The present study is based on analysing the supply and demand for exchange rate of dollar in Australia and USA. The equilibrium situation in the exchange rate market has been identified in this study. Moreover, the reasons behind appreciation or depreciation of exchange rate will also be analysed in this study. Finally, different policies for appreciating Australian have been discussed.
The demand curve for exchange rate of Australian dollar and US dollar [S (USD/AUD)] is depicted by the following equation.
QD = 10 – 0.6Pf
On the other hand, the supply curve of exchange rate of Australian dollar and US dollar is presented as the following.
QS = 5 + 0.2Pf
In the equilibrium, the demand for exchange rate will be equal to its supply as the following.
10 – 0.6Pf = 5 + 0.2Pf
=> 0.2Pf + 0.6Pf = 10 – 5
=> 0.8Pf = 5
=> Pf = 5/0.8
=> Pf = 6.25
Therefore, the equilibrium price is 6.25
The demand and supply framework for exchange rate can be depicted as the following.
1: Demand and Supply Framework for Exchange Rate
It can be identified that the demand curve for exchange rate is sloping downwards and the supply curve is sloping upwards. The price for exchange rate is measured in the vertical axis. On another hand, quantity of demand and supply is presented in the horizontal axis.
If the exchange rate is in equilibrium, there will always be balance in Balance of Payments (BOP). This is due to the fact that under equilibrium exchange rate, demand and supply of exchange rate will be equal to each other (De Grauwe and Grimaldi, 2018).
The equilibrium price of foreign currency can get fluctuated due to spectacular’s expectation. In this case if the speculators expect increase in the exchange rate in the future, they will demand more of the currencies (Gabaix and Maggiori, 2015). However, in this situation, supply of exchange will decrease. In this case, exchange rate will appreciate. This can be depicted by the following diagram.
2: Effect of spectacular’s expectations on exchange rate
Spectacular’s expectation can both stabilise or destabilise the exchange rate in the foreign currency market. In case of stabilising effect, the speculators purchase AUD when it is weak and sell AUD when it is strong (Della Corte et al. 2016). In case of weak AUD, increased demand leads to increase in price of AUD due to which weak AUD recovers and stabilises. In case of strong AUD, high supply reduces price of AUD due to which it weakens and then stabilises in the equilibrium.
3: Stabilising effect of speculation
The above figure shows that when AUD is weak at $6, demand for AUD has increased and shifted to the rightward direction. Hence, the equilibrium has been stabilised by strengthening AUD at $7.
On the other hand, in case of destabilising effect, speculators sell AUD when it is weak in the expectation that it will weaken further. In this case, higher supply decreases price of AUD due to which it further weakens moving away from the equilibrium point and resulting in destabilisation (Ghosh et al. 2015). In case of strong AUD, speculators buy AUD in the expectation that it will strengthen further. In this case, higher demand increases price of AUD due to which it further strengthens. In this way, exchange rate of AUD again moves away from the equilibrium point resulting in destabilisation.
Reasons behind depreciation or appreciation of AUD
1. Global demand:
The economic condition in the international market can have significant impact on the valuation of exchange rate. In this regard, if the global demand for Australian goods is decreased, the demand for Australian dollar will also decline due to which the price of Australian dollar will fall down in order to maintain equilibrium in the foreign currency market. In this way, depreciation of Australian dollar will take place because of lower amount of global demand for Australian products.
On the other hand, if global demand for Australian products and services gets increased, the demand for Australian dollar will also get increased as Australian products and services can only be purchased with Australian dollar (Moosa, 2016). This will lead to excess demand in foreign currency market due to which price of Australian dollar will increase in order to balance the excess demand. Thus, Australian dollar will appreciate due to high global demand for Australian products in the international market.
It can be seen in the above diagram that due to increase in global demand for Australian products, demand for Australian dollar has also increased. Due to this reason, the demand curve for AUD has shifted in the rightward direction. Therefore, the quantity of AUD has increased due to rightward shift of the demand curve. Along with this, the price of AUD has also gone up in the new equilibrium. Thus, the Australian exchange rate has appreciated.
2. Monetary policy of the central bank:
The central bank of Australia is known as Reserve Bank of Australia. Due to various policies of Australia’s central bank, the currency of this country can get fluctuated. When there is inflation in Australia, the central bank of this nation will increase interest rates so that money supply in the economy can be decreased. Due to higher interest rates, demand for Australian dollar will decrease as the foreign investors will anticipate lower returns from investment in Australian dollar. This will again decrease price as well as the value of Australian dollar in order to push the Australian dollar in upwards direction. Thus, because of lowered interest rates by central bank, Australian dollar has been depreciated.
