Australian Dollar: Factors affecting value of the exchange rate

1. Factors affecting the value of the
Australian Dollar
WACE Economics – Unit 3
Video 7.1
(c) Andrew Tibbitt 2017 1

2. Demand and supply for the AUD
• The value of a floating currency is determined in foreign
exchange markets by the relative levels of demand and
supply of the currency
• Financial inflows (i.e. credit entries in the balance of
payments) create the demand for the currency
• Financial outflows (i.e. debit entries in the balance of
payments) create the supply of the currency
• Given the balance on current account is largely determined by
the balance on the financial account, foreign investment
flows are crucial to determining the value of the AUD
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3. Summary of factors
SHORT TERM
DAY TO DAY
• SPECULATION
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4. Summary of factors
SHORT TERM
DAY TO DAY
• SPECULATION
MEDIUM TERM
MONTH TO MONTH
• INTEREST RATE DIFFERENTIALS
• COMMODITY PRICES AND EXPORTS
• TERMS OF TRADE
• RISK ENVIRONMENT
• ECONOMIC FUNDAMENTALS
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5. Summary of factors
SHORT TERM
DAY TO DAY
• SPECULATION
MEDIUM TERM
MONTH TO MONTH
• INTEREST RATE DIFFERENTIALS
• COMMODITY PRICES AND EXPORTS
• TERMS OF TRADE
• RISK ENVIRONMENT
• ECONOMIC FUNDAMENTALS
LONG TERM
YEAR TO YEAR
• RELATIVE INFLATION RATES
• REAL EXCHANGE RATES
• PURCHASING POWER PARITY (PPP)
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6. Short term – day to day movements
Influenced by speculation: Investors reacting to, for example:
• News
• Hunches / educated guesses
• What they think other currency traders will do
In the absence of new economic information movements in the
exchange rate follow a ‘random walk’. Random walks can lead the
currency quite a long way off the trend or underlying path.
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7. 1. Interest rate differentials
2. Commodity prices and exports
3. Terms of Trade
4. Risk environment
5. Performance of Australian economy
Medium term factors
Month to month movements
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8. (c) Andrew Tibbitt 2017 8
1. Interest rate differentials
Overall relationship: The higher the interest rate differential
between Australian and US bonds, the higher the value of the
exchange rate

9. (c) Andrew Tibbitt 2017 9
1. Interest rate differentials
Overall relationship: The higher the interest rate differential
between Australian and US bonds, the higher the value of the
exchange rate
Strong link
until mining
boom

10. 2. Commodity prices and exports
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Overall relationship: The higher the index of commodity prices the
higher the value of the exchange rate.

11. 2. Commodity prices and exports
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Overall relationship: The higher the index of commodity prices the
higher the value of the exchange rate.
Strong link
especially after
mining boom

12. 3. The Terms of Trade
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Overall relationship: The terms of trade are dominated by the level
of commodity prices. The higher the terms of trade the higher the
value of the exchange rate.

13. 3. The Terms of Trade
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Overall relationship: The terms of trade are dominated by the level
of commodity prices. The higher the terms of trade the higher the
value of the exchange rate.
Strong link
especially after
mining boom

14. 4. Australia’s economic performance
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Overall relationship: The better the performance the higher the
value of the AUD

15. 4. Australia’s economic performance
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Overall relationship: The better the performance the higher the
value of the AUD
Weaker indirect
connection

16. 4. Australia’s economic performance
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Overall relationship: The better the performance the higher the
value of the AUD

17. 4. Australia’s economic performance
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Overall relationship: The better the performance the higher the
value of the AUD
Weaker indirect
connection

18. 5. The Risk Environment
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Overall relationship: When risk levels are perceived to be high
currency flows to ‘safe haven’ currencies such as USD and JPY, so
the value of the AUD falls

19. 5. The Risk Environment
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Overall relationship: When risk levels are perceived to be high
currency flows to ‘safe haven’ currencies such as USD and JPY, so
the value of the AUD falls
Difficult to
assess
relationship

20. Long term factors
Purchasing Power Parity
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Overall relationship: The AUD may adjust to a level where it has
equal international purchasing power. The higher Australian inflation
relative to inflation elsewhere, the lower the value of AUD

21. Long term factors
Purchasing Power Parity
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Overall relationship: The AUD may adjust to a level where it has
equal international purchasing power. The higher Australian inflation
relative to inflation elsewhere, the lower the value of AUD
Weak long term
impact – difficult
to detect

22. Summary of important factors
Factors affecting
investment flows
Relative interest rates
Risk environment
Commodity prices
Economic performance
Factors affecting trade
and income flows
Relative inflation rates
Terms of trade
Commodity prices
Profits
Economic performance
Equilibrium price
of AUD
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Demand for AUD
Credits into BOP
and
Supply of AUD
Debits from BOP

23. RBA says
• It has been demonstrated that forecasting exchange rates is
fraught with difficulty.
• Attempts to model historical movements in exchange rates
have met with mixed success.
• However, efforts to model the Australian dollar exchange rate
in the post-float era have been reasonably successful
compared to other currencies, given its correlation with
commodity prices and the terms of trade.
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24. Prediction
a) What will be the value of the AUD (v USD) on
January 1st 2020?
b) What degree of reliability would you place on
your forecast?
Estimate a value.
Write down three key factors that informed your
estimate.
Why is/isn’t your forecast likely to be reliable?
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25. End of slide show
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