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Case Study Is the Australian dollar overvalued


 Answer to question A

In the case study of ‘Is the Australian dollar overvalued?’ it has been discussed about the strength of Australian dollar on the basis of exchange rate. This article consists of several issues which has an impact upon the strength of Australian dollar with the effect of exchange rate.

i. In this article, one issue is that exchange rate fundamentally remains high all the time. However, it can decrease or increase with the shift of interest rate (Arvis et al. 2014). This affects the country’s growth rate and also the growth outcomes affecting both national income and GDP.

ii. Second issue found in this article is that Australian dollar has been higher of amount third of a cent when traded according the governor of RBA (Bacchetta & Van Wincoop, 2013). However, it has got decreased due to increase in the interest rate by US 76.3c. This has led to undervalued Australian dollar slightly.

iii. Thirdly, it has been seen that use of fair value instead of trade weighted index has left Australian dollar to be undervalued slightly (Beckmann & Czudaj, 2013).

iv. Fourthly, as bank uses the index measure of trade-weighted for Australian currency to gauge the appropriate level, rise in trade weighted index has become larger than it was expected for terms of trade.

v. Fifthly, it has been identified that if US Federal Reserve raises that rate of interest in the year 2017 and if RBA does not do so then it could lead to recalibration of Australian dollar (Bodenstein, Erceg & Guerrieri, 2017). This might create problem of under pricing in the economy of Australian.

vi. Lastly, another issue has been found in the article that for AUD the concept of tariff and trade conflict is not suitable. This can create problem for the growth of economy of Australia, its national income as well as GDP per capita.     

Answer to question B

In order to determine the next economical period’s exchange rate, use of demand and supply framework is an effective one. Change in exchange rate is being analyzed by the help of demand and supply framework. According to Cashin et al. (2014), exchange rates are considered to be such rates that implies currency’s relative price. The demand-supply model of exchange rate determination implicates that exchange rate that is in the equilibrium position, changes due to change in factors that usually affect the change in the condition of demand and supply. For determining AUD in terms of forex market, application of this demand-supply model of exchange rate determination is effective. This model is perfect to analyze the exchange rate that takes place in the dollar market (Engel, 2013)

In the above figure, the dollar market of Australia has been identified. The quantity on the x-axis should be the quantity of dollar that is present in the market. In the y-axis, it should remain price of dollar in another currency which in this article is USD. Therefore, in this article the exchange rate is being calculated in terms of exchange rate presented in euro-dollar (Engel, Mark & West 2015). In the above figure, both the demand as well as the supply curves indicates the dollar’s demand and supply. The figure shows an initial equilibrium point of exchange rate as 0.89 per dollar.

There are many factors that influence the fluctuation of demand and supply of dollars. Ceteris Paribus conditions are the one, which are associated with dollar’s demand and supply. In analyzing the effectiveness of AUD in forex market, these conditions or factors represent the exchange rate that exists between two countries by means of trade. The factors are:

       Inflation rate

       Interest rate

       Growth rate

       Government restrictions

Both inflation rate and growth rate are usually considered to be effective for trade related factors. Implication of these rates helps both countries to determine and follow a good exchange rate. Change in the interest rate affects the exchange rate too (Gabaix & Maggiori, 2015). Both the currency rate changes which further lead to either positively or negatively change in exchange rate.  Implication of government restriction tackles all the three rates, inflation, interest as well as growth, thereby tackling the exchange rate in terms of AUD to determine it in forex market.  

Answer to question C

The above graph consists of movement of AUD relative to that of USD according to the exchange rate system from the year 2014 to 2017. In the above graph it has been seen that in 2014, the movement of AUD relative to USD was 0.9035. In the mid 2014 to 2015, the AUD/USD exchange rate has increased to a higher level depicting the range of 0.9454. It has decreased when entering 2015 of rate 0.7857. The AUD/USD exchange rate has fluctuated at a higher rate throughout the year 2016 and the beginning of 2017.  However, in July 2017, the rate has increased slighter than that of previous year, 2016. After july, 2017 the exchange rate of AUD/USD has increased slighter than before of range 0.8121. From the above graph it can be seen that after increasing to 0.8121 it has decreased again and till now it is 0.7755 which seems better that the condition in year 2016.

In trade-weighted index graph, it can be analysed that in 2014, the index amount was 69.4. Soon after that, in that year only it has decreased to 67.4 which was not an effective one for Australian economy. Throughout the year 2015 and 2016, the trade weighted index remained fluctuating. However, in the graph it can be seen that after January, 2017 it has started increasing that to with several ups and downs. After July 2017, it has increased to the level of 67.8 and again started decreasing.  

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