as disproportionally distributed. Australia has exports dominated by primary products; hence has the potentials of experiencing enormous, real rates misalignment. The Australian markets authority requires estimations of the real rate

misalignment. It is suggestible that Australia may have experienced real rates misalignments as a response to shocks that touched the primary products. This study will apply the Johansens FIML (full information maximum likelihood) to establish estimates of the equilibrium real rates and the resultant misalignment. The review will also highlight the equilibrium real rates over the years. Consequently, the review aims to show that relationships exist between the exchange rate and price for commodities (Robyn, 2001, p. 14). Commodity prices increase cause appreciations of the real exchange rate, which has a threeyear speed of adjustment. Theoretical Framework The fundamental approach to the estimation and determination of equilibrium real rates has gained immense acceptance. Despite this acceptance, the model has faced criticism for its attempt to model long-run movements for the real rates, resulting to mixed results. Results from time varying models trying to understand the association between economic fundamentals and the real rates has been controversial. Other studies fail to locate robust relationships between the two aspects and its determinants (Bodart, Candelon, Carpantier, 2011, p. 15). Numerous empirical studies especially for Australia and Canada exist for the issue. This literature concentrates on understanding real rates and their fluctuations in developed countries. The Australian dollar is referred as a commodity currency because of the exporting nature of its economy. In this case, the currency has an enormous role in influencing the price of commodities. Real factors have immense roles in determining real rate through the application of channels including the Balassa-Samuelson effects. Portfolio balance level and interest rate differentials have high potentials of driving appreciation of the real rates. According to Cashin

(2004), the real aspect in the determinations of the real rate in the Australian context, which has a commodity currency, lies in the trading terms. Primary commodities dominate Australian exports, and fluctuations in global prices have the potentials of determining movements in trading terms. Though terms of trade apply as principal features in the case of Australia, limited, comprehensive empirical study exists on the assessment of mechanisms that lead to changes in commodity prices that affects the real rate. This review will determine price changes in tradable goods, especially changes in commodity prices for export, which act as key determinants of Australia (Arezki, Dumitriescu, Freytag, 2012, p. 15). However, it is essential to note that real prices of the commodities do not have unique effects in the determination of the real rates; however, they have a likelihood of influencing the real rates of commodities for exporting countries. Empirical Studies Cashin et al (2004) studied the real rate of exporting countries and the movement of commodity prices in time. They created a monthly data for countries export indices, with each countrys data being geometric weighted average of the commoditys price. Empirical techniques allow structural shifts in long-run relationships between the time series used. As a result, strong relationships existed for two thirds of the study countries in the real exchange rate and prices of commodity relationship. The findings from this study showed that for commodity currencies, as is the case with Australia, the movements of the real prices for commodities acts as an essential determinant for the long-run divergence of the real rates from the PPP (Cashin, Cespedes, Sahay, 2003, p. 10). The behavior of the real rate can be said to be independent of the equilibrium rate

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regime. This also showed that, for commodity currency, the half-life for adjustment was 8 months. In another study, Chen and Rogoff evaluated the real rate for three OECD nations. This included New Zealand, Canada and Australia, where the main commodities make up an enormous share of the export commodity. Since the primary commodities constitute significant components of exports for these nations, global movements in commodity prices are exogenous with the exception of a few goods (Cashin, Cespedes, Sahay, 2003, p. 11). This explains the leading components of the trading terms fluctuations. The study found connections between real rates and goods prices for Australia. It shows that Australia has a goods price elasticity of 0.5. The Model Since Australia has a commodity currency, and it is a commodity-exporting country, the review will rely on the Cahins model. This model has its basis on goods price, and the relative productivity augmented PPP. It considers an open economy, as is the case with Australia that produces two main goods; exportable and non-tradable goods (Cashin, Cespedes, Sahay, 2003, p. 12). The production of exportable goods relies on the production of primary commodities for instance, agriculture and mineral goods. The factors in this case have mobile characteristics for both the non-tradable and exportable goods produced domestically. Domestic Production The domestic economy comprises of two sectors, one producing exportable goods and the other non-tradable goods. Both sectors depend on labor immensely to produce these goods. Therefore, the production functions in this case will be;