It can be seen in the above diagram that due to lower demand for AUD in case of decreased interest rates, the demand curve has shifted in the leftward direction. In this case, the price as well as the quantity of AUD has decreased. In this way, the Australian exchange rate has depreciated in this situation.
On the contrary, if there is low economic growth in the Australian economy, the central bank will decrease interest rates so that money supply in the economy can rise in order to increase economic activity. In this case, lower interest rates will result in higher demand for Australian dollar due to the anticipation of higher returns for foreign investors. In this way, high demand for Australian dollar will push up its price and value until the excess demand is absorbed. In this way, Australian dollar has appreciated due to increased interest rates by central bank of Australia.
3. Condition of the international market:
Fluctuation in the Australian exchange rate is also dependent on the current situation of the international market. In this regard, majority of the exports of Australia are imported by USA and different Asian countries such as China (Galí and Monacelli, 2016). In this case, if the American economy or the Chinese economy is facing an economic downturn, then their purchasing power for exporting Australian products will decrease. In this process, demand for Australian products and services among the American and Asian consumers will decrease significantly. This will further reduce the demand for Australian dollar due to which price of Australia dollar will also decrease resulting in depreciation of Australian dollar.
On the other hand, if the American or Asian economies are facing an economic boom, then their purchasing power to consume Australian products will also increase. Hence, demand for Australian dollar will also increase due to which excess demand will take place in foreign currency market. In this case, price of Australian dollar will rise in order to nullify the excess demand. In this way, appreciation of Australian dollar has taken place due to high economic growth in the Asian countries.
The Australian government as well as the central bank of Australia has high contributions in adjusting the value of Australian dollar (AUD). In this context, Australian government can review its fiscal policy in order to adjust AUD. On the other hand, Reserve Bank of Australia can modify its monetary policy for adjusting AUD.
The Australian economy is highly dependent on its export sector. Some of the primary export commodities of Australia are coal, iron ore and many other mining items. If there is an increase in the commodity prices of Australia, there will be significantly reduced demand for Australian products in the international market due to which demand for AUD will also decrease. Hence, the price of AUD will decrease in order to equilibrate the foreign currency market. This will further lead to depreciation of the Australian dollar. On the other hand, decrease in commodity prices of Australia will significantly increase the demand for Australian exports in the international market (Chen and Juvenal, 2016). Thus, demand for AUD will also increase so that higher amount of Australian exports can be purchased by the foreign countries. Thus, there will be excess demand for AUD in the foreign exchange market due to which price of AUD will rise in order to balance the situation of excess demand. In this way, appreciation of Australian dollar can take place.
Fluctuations in exchange rate is also highly dependent on the monetary policies undertaken by the government of the country. In this regard, the central bank of Australia can not only adjust the economic growth through monetary policy but also can regulate the exchange rate of the country. Reserve Bank of Australia (RBA) can undertake loose monetary policy in order to achieve currency appreciation. In this context, the RBA can decrease the interest rates in order to increase money supply in the economy so that greater economic growth can be achieved. Under this scenario, the foreign investors will anticipate higher returns for their investment in the Australian economy due to which demand for Australian dollar will rise (Forbes et al. 2016). Due to higher demand for Australian dollar, there will in turn take place a situation of excess demand for AUD in the foreign exchange market. In order to curb this situation of excess demand, price of AUD will eventually increase. Hence, AUD will also appreciate due to rise in its price. In this way, RBA will be able to achieve currency appreciation by implementing loose monetary policy.
It can be concluded that exchange rate of Australia can be fluctuated due to global market situation as well as monetary and fiscal policies. In this case, tight monetary policy can lead to currency depreciation whereas loose monetary policy can lead to currency appreciation.
finance assignment help, finance homework help, finance assignment, finance homework, financial accounting assignment, corporate finance assignment help, corporate finance assignment, finance assignment help online, do my finance homework, finance homework solutions, business finance assignment, corporate finance homework help, financial management assignment help, finance homework help online, business finance assignment help, international finance assignment help, financial planning assignment help, personal finance assignment help, financial management homework help, accounting and finance assignment, finance assignment writing service