Free Essay. Determinants of Australian Dollar Exchange Rate

The value of one country’s currency in terms of another country’s currency is what entails an exchange rate. Every nation is free to choose the most appropriate exchange rate system suitable to meet its needs. The significance of the exchange rate system is that it guides the formulation of local and international economic policies of a nation. Also, the choice of the type of exchange rate system to adopt depends on the economic characteristics of the country. There are distinct forms of exchange rate systems, which include free-floating, currency peg, restricted currencies, and spot vs. forward. The free-floating exchange rate is determined by the changing market forces of supply and demand, which makes it fluctuate from one currency to another. A pegged exchange system involves a country pegging its currency against that of another country within a given range. Restricted currency has its limitation within the borders of the country, and at times the value is set by the ruling authority. An exchange rate system may have a forward value whose determination is on the expectations of its rising or falling, or it may have a spot value, which is usually the current market value.

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Determinants of Exchange Rate

The inflation rate entails the speed of increase in the prices of goods and services within a country. Any changes that occur in the inflation rate of a country usually cause changes in the currency exchange rate. The inflation rate may either be high or low. If a nation experiences a low inflation rate, then its currency value increases while it decreases when the inflation rate rises. When the inflation rate lowers in a country, its exports will earn a competitive advantage as people will have increased demand for them due to the low prices (Hamilton, 2018). The citizens of that country will purchase more of the locally produced commodities and less of the imports. Thus, a low inflation rate results in an appreciation of the currency value of a country.

On the other hand, when the inflation rate rises in the country, the value of its country lowers, resulting in a fall in the exchange rate. High inflation implies that the prices of the commodity increase due to the increase in the quantity of money in circulation, and the costs of exports escalate, resulting in their low demand and high demand for imports. When prices are high, the demand for goods lowers due to the fall in the purchasing power of the currency while the supply increases, as illustrated by the figure below.

When the interest rate changes, it affects the currency value of the exchange rate. It means that an increase in interest rate results in appreciation of the currency hence an increased exchange rate. When the interest rate is higher, people tend to increase their investments. Also, it attracts foreign investors who bring in foreign capital, which results in a rise in the exchange rate. Investing in a country that has high levels of interest will result in a high rate of returns as the demand for the currency value of that country rises. On the other hand, a fall in the interest rate of a country causes a decline in the demand for investment, which causes depreciation of the currency and a fall in the exchange rate, as illustrated by the figure below.

The economic growth rate also affects the exchange rate in a country. When a nation experiences a recession, its exchange rate depreciates because the interest rate falls, and there is little or no investments in the country. Recession is also characterized by a steady decline in the growth rate of an economy, which is attributable to the country having a large current account deficit. Recession weakens the currency of a country due to the fall in foreign capital resulting in a decrease in the exchange rate. On the other hand, when the economy is growing at a steady rate, the interest rate increases and encourages investors to put in their capital in investment. More so, foreigners bring in their foreign capital for investment, which results in the appreciation of the nation’s exchange rate.

Factors That Affect the Australian Dollar Exchange Rate

Australia employs a free-floating exchange rate system, and the Australian dollar is a currency traded substantially in the market. The Reserve Bank of Australia (RBA) is a conservative institution that has the mandate of regulating the trading of the Australian dollar. Some primary factors affect the Australian dollar exchange rate, and they include prices of commodities and the terms of trade, interest rate differentials, speculation, the credit rating of the government, and purchasing power parity.

The prices of main commodity exports and terms of trade for the nation have a great impact on the Australian dollar. The dominant exports in this country are coal, aluminum ore, liquefied natural gas, iron ore, wheat, and beef. The prices of these commodities greatly determine the terms of trade in the country since the floating of the currency in 1983 (Roy & Bhar, 2020). Terms of trade entail the ratio of the cost of imports to the price of exports. Thus, the implication is that the reserve bank of Australia takes into account the terms of trade and commodity prices when determining the nation’s exchange rate.

Interest rate differentials entail the value of interest rate in Australia relative to that of a foreign country, and it usually has a significant effect on the Australian dollar exchange rate. It is the benefits accrued to an investor who invests in Australia relative to other countries such as the United Kingdom. Investors tend to establish their investments in countries that have a high-interest rate as the rate of return on the assets is usually high (Cole & Nightingale, 2016). For instance, if the interest rate in the United Kingdom is 0.90 while that in Australia is 1.50, investors will pull their resources and make investments in Australia instead of the United Kingdom. Consequently, the value of the Australian exchange rate will increase as the currency value of the Australian dollar rises because investors sell their United Kingdom currency and buy the Australian dollar as they make their investments. On the other hand, if the interest rate in the united states is 2.40 while in Australia it is 1.70, the value of the Australian dollar lowers as investors sell Australian dollars and purchase United States dollars to facilitate their investments in U.S. assets.

Speculation and sentiment are other factors that impact the Australian dollar. The Australian dollar contributes immensely to national growth and poses a great risk in investment as it is a commodity-defined exchange rate. It means that the Australian dollar is prone to the challenges brought forth by global economic activities. Fluctuations in the value of the Australian dollar usually affect organizations that deal with imports or exports. More so, such changes in the exchange rate affect not only the profits of the companies but also the sales revenue, cash flow, foreign currency income from investments, and balance sheet values (Cole & Nightingale, 2016). When there is a probability of an increase in the value of the Australian dollar when the economic mood is favorable, then traders will purchase more imports due to their cheap costs. On the other hand, a fall in the value of the Australian dollar due to pessimism of the economic activities increases the purchase of local products as their prices are affordable compared to that of imports.

The credit rating by the Australian government has a marginal effect on the Australian dollar. The nature of the credit rating determines the amount to be paid by the government for its debts as it formulates the risk profile of the debts. If the country has a bad credit rating, then it lowers the demand for the Australian dollar because the debt risk increases. However, the government of Australia has maintained a record of AAA credit rating for more than fifteen years, such that its prevailing credit rating status has had short-term harms (Chapman, Jääskelä & Smith, 2019). Having an AAA credit rating implies that the government can repay its loans. Thus, foreign investors gain confidence in investing in the country as they are assured of minimal economic mishaps that result from a government failing to repay its borrowed loans. For instance, if the government borrows from the International Monetary Fund or the World Bank and fails to repay the loan, the credit deficit may result in a fall in the currency value of the Australian dollar. On the other hand, the ability of the government to repay its debts results in an increased value of the currency hence a rise in the Australian dollar exchange rate.

Historically, commodity prices and terms of trade have a significant impact on the value of the exchange rate in Australia, resulting in the currency being referred to as a commodity currency. The significance results from the fact that the purchase of Australian exports requires that a foreign trader sells their local currency and purchases the Australian dollar to facilitate transactions (Roy & Bhar, 2020). For instance, iron ore is one of the primary commodities in Australia that has a high demand in China. Thus it contributes greatly to the strengthening and weakening of the Australian dollar. The terms of trade also determine the value of currency where the evaluation of the ratio of purchasing imports and the prices of the exports is determined.

Also, interest rate differentials have a substantial effect on the Australian dollar exchange rate because investment is one of the drivers of an economy. Trading activities between nations are vital as countries depend on foreign revenue as a source of income for the nation. Thus, encouraging foreign investment is essential. It implies that Australia should control its interest rate differentials favorably to attract investments. The Reserve Bank of Australia has the mandate of regulating the interest rate to maintain a cash rate that stands out compares to the prevailing interest rates of the surrounding economies. Besides, a high-interest rate encourages investors to purchase government bonds.