Exchange Rates

ACKNOWLEDGEMENTS

Recognition must be giving to ___, ___, Vancouver BC, Canada for granting the permission to reproduce the graph image of exchange rate fluctuation, on the basis of which I have made my assignment. I would also like to thank my Lecturer and Subject Coordinator Assoc. Prof. ___ for her guidance and useful tips which have helped me in completion of this task.

ABSTRACT

This assignment defines the exchange rate and then introduces two different ways by which the price of a currency can be determined (fixed or floating exchange rates). Finally discusses and analyses some of the most important factors which have caused changes in exchange rate of Australian Dollars during the last five years and give conclusion on the basis of analysis.

INTRODUCTION

An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country\'s currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency.

There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro or yen. In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. Generally countries which have mature stable economy market adopts floating exchange rate. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. For example, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, and hence self-correction would occur in the market. A floating exchange rate is constantly changing. The Australian government floated Australian dollar in December 1983.

FACTORS DETERMINING THE FLOATING EXCHANGE RATES

Relative Price Levels

Also known as the “Law of One Price,” which states that if two countries produce an identical good, the price of the good should be the same throughout the world no matter which country produced it. The application of this law into real life is often referred to as Purchasing Power Parity (PPP). PPP theory states that exchange rates between any two currencies will adjust to reflect changes in the price levels in both countries. Therefore, when the prices of country X’s goods rise (holding prices of foreign goods constant), the demand for country X’s goods falls until its currency depreciates so that it can still sell abroad. Thus, over the long run, a rise in a country’s price level (relative to foreign price levels) causes its currency to depreciate, and vice versa.

Tariffs and Quotas or Government Policies

First we must define these two terms before examining their impact on exchange rates.

o Tariffs: Refers to the taxes levied by a country on the goods it imports.
o Quotas: Refers to the physical restrictions levied by one country on the quantity of specific foreign goods that can be imported.
Imposing these taxes and restrictions (trade barriers) on foreign goods creates an increase in demand for domestic products. The result of which will be an increase in the comparative value of that country’s currency. That is because barriers rid foreign products of their competitive ability in terms of price. Thus demand on domestic products flourishes. Accordingly buyers will demand less of the foreign currencies and more of the local currency, causing the above mentioned price increase in the local currency. Tariffs and quotas have a positive long run effect on a country’s currency. Under the floating system Australian government through RBA (Reserve Bank of Australia) can interfere directly (by buying or selling foreign exchange), indirectly (by changing the level of interest rate) or by adaptation of macro-economic mix policies to increase or decrease the