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Exportable sector YX=axLx Non tradable sector Yn=anLn In this case, x represents the primary sector or exportable goods and n the non-tradable sector. L represents the intensity of labor required by the sectors and (a) shows the productivity of labor in the sectors. Labor can transfer freely across the sectors in a fashion that the wages for the labor are equal across sectors (Cashin, Cespedes, Sahay, 2003, p. 15). In equilibrium, marginal productivity should equal real wages in the sectors. This is followed by the assumption that primary commodities have exogenous characteristics and perfect competition exists in the non-tradable area. The price of the non-tradable goods is expressed as a function of the value of the exportable and relative productivity between the nontradable and export sectors (Cashin, Cespedes, Sahay, 2003, p. 15). Pn represents the value of the non-tradable goods and PX is the primary commodity. The primary commodity depends on technological factors and independence of demand conditions. Increases in the primary commodity price lead to increases in wages in the sector. Since labor moves freely, prices and wages can rise in the non-tradable sector (Cashin, Cespedes, Sahay, 2003, p. 15). Domestic Consumer Domestic consumers consume tradable and non-tradable goods as they supply labor in elastically. The tradable goods arrive from global markets. Assumptions on preferences denote that primary commodities are not consumed locally. Individuals consume tradable commodities and non-tradable commodities in order to maximize utility (Cashin, Cespedes, Sahay, 2003, p.

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15). This leads to assumptions that utilities increase in accordance with the aggregate consumption. Foreign Production and Consumption This model presumes that the primary commodities are not consumed domestically; hence, they are completely exported. The domestic economy imports goods produced by foreign firms, and it has different characteristics to the global market. The foreign region is composed of non-tradable sectors, final commodity sector and an intermediate sector. The non-tradable commodities sector produces goods for consumption by foreigners (Cashin, Cespedes, Sahay, 2003, p. 15). Labor in this case acts as the sole factor input. The foreign intermediate commodities are used in producing final commodities. The intermediate goods depend on labor as a sole factor input. The movement of workers across the foreign sectors ensures that foreign wages are equated across the sectors. The price for foreign non-tradable commodities functions as relative productivities (Bluedorn, Snudden, Pan, 2012, p. 130). In the Australian case, two intermediate inputs are involved in producing the final commodity. The primary commodity produced by several countries including the domestic economy, and the second intermediate input. The second intermediate commodity is produced globally. Australian producers of the final commodity assemble the foreign intermediate input Y*i and the foreign commodity Y*x by using technology (Bluedorn, Snudden, Pan, 2012, p. 135). Therefore, it is presumed that foreign consumers use the foreign non-tradable commodity in the same way as the domestic consumers. They supply labor to different sectors in elastically.

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Empirical Framework Data Annual data will be employed in this case because of the unavailability of quarterly data. The annual data will be employed in determining or estimating the equilibrium exchange rate. Key observations include a significant depreciation in the exchange rate, which was accelerated until 2002. The exchange rate later appreciated in 2003-2004. In the same instance, the commodity prices have been decreasing, while technology has improved. Estimation Method Through the application of the Johansen FIML estimator, investigations can be conducted on the long run co integrating relationship between the exchange rate and prices for commodities. Ricci and MacDonald used the method to investigate the equilibrium exchange rate in South Africa. This econometric method corrects the endogeneity and auto correlation parameters using Vector Error Correction Mechanisms Specifications. Uni-Variate Characteristic of the Variables and VAR Diagnostic Statistics In order to approximate the empirical models, the variables need to be tested for unit roots. Diagnostic statistics are then conducted on the VAR for serial correlation, stability, autocorrelation, heteroscedasticity and normality. The diagnostic statistics shows that VAR has stabilities because the roots have modulus and they lie within the units of the circle. The VAR diagnostic test shows that there is heteroscedasticity or correlation because the errors have a normal distribution (Asfaha, & Huda, 2002, p. 15).

