Currency Exchange Rate in Australia - Essay Example

CURRENCY EXCHANGE RATE IN AUSTRALIA (Name) (Institutional affiliation) (Tutor) (Date) Introduction As far as foreign market in countries is a very crucial factor that derives the economy, there are many factors which need to be looked into consideration when implementing these strategies. One of them is the foreign exchange rate system in which various nations have their own. On this discussion, we shall focus on the currency exchange rate in the Australia and also discuss on the strategies to be adopted by the reserve bank of Australia in the foreign exchange market. We shall also compare the strategies adopted and relate them with those in other developed nations such as USA, Germany, China, and USSR among others and later conclude on what Australia should do to effectively survive in this competing world of market segmentation and diversification. Part I: Factors Affecting Exchange Rate Movements in Australia Discussion Currency exchange rate of any country is a significant reflection of the vigour of the economy. This connotation is a result of the influence of the exchange rate on the balance of payment of a country (Altman & McKinney, 1987.p.70). The balance of payment of a country will be low if a higher currency exchange rate prevails, vice versa it would be high if a the nation experienced a lower exchange rate. A lower exchange rate implies that a country’s exports will be cheaper while its imports become expensive in foreign markets (Amihud & Levich, 2003. P. 65).On the other hand, a higher exchange implies a country’s export prices rise while the imports become cheaper (Branson & Frenkel, 1990. P.23).In this essay, the exchange rate system in Australia and the strategies that are put forward to mitigate the effects of fluctuation in the exchange rates in Australia comparing with other developed nations will be focused. There are a number of factors that influence movements of a country’s exchange rate movements. The factors, however, are related to the trading relationship that exists between the two countries. Currency exchange rates are expressed relative to another country’s currency (Cobham, 2010. P.34).The first determinant of a country’s exchange rate is the prevailing inflation rates in a country. It’s known as a principle that a nation that exhibits a consistent low inflation rate witnesses a rising currency value. The purchasing power of the currency in the country with the low inflation rates increases relative to those countries with higher inflation rates. Consequently, countries with consistently high inflation rates experience depreciation in their currencies relative to currencies of their trading partners. The prevailing currency exchange rate further affects the prevailing interest rates within a country. The second factor that determines the exchange rate of a currency is the public debt of a country. The large public debt is as a result of deficit financing to fund public projects and other governmental functions. The deficit financing activities of a government aims at stimulating the growth of the domestic economy of a country. However, the large public debts are a deterrent to foreign investment. Foreign investment is discouraged as a result of the high public debt. High public debt on the other hand, attracts a high inflation rate discouraging potential foreign investment as a result of servicing and principal repayment of the debt being made with cheaper real dollars. Therefore, credit rating of countries issued by credit rating agencies is a vital determinant of a nation’s exchange rate. The government may choose to meet the repayments through printing of more currency, which inevitably raises the money supply and hence high inflation rates. On the other hand, it may meet the high debt obligations rates by issuing more domestic and foreign debt which further acts as a deterrent to potential investment as a result of the high risk of defaulting. Another factor that determines a country’s exchange rate is the terms of trade. The terms of trade refers to the ratio that compares the export prices to import prices of goods and services of the country under consideration. For example, if the prices of a country’s exports rise more than the price increase of its imports, then the country is considered to have favorable terms of trade (Wheelock, 1991. P. 75). The terms of trade determines the current account balances and eventually the balance of payments. A deficit in the current account of a country would result in the depreciation of its currency. A deficit in the current account implies that the value of imports is greater than the value of exports. The ideal solution to financing is through surpluses in the capital account. However, for a nation that attracts foreign capital inflows slowly then its currency would depreciate relative to its trading partners. Therefore, the terms of trade between trading partners influence currency exchange rate movements. The fourth factor is government intervention measures. Some governments strive to maintain their currency exchange rates at a given level. The government is said to maintain a fixed regime type of exchange rate system (Benes, 2013. P. 21). In addition to this, the current deficits in accounts also affect the rates of a nation. When we have a deficit in a nation, we say that the country is spending a lot in foreign trade than what it earns. The excess reserve and demand in the currency lowers demand of products and wait till when the exchange rate adjusts till they are cheap enough to foreigners. Public debt is another factor to determine when countries deal in fluctuation in exchange rate in large scale financing. Countries with large debts in the public will attract less of the foreign investors and hence, resulting to high levels of inflation and whose dollars in the market will be paid back in future by the same nation. Governments will like to pay off the debt by printing more money to the economy and as a result cause more of the inflation; most nations do this through the sale of bonds