Australian Dollar Cause or Effect

Topics: Foreign exchange market, Macroeconomics, Exchange rate Pages: 5 (1314 words) Published: April 9, 2014

the australian dollar… cause OR effect?
Christopher Trueman 06876269

Table of contents

1. Introduction2

2. Summary of change in the AUD2

3. Cause of change in the AUD3

4. Effect of change in the AUD4

5. Conclusion5

6. Reference List6

1. Introduction
The Australian Dollar (AUD) is affected heavily by different sources. To develop a better understanding of changes in the AUD’s exchange rate relative to other currencies, it is crucial to examine the cause of its changes as well as the effects it can have on both the domestic and global economies. Government can also play a crucial role in the strength of the AUD. To comprehend its changes, it can be helpful to compare its exchange rate with the US Dollar.

2. Summary of changes in the AUD
The value of the AUD has been fairly volatile over the last three years. In mid-2011 it jumped to record heights and AU$1.00 was buying over US$1.10. These heights, however, proved to be short lived as in the coming months the AUD would rapidly weaken below parity, showing that the market may have been overvaluing the AUD at the time of its record highs. The AUD would soon rally though, and spent most of the next 18 months trading between US$1.00-$1.05. Around May this year the dollar once again plunged below parity. By August the AUD had reached a three year low and was buying less than US$0.90. In recent months the AUD has strengthened and as at the 1st October this year AU$1.00 was buying US$0.9396.

3. Causes of change in the AUD
Since the Australian Dollar was floated in 1983, its value has been determined by supply in demand in the global foreign exchange market. Explaining foreign exchange rate changes can be an extremely difficult task. With so many factors influencing the strength of the Australian dollar, in many circumstances it can be almost impossible to definitively attribute certain events to respective exchange rate changes. By using relevant economic theory we can hope to explain and predict trends in exchange rate movement.

With an economy such as Australia, so dependent on the export of its natural resources, commodity prices are critical to the overall economic prosperity of the nation. Rises in demand for our commodities driven largely by growing Asian economies such as China and India have seen their prices steadily increase over time, albeit with one noticeable plunge at the time of the GFC. This can be seen in Figure 2 which plots the RBA’s calculated Index of commodity prices over the last 10 years.

This increase in the price of commodities strengthens the terms of trade in Australia’s favour as the price of its exports increase at a higher rate than its imports. As Australian export revenues increase, the demand for the Australian Dollar will also increase which will lead to an appreciation of its value against trading partner’s currencies.

Interest rates also play a role in the global markets value of the AUD. Interest rate changes will affect prospective foreign lenders return on their investment relative to other economies. Increasing interest rates will mean a higher return and inversely, decreasing interest rates will mean a lower return. These changes will drive demand for the AUD which will, in turn, shift the equilibrium and therefore its value against foreign currencies.

Another factor influencing movements in the exchange rate of the AUD are relative prices. The Purchasing Power Parity theory suggests that an identical good sold in two different economies should, when expressed in the same currency, have the same price. For instance, if good X is sold in Australia for $100 and in Great Britain for £60 and the exchange rate is AUD/GBP 0.5. When expressed in AUD, good X in Great Britain is purchased for the exchange rate equivalent of $120. A rational consumer would not purchase good X in Great Britain when it can be purchased from Australia for cheaper....
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