Australian Currency Valuation - Coursework Example

AUSTRALIAN CURRENCY VALUATION By name: Course: Tutor: University: City / State: Date: Australian Currency Valuation Reasons for Appreciation of Currency In 2013 The first reason for appreciation of the Australian dollar was largely attributed to the growth of the resources sectors namely the mining sector. It increased demand for the dollar due to increased foreign investments that outmatched the exports made by other industries in the country. It provided avenues for reallocation of capital and labor in various industries throughout the country. Such conditions provided challenges to some industries due to currency value appreciation and combination of flexible labor market, stable and low inflation. Consequently, the high demand for labor in the resources industries did not translate to a high demand for increased wages (Battellino, 2010, p. 11). The RBA responded to currency pressures through combinations of interest rate changes and interventions in the foreign exchange market. The RBA’s decision towards interest rates reduction was aimed at inducing an increase in exports given they had become relatively costly to foreign customers (Bernanke, Olekalns, & Frank, 2008, p.27). The second reason for the appreciation of the appreciation of the Australian dollar is attributed to the financial and current account deficits and surpluses. The trade balances between imports and exports were affected by capital flows in the country. Due to the presence of numerous investment opportunities for foreign investors, there was a high demand for the Australian dollar resulting in sharp appreciation for the currency. The third reason for the appreciation of the Australian dollar was the relative price of products in the country. Cheap Australian products became available to foreign consumers through exports resulting in an increase in the demand for the Australian dollar. The change in incomes in the country can be attributed to the relative price of the products in the market. The fourth reason for the increase in the value of the Australian dollar can be attributed to the monetary policies in place by the RBA. The policies instated by the country were relative to those of its trade partners such as china and other Asian countries. The policies can be termed as restrictive in nature given that they resulted in appreciation of the value of the Australian currency similar to currencies of its trade partners. The decision by the RBA to reduce interest rates was a means of defending the local currencies. Such interventions may involve the sale of international reserves as a means of curbing possible negative effects in the economy in event of currency value decline. The use of high interest rates in the market is a regular defense for local currency as part of broad monetary policies. Thus, the reduction of interest rates is also part of a defense mechanism as well as part of the broad monetary policies instituted by the central bank in Australia. Free-floating exchange rates are based on the belief that variability in exchange rates may lead to output costs. In addition, exchange rate variability is expensive irrespective of the exchange rate appreciating or depreciating. Increase in interest rates usually result in high demand for liquid assets and decline in output. RBA statement: Value of Exchange Rate A reduction in the interest rates is likely to affect many things within an economy such as determining savings and investments. In addition, it can affect the exchange rate under some circumstances. One of the factors to look at that could affect the exchange rate is carry trade. One circumstance in which your comment could affect the exchange rate is if the currency depreciates. This can be explained by the carry trade (Laïdi 2009). Carry trade is simply defined as the difference between the interest rates of two currencies. It happens when an investor borrows a currency that has low interest rates and invests it in one with a higher interest rate. The difference in the interest rate is the carry trade if it is positive. However, investors have to bear the risk of depreciating currencies. In your statement, a reduction in the interest rate could encourage people to buy the Australian currency and invest it in another one with a higher interest rate. A good example can come from the Australian dollar versus the United States dollar. At a near zero interest rate, an investor can borrow money from the American banks and invest it in a fixed account with an Australian bank. At the end of the investment period, the investor will have some positive returns. One circumstance that can affect the exchange rate is if so many investors borrow the United States dollar. This would increase its demand, hence raising its value against the Australian dollar. Under this circumstance, your RBA statement could affect the exchange rate value. By lowering the interest rate as your statement said, it means the returns for carry trade investors will reduce (Laïdi 2009). This is because the investors borrow the foreign currency on the hope that interest rates between the two currencies will be stable over time to allow them to gain returns. Therefore, reducing the interest rate of the Australian dollar would reduce the demand for Japanese currency in our example, lowering its currency value against the Australian currency. Recommended Policy The policy I would recommend is intervening in the foreign exchange market to solve the current issue. Intervention in the foreign exchange market largely refers to an official purchase or sale of foreign currency, which is undertaken to control the exchange rates. Under this strategy, the RBA can use several transactions. One of the transactions is reserves and borrowing. A government can influence the exchange rate by selling its currency and buying the one in target. The decision to sell or buy its currency will depend on the motive of the transaction (Laïdi 2009). In this case, you aim to reduce the value of the Australian dollar against the United States dollar. Therefore, RBA should sell its reserves of the Australian dollar and buy more of the United States dollars. This will affect the supply and demand of the currencies, where the Australian will be in higher supply, which