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Estimation Results The Johansens FIML was used to test the co integration of the variables. The maximum eigenvalues and the trace statistics show a co integration vector. This confirms the appropriateness of the proceedings with the Vector Error Correction Methodology. Long Run Restrictions The Cashins model was imposed, in addition to the long-run restrictions, theoretical framework. The long run zero boundaries were forced on GDP per capita and commodity price. Both restrictions were ignored or rejected, which means that the GDP per capita and the commodity price have immense influences on the exchange rate in Australia. These variables must be within the long run expression equation for the determination of the exchange rate. From this expression, the following scenarios are possible. Increases in commodity prices cause the exchange rate to appreciate, and increases in GDP per capita cause the exchange rate to appreciate (Bluedorn, Snudden, Pan, 2012, p. 132). These results have a consistency with the Cashins empirical findings and theoretical model predictions. Australia is an exporting country; hence, fluctuations in commodity prices will influence the exchange rate, which is dependent on productivity. Discussion Relationships existing between the commodity price and the exchange rate in Australia have their basis on the Swan (1995) and Salter (1959) economic analysis for small economies. These economies do not have immense influence on global economics or prices of their export products. A global commodity price boom will lead to higher domestic income in exports and an

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appreciation of the Australian dollar. This acts directly to reduce the prices of domestic exports. Increases in Australian national income generate or lead to increased demand and value for the non-traded commodities sector. The resultant rise in production cost and inflation in the long term cannot be passed to, externally, determine global prices. This acts in reducing the profitability of the export commodity sector. In case the exchange rate pass through is higher than zero, the model becomes more complex. The completion of the pass-through means that the appreciating currency will not have effects on the income of the domestic export. However, it will raise the foreign-currency values so that the Australian dollar will not influence global prices (Cashin, Cespedes, Sahay, 2003, p. 14). Additionally, in case the exchange rate movements are not passed through to foreign customers, the Australian producers must increase their prices in order to incorporate raising production costs. Models used to estimate the relationship should allow possible endogeneity of the productions cost and endogeneity in case of a zero pass through. In order to allow for varying degrees of pass-through, mark-up models of the traded goods are used. This incomplete passthrough could lead to variations in profit margins as the exporters endeavor for strategic advantages (Cashin, Cespedes, Sahay, 2003, p. 15). Therefore, Australian firms set exporting price in Australian dollar (PX) and (M) as profit over cost of production in Australia (CP). Therefore, PX=M x CP. Following Mann and Hooper (1989), the profit varies inversely to competitive pressure in global markets. It also varies directly to the levels of global demand for the goods. Increases in competitive pressures in the global markets will result to reductions in competitors prices, and squeezing of the profit margins for exporters. In addition, decreases in foreign demand will result to decreases in market prices and producers profits. In this case, conditions in the trading markets

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are proxies by transitions in global and competitors prices. These are expressed either in foreign currency or converted to Australian dollar. This should be relative to domestic value of production (Cashin, Cespedes, Sahay, 2003, p. 15). Therefore, price setting trends by Australia exporters is characterized by PX=[(WP x ER/CP). sup. [Alpha]] x CP, where ER refers to the exchange rate in domestic currency. Conclusion Exporters of homogeneous goods are regarded as price takers operating in perfectly competitive global markets. Australian export commodities are influenced immensely by pricing strategies, even in global markets in which its products are predominant. This review relied on multivariate co integration analysis to examine the relationships between the prices for commodities and the exchange rate. It also placed emphasis on timing and the extent of passthrough of other changes in addition to the exchange rate. The analysis also analyzes the equilibrium exchange rate and the resultant exchange rate misalignment in Australia. The estimations were based on the Cashins model of determining the relationship between the prices for commodity and the exchange rate. The results show the long run movement and relationship of the exchange rate and the commodity prices. An increase in real exchange rates concerning the Australian dollar leads to increases in commodity prices and an increase in the commodity prices leads to an appreciation of the exchange rate. This confirms that theories and findings of the literature. Improvements in technologies proxies by GDP per capita have a relationship with exchange rate appreciation. The impulse responses show that variables do not lead to a return to equilibrium, which may suggest that policies have been slow in addressing the shocks that may affect the economy. Variance decompositions revealed goods prices stand for 20% of the variations in the exchange rate. The speed of adjustment in the case for Australia is 8 months.

