Factors Affecting the Demand-Supply in the Foreign Exchange Market

Question:

Discuss about the Currency Speculation and Dollar Fluctuations.

The assignment takes reference of the article “Is the Australian Dollar overvalued” written by Myriam Robin, published on February 10, 2017, in Sydney Morning Herald. This section of the assignment discusses the main issues of concern, which has been highlighted in the concerned article. The Australian economy is one of the most stable and eminent economies in the global framework and therefore the value of the domestic currency and the changes in this value have immense implication on both the domestic and the international economic scenario (Delatte and López-Villavicencio 2012).

As per the article, the performance of the Australian dollar, in the recent period has been impressive according to the opinion of the Reserve Bank of Australia. However, this opinion is not an unanimous one as one part of the speculators and economists assert that the currency has been appreciating in its value in the recent times. This trend was also observed empirically with the rise in the value of Australian dollar, when measured in terms of the domestic currencies of America, China, Japan, Britain and others (Smh.com.au, 2017).

This was, however opposed by another school of thought, including the NAB currency strategist, according to whom there has been no noticeable appreciation in the value. Instead there has been slight devaluation of the currency compared to the earlier periods, which actually helped the economy to float when the effects of mining boom started dissipating. On the other hand, the opinions are unanimous in case of the trends observed in the value of the Australian dollar when measured with respect to the Trade Weight Index of the country. The trend, as suggested by the article has been clearly positive, mainly because of the increase in the terms of trade of the country (Diebold 2012).

The value of the Australian dollar, however, is subjected to change provided the interest rate in the USA changes when the rate of interest in the country is kept the same.

The foreign exchange market of a country as well as in the international scenario is like any other market as per the theoretical economic framework and the equilibrium and the stability in this market is also determined by the demand and the supply forces. The consumers and the suppliers in the currency market mainly are comprised of the multinational companies, the international banks and those speculators who invest in the risk and returns in this market (Frenkel and Johnson 2013).

Trends in the Value of the Australian Dollar

The demand supply model in the foreign exchange market attributes the determination of the value of a currency at any particular point of time, to the demand and the supply scenarios present in the market during that time. These in turn gets determined by the economic factors like the rate of inflation, interest rate and the regulatory policies taken by the governing authority of the concerned country (Rios, McConnell and Brue 2013).

The situation in the foreign exchange market in the Australian economy can be analyzed with respect to the above discussion and the above figure. The Australian economy keeps the exchange rate at a floating level and therefore, the value of the currency is highly influenced by the demand and the supply of the domestic currency in the money market, both in global as well as in international scenario (Andrade and Prates 2013).

• Export demand for the goods and services which are produced in the country and are demanded by the foreign residents
• The international tourists that Australia attracts every year
• The venture of the foreign multinational companies in the markets of the country, both in terms of expanding its business and setting up of production units in the country itself
• The amount of foreign direct investment the country receives from abroad
• The demand for the domestic currency of the country by the speculators, whose demand for the same usually increases with an expectation of a future increase in the value of the Australian dollar (Forbes.com, 2017)

The supply side determinants, on the other hand, in this scenario can be shown as follows:

• The demand for foreign exchange by the domestic players of the country, who need the foreign exchange for the purpose of importing goods and services from the other countries.
• The demand for asset building in other countries by the residents of Australia
• The expectations and speculations regarding the future value of the domestic currency, by the investors, who, if expect the value to fall, will increase the supply of the Australia dollar in the international market (MacDonald and Stein 2012)

Apart from the above-discussed factors, the rate of interest and the price levels prevailing in the country vis-à-vis the rates in the global framework also plays a crucial role in determining the value of the domestic currency of the country.

In the current business scenario, in the global economic framework, a lot of the business activities of the country, especially those with foreign countries depend on the value of the domestic currency prevailing in the economy and vice versa. Therefore, the monitoring and analyzing of the trends in the dynamics of the domestic value of the currency is important as with time the countries are getting more interlinked, especially through trade. The movement of the domestic currency has crucial implications on the trade statistics as well as the growth of the country (Burstein and Gopinath 2013).

To analyze the trends of the same, it is necessary to compare the value of the domestic currency with respect to the currency of the USA, which is one of the most stable currencies in the international scenario and is conventionally used broadly for this purpose. With respect to the US dollar, the performance of the Australian dollar in the last three years can be seen from the following figure:

The figure above, published by the Reserve Bank of Australia, incorporates the changes in the concerned exchange rate over the last few years on a six-months basis. From the above figure it can be seen that the exchange rate of the country has been considerably high in the year 2014 with the rates prevailing above 0.90 during this period. However, the rate started falling after that till the first half of the year 2016 with the lowest value going down below 0.70 during this time span. After this, there has been a little and almost inconsiderable hike in the exchange rate value of the domestic currency of Australia, with the values prevailing near 0.75 in the current period.

Effect of Overvaluation on the External Sector and Export-Import Dynamics

The statistics, however is a bit different when the when the dynamics in the value of the currency is seen in terms of the Trade Weight Index of the country, which can be seen with the help of the following figure:

The data of the Trade Weight Index reflects the term of trade prevailing in the country and thus, indirectly reflects the condition of the trade sector of the concerned country. The trade weight index of the country, in this case, can be seen to be substantially high during the year 2014, with the value remaining near 72.5. The value, like that of the exchange rate, fell after that period and the fall continued till January 2016 before coping up again. Post the first half of 2016, the TWI is seen to have increased, though nit reaching the initial level, but still considerably. The trade weight index is seen to have reached to 65 in the current period from that of 60, which was prevailing in the economy during the second half of 2015.

