Exchange Rate and Inflation Rate Analysis - Example

Name: Tutor: Title: Economic Research Course: Institution: Table of Contents Table of Contents 2 Introduction 3 Literature Survey 4 Exchange rate and inflation rate analysis and result 7 Bibliography 12 Introduction The process of determination of the price of the currency depends on the mechanism of exchange rate that has been used. In a regime where there is floating exchange rate system, the exchange rate is obtained by the interaction of market forces, and it is exposed to continuous fluctuation as determined by the conditions in the market. Inflation plays a big role in the determination of the growth of a given economy. The balance of payments affects the rate of inflation. When imports are more than exports the inflation rate goes up since foreign currency is used to pay for the imported products. A shortage of foreign currency raises the exchange rate making is necessary to have of the local currency when importing. Imports become expensive while exports become cheaper. In a fixed system or managed systems, the authorities have a role of regulating the exchange rate at some point when they consider it necessary. Changes in exchange rates are closely linked to inflation rate adjustment. Such type of system is attractive to investors who are uncomfortable with the floating rate environment that is highly volatile and full of uncertainties. The choice of exchange regime involves many other factors apart from the issue of stability. High rates of inflation result into unemployment and decline in growth rate of the economy. The Central Banks use fiscal policy in an attempt to deal with the effects of inflation. Control of banks’ deposits reserves is aimed as controlled the amount of money in circulation. Purchase of bonds and other securities also affect the amount available for exchange in the economy. High exchange rate leads to increase in the rate of inflation. Literature Survey Australia has adopted the floating exchange rate. In this kind of regime, the price of the dollar depends on forces of demand and supply. In the floating system, the currency’s price adjusts automatically to the degree required to attain balance between demand and supply of the currency. The economic meltdown in 2008 affected many economies in the world and Australia was not spared. The inflation rate and interest rate were affected by the economic activities that occurred during this period. The Australian Reserve Bank regulates the interest rate to suit the rate of growth in the economy. The booming China economy and her trading with Australia have helped Australia to mitigate the effects of the economic crisis witnessed in 2008 in many parts of the world. As the economy slowed down the Central Bank of Australia moved to reduce the interest rate due to weak inflation rate (Edwards & Plumb, 2009, p.9-16). The floating regime rate of the interest rate provides a chance for the market forces to determine the exchange rate. The flow of funds between nations to pay for bonds and stock purchases contributes towards determining the exchange rate across currencies. Over a period, the capital flows are hugely influenced by differential yields. The higher the yield on securities in German as compared to American securities, the more attractive securities in German relative to securities in America. German yields increase would subsequently raise the flow US dollar into securities in German as well as reduce the outflow of Euros to securities in America. Theoretical Framework In an environment that maintains a floating exchange rate, the rate of exchange is responsive to various factors including the flow of exports and imports, the relative rates of inflation and the flow of capital. One of the main factors influencing the exchange-rate between the Australia Dollar and other world’s currencies is trade balance in merchandise. Merchandise trade balance refers to the net difference between imported merchandise and exported merchandise in any given country. For instance, when the exchange rate for AUD/USD is looked at, the following scenario is unveiled. Australia imports certain products from the United States. For payment, Australian companies require US dollars; consequently, companies in Canada trade Australian Dollars for US dollars. Conversely, since consumers in America desire goods which are made in Australia, they therefore purchase Australian Dollars to pay for these products. Australians demand for goods and services from America leads to increase in demand for US dollars whereas American purchase of goods from Australia enhances demand for Australia Dollars (Debelle & Plumb, 2006, p.22-29). In this context, the net difference between the purchase of American goods by Australia and Australia goods purchase by America is what is referred to as the merchandise trade balance of the two countries. Foreign Direct Investment is the amount of capital that foreign investors invest in a particular country. This shows capital inflow from other countries into the Australian economy. The following graph summarizes the capital inflow to Australia from around 2004 to 2010. Foreign direct investment in the first three quarters of 2006 showed a negative figure, meaning there was no capital inflow into the country, but instead Australians are the ones who invested in other countries. In 2007, the capital inflow in Australia increased tremendously to over AUD 2 billion. High rate of inflation scare business investor from engaging in direct foreign investment. The capital inflow reduced in the wake of the economic crisis in 