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The results from the review have implications for exchange rate and monetary policies for Australia. In case the shocks have dominant influences on the real exchange rate, Australia can adopt wage or price flexibilities, or flexible nominal exchange rate regimes.

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List of Reference Asfaha, S, & Huda, S. 2002, Exchange Rate Misalignment and International Trade Competitiveness: A Cointegration Analysis for South Africa, A Paper Presented at the TIPS Annual Forum at Glenburn Lodge, Muldersdrift. Arezki, R, Dumitriescu, E, Freytag, A. 2012, Commodity Prices And Exchange Rate Volatility: Lessons From South Africas Capital Account Liberalization. IMF Working Paper. Vol. 12. Page 4-12. Bodart, V, Candelon, B, Carpantier, J. 2011, Real Exchange Rates, Commodity Prices And Structural Factors In Developing Countries. Discussion Paper. Page 12-20. Bluedorn, J, Snudden, S, Pan, K. 2012, Commodity Price Swings And Commodity Exporters. International Monetary Fund. Page 125-140. Cashin, P, Cespedes, L, & Sahay, R. 2003, Commodity Currencies and the Real Exchange Rate, Central Bank of Chile Working Papers, No

236.http://ideas.repec.org/p/chb/bcchwp/236.html Chen, Y, & Rogoff, K. 2002, Commodity Currencies and Empirical Exchange Rate Puzzles, DNB Staff Reports 2002, No 76.http://ideas.repec.org/p/dnb/staffs/76.html Clements, K, & Fry, R. 2006, Commodity Currencies and Currency Commodities, http://www.cbs.curtin.edu.au/files/Clements_Fry.pdf Ellis, L. 2001, Measuring the Real Exchange Rate; pitfalls and Practicalities, Research

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Discussion Paper, Reserve Bank of Australia, http://www.rba.gov.au/rdp/RDP200104.pdf. Gruen, D, & Kortian, T. 1996, Why Does The Australian Dollar Move So Closely With The Terms of Trade?, Research Discussion Paper, Reserve Bank of Australia, http://www.rba.gov.au/rdp/RDP9601.pdf. Makin, T. 1997, The Main Determinants of Australias Exchange Rate, The Australian Economic Review, 30 (3) pp 329-39. RBA,1998, Alternative Measures of the Effects of Exchange Rate Movements on Competitiveness, Reserve Bank of Australia Bulletin,

http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jan98/bu_0198_1.pdf. Sanidas, E. 2005, The Australian Dollars Long Term Fluctuations and Trend: The Commodity Prices-cum-Economic Cycles Hypothesis, University of Wollongong, Economics Working Paper Series 2005 WP 05-29.

http://ideas.repec.org/p/uow/depec1/wp05-29.html Simpson, J. 2003, The Relationship between Commodity Prices and the Australian Dollar, Department of Banking and Finance, Working Paper, Curtin University of Technology, W.A. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=314872 Swift, R. 2001, Exchange Rates and Domestic Commodity Prices: the Case of Australian Metal Exports, Applied Economics 33, pp. 745-753. Robyn, S. 2001, Exchange Rate and Commodity Prices: The Case of Australian Metal Exports. Applied Economics. Page 12-15.