An exchange rate is a relative price of one currencyexpressed in terms of another currency (or groupof currencies). For economies like Australiathat actively engage in international trade, theexchange rate is an important economic variable.Changes in it affect economic activity, inflation andthe nation's balance of payments. (See Explainer:Exchange Rates and the Australian Economy.)The Australian dollar is also the sixth mosttraded currency in foreign exchange markets.There are different ways in which exchange ratesare measured and, over the years, there havebeen different operational arrangements fordetermining the value of Australia's exchange rate.
Measuring Exchange Rates
Bilateral exchange rate
There are many ways to measure an exchange rate.The most common way is to measure a bilateralexchange rate. A bilateral exchange rate refersto the value of one currency relative to another.Bilateral exchange rates are typically quotedagainst the US dollar (USD), as it is the most tradedcurrency globally. Looking at the Australian dollar(AUD), the AUD/USD exchange rate gives you theamount of US dollars that you will receive for eachAustralian dollar that you convert. For example,an AUD/USD exchange rate of 0.75 means thatyou will get US75 cents for every AUD1 that isconverted to US dollars.
Bilateral exchange rates are visible in our daily livesand widely reported in the media. Consumers areexposed to them when they travel overseas orwhen they order goods and services from othercountries. Businesses are exposed to them whenthey purchase inputs to production from othercountries and enter contracts to export theirgoods and services elsewhere.
Cross rates
Bilateral exchange rates also provide a basisfor calculating ‘cross rates’. A cross rate is anexchange rate calculated by reference to a thirdcurrency. For instance, if the exchange rate for theeuro (EUR) against the US dollar is known as wellas for the Australian dollar against the US dollar,the exchange rate between the euro and theAustralian dollar (EUR/AUD) can be calculated byusing the AUD/USD and EUR/USD rates (that is,EUR/AUD = EUR/USD x USD/AUD).
Trade-weighted index (TWI)
While bilateral exchange rates are the mostfrequently quoted exchange rates (and are mostlikely to be quoted in the press), a trade-weightedindex (TWI) provides a broader measure ofgeneral trends in a currency. This is because a TWIcaptures the price of a domestic currency in termsof a weighted average of a group or 'basket' ofcurrencies (rather than a single foreign currency).The weights of each currency in the basket aregenerally based on the share of trade conductedwith each of a country's trading partners (usuallytotal trade shares, but import or export sharescan also be used). As a result, a TWI can measurewhether a currency is appreciating or depreciatingon average relative to its trading partners. A TWIgenerally fluctuates less than bilateral exchangerates because movements in the bilateralexchange rates used to construct a TWI will oftenpartly offset each other.
Exchange Rate Regimes
There are numerous exchange rate regimes acountry may choose to operate under. At one endof the spectrum a currency is freely floating, and atthe other end it is fixed to another currency usinga hard peg. Below, we have divided this spectruminto two broad categories – floating and pegged –although finer distinctions can also be used withinthese categories.
Floating
Australia has had a floating exchange rate regimesince 1983. This is a common type of exchange rateregime as it contributes to macroeconomic stabilityby cushioning economies from shocks and allowingmonetary policy to be focussed on targetingdomestic economic conditions. In a floating regime,exchange rates are generally determined by themarket forces of supply and demand for foreignexchange. For many years, floating exchange rateshave been the regime used by the world's majorcurrencies – that is, the US dollar, the euro area'seuro, the Japanese yen and the UK pound sterling.
In the long term, the theory of purchasing powerparity says that floating bilateral exchange ratesshould settle at a level that makes goods andservices cost the same amount in both countries,although it is difficult to see this in the historicaldata. In the medium term, movements in anexchange rate reflect things like changes in interestrate differentials, international competitiveness andthe relative economic outlook in each economy.On a daily basis, exchange rate movements mayreflect speculation or news and events that affectthe respective economies.
A floating exchange rate can result in largerand more frequent fluctuations in the currencycompared with pegged regimes. In a freelyfloating regime, the monetary authority intervenesto affect the level of the exchange rate only onrare occasions if market conditions are disorderly.In contrast, some floating regimes are moremanaged, and the monetary authority intervenesmore frequently to limit exchange rate volatility.
Pegged
Under a pegged regime (sometimes referred toas a fixed regime), the monetary authority ties itsofficial exchange rate to another nation's currency.In most cases, this will be in the form of a currencytarget or target band at a rate against the US dollar,the euro or a basket of currencies. The targetprovides a visible anchor and stability in thecurrency, although the target may move over time.
The monetary authority manages its exchange rateby intervening (buying and selling currency) in theforeign exchange market to minimise fluctuationsand keep the currency close to its target (or withinits target band). A pegged exchange rate regimelimits monetary policy independence since itrestricts the use of interest rates as a policy tool andrequires the monetary authority to hold substantialforeign currency reserves for interventionpurposes. (For a discussion of monetary policyimplementation, please see Explainer: How theReserve Bank Implements Monetary Policy).An example of a pegged exchange rate is theDanish krone, which is pegged to the euro sothat 1 euro equals 7.46 kroner, but can fluctuatebetween 7.29 and 7.62 kroner per euro.