2008. Many investors feared the eventuality of their investment due to the uncertainties of the world-wide felt economic crisis. By the end of 2009, the capital inflow began to show a positive trend hence decline in inflation and exchange rates (Belkar, Cockrell & Kent, 2007, p.3-4). Exchange rate and inflation rate analysis and result The exchange rate affects inflation rate, they demonstrate a direct relationship. When the inflation rate goes up, the exchange rate will also go up due to macroeconomics adjustments in the market to reach equilibrium. The interest rate shows the correlation between the borrowed money against the maturity of the debt. The balance of payment affects the rate inflation and exchange rate. The inflation shows the rate at which the country’s currency loses its value against other currencies. When the inflation rate goes up, the currency loses its value against other currencies and people have to spend more on goods that they previously bought at a lower price. The inflation rate was highest towards the end of 2008 following the economic crisis that was witnessed around the world. When the Australia economy improved in 2009 onwards, the inflation rate declined to almost 1%. The low inflation rate shows appreciation in the Australian Dollar due to tremendously improvement in the balance of payment. A weak Australian Dollar will be reflected with an increase in the rate of inflation. Balance of payment describes the relationship of exports, imports, and their subsequent payment transactions that occur between countries (McCauley, 2006, p. 41-54). The balance of payment between the US and Australia will depend on the amount of merchandise that the two countries have traded between them and the amount of money that has been used in the ensuing transactions. When imports to the USA are more that exports, there will be more demand for US dollar. One will need more Australian money to import goods from the US. Increase in the flow of Australia dollars will lead increase in the rate of inflation. The above balance of trade curve shows the relationship between the goods and services exported from Australia to other countries and the imports of services and goods that Australia got from other countries. The disparity between the export and imports was small up to January of 2007, thus the inflation rate was low. Towards the end of 2007, exports from Australia declined as a result of the economic crisis that was experienced in the world, hence increasing inflation rate. The exchange rate was between the US Dollar and Australian dollar was high. In 2008, the economy recovered and Australia was able to export more merchandise; inflation rate went down. In the last quarter of 2008, the exports surpassed the imports. In January 2009, there was a balance between the exports and imports. The exports increased in the first quarter of 2009. From here the exports dwindled indicating a negative value of balance of trade. High rate of inflation can also lead to negative balance of trade as the currency of a country depreciates. The flow of funds between two nations to pay bonds and stocks purchases contribute to the exchange rate between currencies. Capital flows are hugely influenced by yield differentials. Up to the beginning of 2007, the Australian Dollar was equivalent to 0.8 and below of US dollar. In the first quarter of 2006, the value of the Australian Dollar appreciated to about 0.7 of the US dollar. However, by the last quarter of the same year, the Australian dollar weakened against the US dollar to move close to 1 dollar mark by mid 2008. In the last quarter of 2008, and early in 2009, the Australian dollar strengthened against the US dollar. In 2009, Australian Dollar was very strong against the dollar before it began to depreciate. The interest rate determines the lending rate that banks fix on money borrowed from by various banks. High interest rate discourages investors from borrowing since they will be forced to buy high interest costs which cut reduces their profit margin tremendously (Clifton & Plumb, 2008, p. 1-9). The graph below shows the trend in the Australia interest rate over a period of time. The interest rate has remained almost constant to around 2007, but eventually to slightly above 7% in 2008 following the economic crisis that was witnessed in the world. The banks have to fix a high lending rate for fear of losing their money to collapsed business ventures. When the interest rate is high, investors are discouraged from borrowing money for investment. The interest dropped by the end of 2008 as the economy began to improve. The interest hit its lowest in the first quarter of 2009 and 2010. The inflation rate went down. The interest stayed constant at the 3% before it rose against. Banks lower the interest rate to encourage investors to borrow money for investment. This happened due to improved economic performance in Australia in 2010. Bibliography Belkar, R, Cockrell, L & Kent, C, 2007, Current account deficits: the Australian debate, Reserve Bank of Australia Research Discussion Paper, no 2007-02. Clifton, K & Plumb, M, 2008, Economic data releases and the Australian dollar, Reserve Bank of Australia Bulletin, April, pp.1-9. Debelle, G. & Plumb, M., 2006, The evolution of exchange rate policy and capital controls in Australia, Asian Economic Papers, 5 (2), 7-29. Edwards, K & Plumb, M, 2009, US economic data and Australia dollar, Reserve Bank of Australia Bulletin, July, pp.9-16. McCauley, R, 2006, Internationalizing a currency: the case of the Australian dollar, BIS Quarterly Review, pp. 41-54. Read More