and others by defaulting risks. Terms of trade also affects the exchange rate of a nation. This is normally related to balance of payments in various related fields of current accounts. If the price of exports rises more than that of imports, this shows that the nation has favorable terms of trade. A good term of trade means that the nation has increased demand for its currency. To finish with, political stability is another fundamental factor that contributes to the country’s exchange rate system; foreign investors can only invest in nations with good and well organized government that is free from chaos such as unnecessary fights. Political turmoil will result to lack of confidence in the movements of currency to more stable nations. Part II: Strategies adopted by the Reserve Bank of Australia in the foreign exchange market The second part of the question was on the foreign exchange market of Australia. In this case we shall look at the various strategies which have been adopted by the reserve bank of Australia in the exchange market (Crocket, 1987. P. 56). These strategies will be highlighted and discussed in detail in relation to the reserve bank of Australia and how they effect in the foreign exchange market. We have the first strategy of the foreign exchange intervention as discussed below; a) Foreign Exchange Intervention In the first place we shall define what we mean by foreign exchange intervention. By definition, it refers to those transactions which are conducted by the monetary policy authorities with the main objective of influencing the rates of exchange (Edwards, 1986. P. 32). In this process, the monetary policies and the authorities try to influence the market conditions and the value of the domestic currency in Australia (Ghosh & Wolf, 2002. P. 43). The major aim of this is bringing up stability and ensuring that there is proper arrangement of markets at any special circumstances. Various counties have special people who control or are in charge of the intervention in the foreign exchange markets For example in Japan, the minister of finance is the one who is legalized to purely carry on the intervention as means of achieving stability rates(Issing, 2001. P. 25). In the United States of America, the government plus the Federal Reserve board is the one responsible, in the United Kingdom, the bank of England does the work better, and in the area of euro, and the European central bank carries out the whole process (Kidwell et. al, 1993. P. 34). There are some of the general thoughts which guide the exchange market of Australia. In the foreign exchange market, in order to invest in other nations so as to engage in buying and selling of foreign products, the firms and especially individuals will need to first acquire currency of the country in which they are intending to deal with amicably (Kisinbay et al., 2009. P. 37). Some business people who export goods and services may demand to be paid for the goods and services they deal with either in their own currency or in the US dollars. A market which is generally accepted nationwide and in which international currencies are involved is the one called Forex market or simply foreign exchange market b) Exchange Rate Every country has a specific currency in which prices of its goods are quoted. For example in the United States, goods are quoted in dollars, in Germany, they are quoted in Euros, and the sterling pounds in Britain. In this case, the exchange rate is simply a ration between the two currencies in which goods can be expressed in terms of one another (Madura, 2011. P. 33). The quantity of one currency that another country requires in order to trade can be well termed as the exchange rate. A theory on exchange rate was developed called three exchange rate regimes, in this theory, we have three exchange rates which are the flexible, fixed and the intermediate ones. In the flexible exchange rate system, the value of the currency is to be determined by the forces of demand and supply in the market, under flexible exchange rate system, the monetary authority is the one that pegs the domestic currency to one or basket in the foreign currencies (Madura, 2011. P.46). On the other hand, under intermediate exchange rate system, the flexibility of the system lies between the flexible and the fixed one. According to Mishkin (2007), there are favors in the arguments for the floating exchange rate regime that supports it. They are a simple laissez-faire view in which it focuses the rate which needs to be predetermined in the demand and supply without government interference, the parallel view which looks at the exchange rate as an easier way to be adjusted and responded to new in the development of an economy, and the policy of independency in which the floating exchange rate is said to be an equilibrate to terms of trade in the foreign market. Arguments in favor of the fixed exchange rate system include the following; certainty in the rate of exchange in the sense that the volatility of the exchange is low under this fixed method of regime. It thus reduces the risk which occurs from investment which may occur due to larger importation, lending and borrowing (Sharan, 2006. P. 43).It thus means that, the stable rate of exchange rate will promote international trade; we also have the nominal anchor, whereby the fixed exchange rate becomes an effective way of providing nominal anchor to the monetary policy. Dowelling will convince individuals that the inflation is unlikely to occur, and that lower rates of inflation will lower expectation yields. At various counties, central bank plays roles which can be classified under different exchange rate systems or regimes. To start with, the fixed exchange rate regime, countries which operate under it, the central bank tries to automatically clear any excess demand or the supply of foreign currency with the effect of maintaining the fixed exchange rate. When there is excess demand of foreign currency, the government or the central bank will sell the foreign currency for the local currency (Ponsi, 2007. P. 53). The rates of interests