Exchange Rate Movements

Assignment Topic 2

AUD/USD Exchange Rate

The main movements of the AUD/USD exchange rate in the past eighteen months will be studied, as well as the underlying conditions that caused these specific movements to happen. Economic models and theories will be used to support the discussion and to analyse the reason for these fluctuations.

Discussion will then take place to whether these movements have been a help or a hindrance to the overall health of the Australian economy.

FIGURE 1.0

As seen above in Figure 1.0, the main direction of the AUD/USD exchange rate over the past eighteen months has been in a positive direction, shown here by a simple 15 day moving average over the price of the AUD in $USD.

FIGURE 1.1

Figure 1.1 above shows the four main fluctuations that have happened to the AUD/USD exchange rate in the past eighteen months that will be discussed in this essay.

To understand these movements, the demand and supply for these two currencies on the foreign exchange market has to be discussed.

FIGURE 1.2

The foreign exchange market concerning the AUD/USD is a flexible exchange rate system, and is determined by free market forces. Like any other free market, it can be modeled by the demand and supply graph, as seen above in Figure 1.2.

QUT Power Point Slide, Module 8, Tommy Tang, 2007_2

Fluctuations in the foreign exchange market occur from a change in either the demand or the supply for that particular currency, thus changing the price of the exchange rate.

The reasons behind the changes in supply and demand will be analysed for the four major movements noted in the exchange rate of the AUD/USD over the past eighteen months.

The first movement that will be analysed is the major up trend that started around the end of June 2006 and continued to trend until approximately August of 2007.

This can be seen in Figure 1.1 next to box 1.

The economy in general was very strong at this time and world commodity prices were dramatically rising due to high demand, increasing Australia’s export earnings. This has expansionary effects on incomes and spending, with a positive influence on the Australian economy.

Reserve Bank of Australia, Media Release, 03/05/2007, www.rba.gov.au/MediaReleases/2006, accessed 03/01/08

Interest rates increased to 5.75% in May 2006 as the RBA considered this necessary to control inflationary risks. Reserve Bank of Australia, Media Release, 03/05/2007, www.rba.gov.au/MediaReleases/2006, accessed 03/01/08

This increased demand for these commodities, of which Australia is a significant supplier to the world market. This therefore means Australian dollars are needed to buy our exports, thus increasing demand for the AUD.

International Monetary Fund Website, Why is China growing so Fast? 1997, Zuliu Hu, http://www.imf.org/external/pubs/ft/issues8/ , accessed 01/01/08

Figure 1.3 below shows a graphical representation of the AUD strengthening due to an increase in demand. P1 displays a higher price as demand increases for the AUD.

FIGURE 1.3

Around the 25th to 30th of July, the Aussie dollar weakened quite dramatically against the USD which is evident in Figure 1.1 next to box 3.

At the start of the month the Reserve Bank of Australia decided to leave the cash rate at 6.25%. Reserve Bank of Australia, News Bulletin 03/07/2007, accessed 09/01/08, ttp://www.rba.gov.au/NewsArchive/index.html

A month earlier, on the 25th of June, the US Federal Reserve decided to keep the existing rate of 5.25%, after a meeting on monetary policy. US Federal Reserve Website, News Events, http://www.federalreserve.gov/newsevents/press/monetary/20070724a.htm, accessed 09/01/08.

The month of July 2006 brought the sub-prime mortgage crisis in the US, and the equity market in the US took a huge fall as consumers and lenders started coming to terms with the credit crunch caused by the housing crisis.

Economic theory suggests demand and supply is influenced by the expected future exchange rate. Economics 5th Edition, D McTaggart, C Findlay, M Parkin. Pearson Education Australia. Printed in China 2007. P671

As the full consequences of the sub prime mortgage crisis were just being discovered, confidence in all markets was diminished. With the news of interest rates staying fixed for both currencies and the sub prime mortgage crisis, exchange rate expectations were negative, causing demand to decrease, thus weakening the Aussie dollar.

As seen in Figure 1.4, as demand for AUD decreased, the price of the AUD quickly retreated against the USD.

FIGURE 1.4

The third movement happened during the middle of August as seen in Figure 1.1 at box 2. A quick reversal took place with the value of the Aussie dollar strengthening rapidly. On the 8th of August the Reserve Bank of Australia released a statement which disclosed that another interest rate rise was necessary, due to an increase in the pace of demand and activity as well as high global economic growth, even with the slowdown of the US economy. Reserve Bank of Australia, Media Release, 08/08/07, Statement by Glenn Stevens. www.rba.gov.au/MediaReleases/2007/mr, accessed 09/01/08 The cash rate was increased to 6.50%, while in the US on August the 17th; the Federal