As discussed above, it is evident that the value of the domestic currency of Australia is highly dependent on the demand and supply conditions prevailing in the international market, as the value of the same is kept at a floating framework by the monetary authority of the country. The recent changes in the value of the Australian dollar can be empirically seen to be affected by the recent fluctuations in the price of oil and iron ore in the recent international scenario. As the data suggests, the fall in the value of these products also led to a considerable fall in the Australian exchange rate, thereby implying that the value of the currency moves more or less in line with the changes in the price of the commodities in the international scenario (Basher, Haug and Sadorsky 2012).

The external sector of the country and its relation with the global economic giants like China, the USA and Japan can be seen from the recent global economic phenomenon. Here, the depreciation of the value of Japanese yen led to an upward pressure on the value of the Australian dollar as more and more investors went on drawing their financial resources from the former to the Australian economy.

The fluctuations in the value of the domestic currency of a country and the changes in the exchange rates of the same have direct implications on the economy of the county, especially the external sector as the export import dynamics are considerably affected by these concerned fluctuations. In general, overvaluation of the domestic currency decreases the exports and increases the imports in a country (Atkin and Connolly 2013).

Conclusion

For an alcoholic beverage producer of Australia, the overvaluation of the Australian dollar, thus, is expected to have implications on the export of his products in the USA. The overvaluation of the Australian dollar is in general expected to decrease the overall export of his product to the USA. However, by how much the export of his product will decrease depends on the type of alcoholic beverage he is selling, as the demand for beer in the USA is much higher and inelastic than the demand for other types of alcoholic beverages (Michie et al. 2012).

However, in an overall framework, as alcoholic beverage does not fall under the domain of necessary goods, the overvaluation of the domestic currency will make the product more costly to the foreign nationals and thus will decrease the demand, thereby leading to a fall in the revenue of the concerned alcohol producer.

Apart from increasing the import and decreasing the exports of the country, the overvaluation of the Australian currency also leads to increase in the aggregate import demand in the country with an increase in the purchasing power in the hands of the residents of the country. The overvaluation of the domestic currency in the Australian economy also affects the investment scenario, both by the domestic investors in the foreign market and by the foreign investors in the domestic market (Schulmeister 2013).

As has been asked in the concerned question, to bring down the exchange rate in the Australian market, from US 76 C to US 72C, the governing authority has to embark on the process of evaluation of the domestic currency. This process involves mainly the release of the domestic currency in the international market, which can be done by activities like dumping and printing of the money. The imports in the country can be increased and restrictions can be imposed on the exports by the country to facilitate the devaluation of the currency in the economy, which in turn increases the supply of the domestic currency in the international market (Patro, Wald and Wu 2014).

The devaluation of the domestic currency in an economy has considerable implications on the economic conditions of the country as a whole. On one hand, where the devaluated currency facilitates exports in the country, with the goods and services produced in the economy becoming more cheap to the foreign consumers and thus helps the domestic producers by increasing the nominal revenue earned by them. However, the fall in the value of the domestic currency makes importing goods and services painful for the domestic residents, as the real value of the domestic currency becomes less due to the devaluation (Towbin and Weber 2013).

References

Andrade, R.P. and Prates, D.M., 2013. Exchange rate dynamics in a peripheral monetary economy. Journal of Post Keynesian Economics, 35(3), pp.399-416.

Atkin, T. and Connolly, E., 2013. Australian exports: global demand and the high exchange rate. RBA Bulletin, pp.1-10.

Basher, S.A., Haug, A.A. and Sadorsky, P., 2012. Oil prices, exchange rates and emerging stock markets. Energy Economics, 34(1), pp.227-240.

Burstein, A. and Gopinath, G., 2013. International prices and exchange rates (No. w18829). National Bureau of Economic Research.

Delatte, A.L. and López-Villavicencio, A., 2012. Asymmetric exchange rate pass-through: Evidence from major countries. Journal of Macroeconomics, 34(3), pp.833-844.

Diebold, F.X., 2012. Empirical modeling of exchange rate dynamics (Vol. 303). Springer Science & Business Media.

Forbes.com (2017). Forbes Welcome. [online] Forbes.com. Available at: https://www.forbes.com/2006/08/23/forex-trading-education-in_swh_0823investools_inl.html [Accessed 7 Oct. 2017].

Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.

MacDonald, R. and Stein, J.L. eds., 2012. Equilibrium exchange rates (Vol. 69). Springer Science & Business Media.

Michie, S., Whittington, C., Hamoudi, Z., Zarnani, F., Tober, G. and West, R., 2012. Identification of behaviour change techniques to reduce excessive alcohol consumption. Addiction, 107(8), pp.1431-1440.

Patro, D.K., Wald, J.K. and Wu, Y., 2014. Currency devaluation and stock market response: An empirical analysis. Journal of International Money and Finance, 40, pp.79-94.

Rba.gov.au (2017). Exchange Rates | RBA. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/statistics/frequency/exchange-rates.html [Accessed 6 Oct. 2017].

Rios, M.C., McConnell, C.R. and Brue, S.L., 2013. Economics: Principles, problems, and policies. McGraw-Hill.

Schulmeister, S., 2013. Currency speculation and dollar fluctuations. PSL Quarterly Review, 41(167).

Smh.com.au, M. (2017). Is the Australian dollar overvalued?. [online] The Sydney Morning Herald. Available at: https://www.smh.com.au/business/markets/currencies/is-the-australian-dollar-overvalued-20170210-gu9wl7.html [Accessed 6 Oct. 2017].

Towbin, P. and Weber, S., 2013. Limits of floating exchange rates: The role of foreign currency debt and import structure. Journal of Development Economics, 101, pp.179-194.