will adjust in the inter market so as to clear the market. Under the flexible exchange rate, central banks in various counties, adopts it and most of them have discretion of intervening in the exchange rate market system. The reasons as to why the central bank must intervene in the foreign exchange market include; minimizing the effect of overshooting, reducing the effect of volatility, leaning alongside the wind, misalignment against the exchange rate system, intervention of profit technical trading in the rule of profitability. Volatility is a major issue in the foreign market. The volatility in the foreign exchange market is attributed to three major factors which include; volatility in fundamental volatility, changes in the expectations which is as a result of exchange rate volatility, and the bandwagons of speculation (Fons Monetari International, 2005. P. 36). In foreign exchange intervention, we have types of interventions namely: Entrustment Intervention which is conducted overseas, reverse entrusted intervention conducted in the foreign exchange market when a country is requested to do so, coordinated intervention occurs when countries implement an authority jointly upon using their own funds such as in the plaza agreement in 1995 carried out by the G7 countries to discuss the depreciation of the overvalued US dollar so as to restore it to the state of balance. In Australia, a substantial body of literature that deals with estimation of linkages in the foreign exchange rate is highly associated with the macro-economy of a nation. Most of the firms in Australia are in a position of those linkages. We have the hedging instruments which encompasses the strategies in which the people adopt in assurance of eliminating their exposure to exchange rates changes which arise from the transactions of existing assets and the liabilities. c) Cross-currency interest rate swaps A cross-currency interest rate swap in Australia will involve use of exchange stream of interest in which, payments are expressed in terms of receipt of another nation. In Australia, we have application of hedging practices which are meant specifically to bring about equilibrium in the banking sector. The hedging system is very healthy since they help the nation adjust to equilibrium in case there is any disturbance from the equilibrium and bring it to normal. Conclusion In most of the developed nations, firms which are involved in the international markets, often attempt to match their currencies domination with the view of getting payments and receipts so as to limit exchange rate in the foreign market (Wang, 2009. P. 49). In an attempt to manage the risks in the foreign market, firms in developed nations avoid explicitly the use of hedges when they do not have enough funds. They do what is called diversification so as to reduce aggregate demand in the currency exposure. This is sometime s referred to as pooling of risks as adopted in the Australian companies of resources .Many developed nations use the foreign exchange of derivatives as they look into the fluctuations in the hedges. The major derivatives used in this case are the cross currency interest, swaps, forward contracts, and the foreign exchange options. References Altman, E. I., & McKinney, M. J. (1987). Handbook of financial markets and institutions. New York: Wiley. Amihud, Y., & Levich, R. M. (2003). Exchange Rates and Corporate Performance. Washington, D.C: Beard Books. Benes, J. (2013). Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework. Washington, DC: International monetary fund (IMF. P.3 Branson, W. H., Frenkel, J. A., Goldstein, M., & National Bureau of Economic Research. (1990). International policy coordination and exchange rate fluctuations. Chicago: University of Chicago Press. Cobham, D. P. (2010). Twenty years of inflation targeting: Lessons learned and future prospects. New York: Cambridge University Press. Crockett, A., Goldstein, M., & International Monetary Fund. (1987). Strengthening the international monetary system: Exchange rates, surveillance, and objective indicators. Washington, D.C: International Monetary Fund. Edwards, S., Ahamed, L., National Bureau of Economic Research, & World Bank. (1986). Economic adjustment and exchange rates in developing countries. Chicago: University of Chicago Press. Fons Monetari Internacional. (2005). Guidelines for foreign exchange reserve management: Accompanying document and case studies. Washington, DC (Wash.: International Monetary Fund. Ghosh, A. R., Gulde, A.-M., & Wolf, H. C. (2002). Exchange rate regimes: Choices and consequences. Cambridge, Mass. [u.a.: MIT Pr. International Monetary Fund. (2005). Guidelines for foreign exchange reserve management: Accompanying document and case studies. Washington, D.C: International Monetary Fund. Issing, O. (2001). Monetary policy in the euro area: Strategy and decision making at the European Central Bank. Cambridge, UK: Cambridge University Press. Kidwell, D. S., Peterson, R. L., & Blackwell, D. W. (1993). Financial institutions, markets, and money. Ft. Worth: Dryden Press. Kisinbay, T., Kisinbay, T., Nordstrom, A., Restrepo, J., Roger, S., Shimizu, S., Stone, M. R., ... International Monetary Fund. (2009). The Role of the Exchange Rate in Inflation-Targeting Emerging Economies. Washington, D.C: International Monetary Fund. Madura, J. (2011). International Financial Management. Florence, KY: Cengage Learning, Inc. Madura, J. (2011). International financial management. Mason, OH: South-Western/Cengage Learning. Mishkin, F. S. (2007). Monetary policy strategy. Cambridge, Mass. [u.a.: MIT Press. Ponsi, E. (2007). Forex patterns and probabilities: Trading strategies for trending and range-bound markets. Hoboken, N.J: John Wiley & Sons. Sharan, V. (2006). International business: Concept, environment and strategy. Delhi: Pearson Education. Wang, P. (2009). The economics of foreign exchange and global finance. Berlin: Springer-Verlag. Wheelock, D. C. (1991). The strategy and consistency of Federal Reserve monetary policy, 1924-1933. Cambridge [England: Cambridge University Press. Read More