Impact of Interest Rates on Exchange Rates - Essay Example

?Economics: Article Analysis Article Summary The article d “AUD/USD: Trading the Reserve Bank of Australia Interest Rate Decision” written by David Song, was posted on Saturday 30 April 2011. It discusses the impact of Australia’s monetary policies as a response to target inflation rates, on the Australian dollar and the exchange rate (Song, 2011). Introduction: This article highlights the key role played by the government by way of various monetary policies with regard to change in interest rates, and its resultant impact on the exchange rate of the country. While implementing the various monetary policies, it must be taken into consideration that the changes implemented today are likely to impact the economy in the long run, rather than right away, implying that there is a slight delay in time for the strategies to take effect. This entails the use of assumptions rather than facts, for deciding the monetary targets (Dickinson, 2002: 18). Furthermore, there is a strong relationship between inflation, interest rates and the exchange rate of any country. The same is highlighted and discussed in the following sections of this paper. Analysis: Exchange rate management plays a key role in the monetary policy framework of any country (Stone, 2009: 60). This is because the exchange rate of a country is one of the key determinants of its economic health, as it plays a key role in influencing the nation's international trade which is crucial for sustaining the economy. It is for this very reason the government keeps a watch on the exchange rate. Any increase in the currency rate has a direct impact on its exports, since the exports become costlier than before, while imports become cheaper and vice versa (Kirmani, Calika, 1994: 24). According to Takatoshi (1996: 93) the real exchange rate is one of the fundamental factors in defining the rate of exchange between the domestic goods and the international goods. Thus, any change in the exchange rate triggers an economy-wide impact on the international trade. The impact and effectiveness of manipulating the exchange rate by government, as a measure of promoting international trade, and its simultaneous impact on ensuring the long term macro-economic stability of the country have been documented by various researchers over the years (Wikham, 1985; Frankel, 1996). Impact of interest rates on exchange rate: The article states that “Although the Reserve Bank of Australia is widely expected to hold the benchmark interest rate at 4.75% in May, the central bank may strike a hawkish tone for future policy as price pressures intensify, and the statement accompanying the rate decision could push the AUD/USD to a fresh record high as currency traders expect to see higher borrowing costs over the coming months”. There is a strong relationship between interest rates of a country and its exchange rate. Any increase in interest rates attracts foreign investment and hence an increase in capital, thus ultimately leading to a substantial rise in the exchange rate (Miles, Scott, 2005: 534-5). Figure: Impact of rise in interest rates on AUD: In the above figure, the relationship between increase in interest rate and exchange rate is shown with regard to the U.S. dollar rate. It can be seen that as there is an increase in interest rate, the rate of return on investments also increases which leads to an increase in the appreciation of the Australian Dollar. There is a strong relationship between interest rates, inflation as well as the exchange rate of the country. The government, through various central bank policies, manipulates the interest rates, leading to a change in the inflation as well as exchange rates. When the interest rates are changed i.e. either increased or decreased, the inflation and currency value of the country too changes simultaneously. An increase in interest rates affords higher returns to the lenders, as compared to the currencies of other countries. Thus, such a hike in interest rates attracts greater foreign capital in the form of investments, leading to a further rise in the exchange rate. However such a rise in both the interest rates as well as the simultaneous rise in the exchange rate exerts greater pressure on the country's inflation leading it to rise further. In order to mitigate such changes in the inflation rate, the government has to control the interest rates, as any further increase would lead to higher inflation (Israd, Faruqee, 1998: 62). Impact of change in interest rate on aggregate demand: A change in the monetary policy of a country, such as change in interest rates leads to a significant change in the aggregate demand of goods by the consumers. In case of an increase in interest rates the aggregate demand falls, leading to an inward shift in the aggregate demand curve and vice versa. Such a change in aggregate demand causes fluctuations in the short run, with regard to an economy's output of goods and services, while in the long run, such shifts in the aggregate demand curve leads to a significant impact on the overall price structure in the economy (Tucker, 2008: 244; Macdonald, 1999: 185). Figure: Impact of change in interest rates on aggregate demand With the increase in monetary policy of a country, such as changes in the interest rate leading to a change in exchange rate, there are simultaneous changes in the aggregate demand for goods and services in the economy, which further influences inflation. A contractionary monetary policy, will lead to an inward shift in the aggregate demand curve, as shown in the above figure, where the aggregate demand will fall from AD1 to