Exchange Rates — Flashcards & Quiz

Q1: Explain how exchange rates are determined under a floating exchange rate system.

Under a floating exchange rate, the currency's value is determined by supply and demand in the foreign exchange (forex) market. Demand for AUD comes from foreigners buying Australian exports, investing in Australia, or speculating. Supply of AUD comes from Australians buying imports, investing overseas, or speculating. Australia has operated a floating exchange rate since December 1983 when the Hawke-Keating government floated the dollar.

Q2: Identify four factors that influence the value of the Australian dollar.

1) Interest rate differentials — higher Australian rates attract foreign capital, increasing demand for AUD. 2) Commodity prices/terms of trade — rising resource prices boost export revenue and AUD demand. 3) Inflation differentials — lower Australian inflation makes exports more competitive. 4) Economic growth and market sentiment — strong growth attracts investment. The AUD is considered a "commodity currency" due to its strong correlation with resource prices.

Q3: Explain the effects of an appreciation of the AUD on the Australian economy.

An AUD appreciation means: 1) Imports become cheaper — benefits consumers and firms using imported inputs, putting downward pressure on inflation. 2) Exports become more expensive for foreign buyers — reduces competitiveness of export industries. 3) The current account may worsen (cheaper imports increase import spending, dearer exports reduce export revenue). 4) Reduced output and employment in export-competing and import-competing industries. 5) Terms of trade may appear to improve.

Q4: What is a managed float and how does the RBA intervene?

A managed (or dirty) float is a system where the exchange rate is primarily determined by market forces but the central bank intervenes occasionally to smooth excessive volatility or prevent disorderly market conditions. The RBA can buy AUD (to support its value, using foreign reserves) or sell AUD (to lower its value). Australia operates a managed float, though RBA intervention has been very rare since the early 2000s.

Q1: Australia has operated a floating exchange rate since December 1983.

Answer: TRUE

The Hawke-Keating government floated the Australian dollar in December 1983, allowing its value to be determined by supply and demand in the foreign exchange market rather than being fixed by the government.

Q2: An appreciation of the AUD makes Australian exports cheaper for foreign buyers.

Answer: FALSE

An appreciation makes Australian exports MORE EXPENSIVE for foreign buyers (they need more of their own currency to buy AUD-priced goods). A depreciation makes exports cheaper for foreigners.

Q3: Higher Australian interest rates relative to other countries tend to cause the AUD to appreciate.

Answer: TRUE

Higher interest rates attract foreign capital seeking better returns. This increases demand for AUD in the forex market, causing the dollar to appreciate.