shall lower its value. On the other hand, the United States dollar will gain an increased demand, hence increasing its value (Sarno Taylor 2002). Largely, the decision you take should depend on the objective of intervention. Specifically, it should consider the kind of signal it seeks to send to the entire market. Under the prevailing circumstances, the bank should use transactions that are not sterilized. This means that if it decides on purchasing the United States dollars, it should not be buying an equivalent of the domestic currency because this would leave the exchange rate unaltered. Although the RBA has historically used spot rate in intervening in the foreign exchange market, the future rates can be used as well (Sarno Taylor 2002). Using a forward market intervention involves buying a currency in the future, usually about three days at a predetermined rate. This is quite helpful, as the bank does not have to pay the amount immediately. However, this intervention works best when the exchange rate is short lived and the government wishes to reverse it in the future. This comes in handy when the government is not sure of the future o the market. I would recommend that you use both spot and forward rate at the same time, which results in a currency swap as it can help in mitigating risks caused by the other. Effect of the Recommended Policy on Australian Economy By using this policy, the economy of Australia will be affected in several ways. With a reduced interest rate and a lower currency exchange rate, the economy is likely to see a shift in demand. One of the effects of a reduced exchange rate is that the foreign countries with an appreciated currency after the policy will find Australia to be cheaper. This is because when the exchange rate fall the prices of exports and imports are affected. Exports become cheaper in other currencies while imports become more expensive (Atkin, M Caputo, Robinson & Wang 2014). Considering that the country buys the imports, they are regarded as part of the retail index. This means that an increase in the price index goes up the country experiences an inflationary pressure. On the other hand, since exports means selling the country’s products, they become cheaper to other markets. This can trigger an increased in the exports due to their demand. Conversely, the demand for imported goods will fall as they become more expensive for the Australians. The combination of the two means that aggregate demand will increase considering the exports are part of it. Additionally, reduction in imports means an increased demand for the local products. This could also be inflationary if the economy is operating close to its full capacity (Atkin, M Caputo, Robinson & Wang 2014). In the long-term, if the demand for exports continues although it is not guaranteed, it could affect the balance of trade. Therefore, the fallen exchange rate has the potential to affect the inflationary pressure and the balance of trade. However, it is important to consider that the exports will bring the same amount of money it did in terms of the foreign currency. For instance, if a person exported a good and received $1 for 0.89, they would still receive $1 when it falls to 0.68 Australian dollars. Social and Cultural Effects of Policy The proposed policy would result in a change of cultural practices such as reliance on fossil fuels. It would spur the population towards energy efficient fuels. This will be essential towards moving the country from over-reliance on export activities to other non-resources sectors not related to export markets. This cautions the Australian economy from external shocks from its interactions with other economies in the international market. In addition, this would induce the need to consumer local goods as opposed to the national norms of consuming imports. In addition, the proposed policies could provide the country with an avenue to reduce the foreseeable increase in levels of unemployment. Additionally, there is need to reduce the emissions by the mining industry that largely affect the climate and environment. Investments in alternative forms of energy could provide a means of moving the country towards efficient, effective and reliable sources of energy as traditional fossil fuels are becoming depleted. Social shifts in terms of expertise from the resources sector to other sectors such as professional and services sector would enhance growth of the economy. Importance of Policy towards monetary Policy Microeconomic policies can be adopted as a means of reducing the foreseeable pressures and changes to the Australian economy because of the appreciation of the Australian dollar. Training and education can be provided to the public to enable to transition to other sectors that are not reliant on export activities other than the mining industry. Microeconomic policies can provide viable solutions to the supply side issues relative to capacity problems in the economy. The revenues generated by the strong resources sectors can be used to implement such policies (Twomey, 2012, p. 41). Furthermore, this takes off the fiscal pressures on government as induced by imbalanced trade that as resulted in appreciation of the Australian dollar. Bibliography Atkin T, M Caputo, T, Robinson & Wang, H 2014, ‘Macroeconomic Consequences of Terms of Trade Episodes, Past and Present’, RBA Research Discussion Paper, No 2014-01. Battellino, R, 2010, ‘Mining Booms and the Australian Economy’, RBA Bulletin, March, pp 63–69. Bernanke, B.S., Olekalns, N. & Frank, R.H., 2008, Principles of Macroeconomics, (2nd ed.) McGraw-Hill Australia, Sydney. Laïdi, A 2009, Currency trading and inter-market analysis: How to profit from the shifting currents in global markets, Hoboken, N.J: John Wiley & Sons. Plumb M, Kent C & Bishop, J, 2013, ‘Implications for the Australian Economy of Strong Growth in Asia’, RBA Research Discussion Paper, No 2013-03. Sarno, L & Taylor, M 2002, The Economics of Exchange Rates, Cambridge, Cambridge University Press. Stevens, G, 2011, ‘The Resources Boom’, RBA Bulletin, March, pp 67–71 Twomey, B, 2012, Inside the currency market: Mechanics, valuation, and strategies, Hoboken, N.J: Bloomberg Press. Whaley, R. E, 2006, Derivatives: Markets, valuation, and risk management, Hoboken, N.J: Wiley. Read More