AD3. If there is a rise in interest rates, the cost of borrowing rises; simultaneously and hence the public spending rises as a consequence. In the above diagram the changes in various factors due to the implementation of a monetary policy by the government, is depicted, through the aggregate demand graph. Exchange Rate Intervention: The foreign exchange intervention policies adopted by the central bank are aimed at stabilizing the increasing rate of the local currency, are highly controversial in nature. The article states that if the RBA decides to uphold its current policy during the second-half of the year, and talk down speculation for higher borrowing costs; the marked appreciation in the local currency may dampen the outlook for future growth. Thus in order to prevent such negative repercussions on the economy, the government must intervene, through implementation of appropriate economic policies, to control the rising currency rates and stabilize the economy. According to some researchers, such intervention measures are highly ineffective in controlling the rising currency rates and could prove to be dangerous to the economy, by increasing the volatility. However, yet other group of researchers believe that intervention operations are highly successful in controlling and / or stabilizing the increasing currency rates and can go a long way in controlling the disorderly markets, by decreasing the volatility (Dominguez, 1998: 162). However, arguments in support of the government intervention in controlling the exchange rate state that the accuracy of information available to and used by the market agents might be misleading and inaccurate as compared to that available at the disposal of the central banks. Hence on the basis of this information the central banks can take positive steps with regard to the future strategies or policy actions which may have a direct impact on the exchange rate. Thus, foreign exchange intervention can be perceived as a commitment on the part of the authorities designed specifically to undertake a particular pre-decided course of action, to achieve the macro-economic objectives / goals (Sarno, Taylor, 2002: 211). Figure: Exchange Rate Intervention In order to ensure that the exchange rate remains stable and operates at a constant level the central bank is required to trade (i.e. purchase or sell) FX with a view to make sure that the supply intersects the demand at an appropriate price. Thus, if the central bank desires to target an exchange rate of s, the supply and demand curve must intersect at S and D. However, if the demand for AUD increases, the demand curve shifts to the right (as represented by the orange bar in the diagram) and if such an increase is not curbed, the exchange rate will further rise from S to S1 in the long run. Thus in order to avoid such an increase in exchange rate, the central bank must seek to discourage further inflows of capital or try to curb the demand for the same, and push the expanded demand back to the original (desired) level. Conclusion The exchange rate as discussed in the above sections of this paper, is a valuable variable in terms of deciding and implementing monetary policies in an open economy. Any fluctuation in the exchange rate i.e. either increase or decrease may lead to long term negative impact on the economy, thus jeopardizing the economic stability of the nation. It has been observed that a slight change in the interest rates may trigger a change in the country's exchange rates as well, thus leading to a negative impact on the country's exports and aggregate demand. This may adversely affect the balance of trade and thus further affecting the inflation. The government, hence must take adequate care prior to implementing monetary policies taking into consideration the long term consequences of the same. References: Dickinson, D. G., (2002). Monetary policy, capital flows, and exchange rates: essays in honour of Maxwell Fry, Routledge Publication. Pp. 18 Dominguez, K. M., (1998). Central bank intervention and exchange rate volatility, Journal of International Money and Finance, 17: 161-190 Frankel, J., (1996). "Recent Exchange Rate Experience and Proposals for Reform." American Economic Review, 86, 2: 153-158. Israd, P., Faruqee, H., (1998). Exchange rate assessment: Extensions of the macro-economic balance approach, International Monetary Fund, Pp. 62 Kirmani, N., Calika, N., (1994). International trade policies: Principles and issues, International Monetary Fund, Pp.24 Macdonald, N. T., (1999). Macroeconomics and business: An interactive approach, CENGAGE Learning Publishers, Pp. 185 Miles, D., Scott, A., (2005). Macroeconomics: Understanding the wealth of nations, John Wiley and Sons Publication, Pp. 534-535 Sarno, L., Taylor, M. P., (2002). The economics of exchange rates, Cambridge University Press, Pp. 211 Song, D., (2011). AUD/USD: Trading the Reserve Bank of Australia Interest Rate Decision [Online] Available at: http://au.finance.yahoo.com/news/AUDUSD-Trading-the-Reserve-fxcm-1579171787.html;_ylt=AnOX4xQCptnOMzYIGaEaQ4gUW49G;_ylu=X3oDMTFkczluaTAyBHBvcwM4BHNlYwNuZXdzSHViQXJ0aWNsZUxpc3QEc2xrA2F1ZHVzZHRyYWRpbg--?x=0 [Accessed: May 17, 2011] Stone, M., (2009). The role of exchange rate in inflation-targeting emerging economies, International Monetary Fund, Pp. 60 Takatoshi, I., (1996). Exchange rate movements and their impact on trade and investment in the APEC region, International Monetary Fund, Pp. 93 Tucker, I. B., (2008). Macroeconomics for today, CENGAGE learning Publishers, Pp. 244 Wickham, P., (1985). “The Choice of Exchange Rate Regime in Developing Countries.” IMF Staff Papers, 32, 2: 248-288. Read More