An exchange rate is the value of one currency interms of another currency. Exchange rates matterto Australia's economy because of their influenceon trade and financial flows between Australiaand the rest of the world. Changes in exchangerates affect the Australian economy in twomain ways:
- There is a direct effect on the prices ofgoods and services produced in Australiarelative to the prices of goods and servicesproduced overseas.
- There is an indirect effect on economicactivity and inflation as changes in therelative prices of goods and servicesproduced domestically and overseasinfluence decisions about productionand consumption.
Together these effects also have implications forthe balance of payments. This Explainer describesthe effects of exchange rate movements andhighlights the main channels through whichthese changes affect the Australian economy.
If the exchange rate between the Australian dollarand the US dollar is 0.75 then one Australiandollar can be converted into US75c. An increasein the value of the Australian dollar is calledan appreciation. A decrease in the value of theAustralian dollar is known as a depreciation.(For more information on exchange rates and their measurement, seeExplainer:Exchange Rates and their Measurement.)
Direct Effects
The direct effect of an exchange rate movementis to change the prices of goods and servicesproduced in Australia relative to the prices ofgoods and services produced overseas. When theAustralian dollar depreciates, or loses value, lessforeign currency is required to purchase a givenamount of Australian dollars. This makes Australianproduced goods and services cheaper thanbefore when compared with goods and servicesproduced overseas. For example, if the Australiandollar depreciates, tourists visiting Australia willneed to change less foreign currency to payfor their meals and hotel rooms in Australia. Anappreciation of the Australian dollar will have theopposite effect – Australian produced goods andservices will become more expensive comparedto goods and services produced overseas. If theAustralian dollar appreciates, Australian tourists willneed to change fewer Australian dollars to pay fortheir meals and hotel rooms overseas.
Indirect Effects
The indirect effects of exchange rate movementsarise because changes in the relative prices ofAustralian and overseas goods and servicesaffect economic activity and inflation inAustralia. To highlight this, we use the exampleof a depreciation of the Australian dollar.(An appreciation of the Australian dollar has theopposite effect on economic activity and inflation.)
Economic activity and the labour market
By reducing the relative price of Australianproduced goods and services, a depreciation ofthe Australian dollar increases the internationalcompetitiveness of Australian exporters. BecauseAustralian goods and services have becomecheaper relative to overseas goods and services,foreign consumers and firms will demand moreAustralian goods and services, leading to anincrease in the volume (that is, quantity) ofAustralian exports.
At the same time, following an exchange ratedepreciation, imported goods and servicesbecome relatively more expensive for Australianconsumers and firms. In response, Australianresidents are likely to change their consumptionpatterns to demand more import-competinggoods and services produced in Australia, leadingto a decrease in the volume of imports.
Relative changes in export and import pricesarising from a change in the exchange ratemainly influence demand for tradablegoods and services. But exchange rate movementsalso have implications for the demand fornon-tradable goods and services. In thecase of depreciation, the resulting increase in exportvolumes and decrease in import volumes willincrease national income in Australia. This, in turn,will increase demand for non-tradable goodsand services produced in Australia. In order tomeet the increased demand for their products,Australian firms will have to hire more workers,which will increase employment and lower theunemployment rate in Australia.
Inflation and interest rates
In principle, a depreciation of the exchangerate will increase inflation in two ways. First,the prices of imported goods and services willincrease, contributing to inflation. Second, theexpansion of aggregate demand and increase inemployment will cause an increase in wages andother costs that are inputs to production and maybe passed on to prices more generally, which willalso contribute to higher inflation (seeExplainer: Causes of Inflation).
Should these factors contribute to excessiveinflation, the Reserve Bank may need totighten monetary policy in order to achieve itsinflation target.
In practice, there is typically a lag between anexchange rate movement and its effect oneconomic activity and inflation. In the discussionabove we have assumed exchange rate changesare immediately reflected in the prices ofimported goods and services. But firms sellingimported items often price them in Australiandollars, so it is up to the firm selling the item todecide when to pass on the higher cost (fromthe depreciation) to those buying the product.Exchange rates are volatile, and firms may bereluctant to change their prices until they aresure that an exchange rate movement will notreverse. Even after prices adjust, it may taketime for households and firms to adjust theirspending patterns. The extent and timing of theresponses will also depend on how easy it is forhouseholds and firms to substitute betweengoods and services produced in Australia andgoods and services produced overseas. Mostestimates suggest that it takes between one andthree years for exchange rate movements tohave their maximum effect on economic activityand inflation.
Balance of Payments
Exchange rates and the balance of payments
When considering the implications of exchangerate movements for economic activity whatmatters is the change in the volume, or quantity,of exports and imports. In determining theconsequences of exchange rate movements forthe balance of payments, however, it is the value– that is the prices as well as the quantity – ofexports and imports that matters. Once again, weuse the example of a depreciation of an Australiandollar to describe these effects.
The direct effect of an exchange rate depreciationis to increase the price of imports relative toexports, which will tend to decrease the valueof net exports (exports less imports) and widenthe current account deficit. However, the indirecteffects of an exchange rate depreciation increasethe volume of exports and reduce the volume ofimports. This will tend to increase net exports anddiminish the current account deficit.
These two effects differ in their timing. The directeffect of an exchange rate depreciation occursimmediately, while the indirect effects on exportand import volumes typically occur with a lag.Because of this, in the short run, an exchangerate depreciation is likely to reduce the value ofnet exports. But over time, as export and importvolumes start to respond, an exchange ratedepreciation is likely to increase the value of netexports. This pattern is sometimes referred to asthe ‘J-curve’.
Exchange rate movements also affect theother major component of the current account– the net income deficit. An exchange ratedepreciation will increase the cost to Australianresidents of servicing foreign debt that isdenominated in foreign currency. This is becausethe amount of Australian dollars required topurchase the foreign currency needed to paythe interest owed on the debt has increased.This increases net income outflow and widensthe current account deficit. On the other hand,an exchange rate depreciation will increase theincome that Australian residents receive on theirforeign asset holdings, as the returns on thoseassets are now larger in terms of Australiandollars. This reduces net income outflow andnarrows the current account deficit. (AlthoughAustralia's foreign liabilities exceed its foreignassets, a large proportion of the foreign liabilitiesare denominated in Australian dollars so that adepreciation of the Australian dollar will actuallytend to diminish Australia's net income deficit.This is because the interest owed on the foreignliabilities is not affected by the change in theexchange rate but the returns on the foreignassets are.)
An exchange rate depreciation has an additionaleffect on the balance of payments throughvaluation effects on Australia's net foreignliabilities. Valuation effects occur because adepreciation of the Australian dollar increases thevalue in Australian dollars of assets and liabilitiesdenominated in foreign currency. As was thecase for the net income deficit, because theforeign assets of Australian residents that aredenominated in foreign currency exceed theliabilities of Australian residents denominated inforeign currency, an exchange rate depreciationwill tend to reduce the value of Australia's netforeign liabilities.
To learn more about the balance of payments, seethe Explainer: The Balance ofPayments.
