4.2 Deciphering exchange rates
Study Notes
Nominal exchange rate
When the ‘exchange rate’ is quoted on the nightly finance report, it is the nominal exchange rate that is being referred to.
The nominal exchange rate is the number of units of one currency that can be purchased with one unit of another currency. It can be quoted in two different ways. Consider the relationship between the Australian dollar ($A) and the United States dollar ($US).
First, how many $As are necessary to purchase one unit of the US currency ($US1)? In this case, the $US is the reference currency, and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So $A1.25 = $US1 means that it takes $1.25 of Australian currency to buy one $US.
Second, if the $A is the reference currency, then we are asking how many US dollars are needed to buy one unit of Australian currency ($A1). So, in the example above, this is written as $US0.80 = $A1. Thus, if it takes $A1.25 to buy one $US, then $US0.80 is required to buy one $A.
The second quotation convention is typically used by the media.
What determines the exchange rate?
Exchange rates are influenced by the supply of and the demand for currencies in the world foreign exchange (forex) markets, which could be the local bank foreign currency desk or elsewhere, like a train station kiosk in a city where travellers meet.'
When Australian residents buy foreign goods (imports), buy foreign assets or lend abroad, they need to purchase the relevant foreign currencies in which the transaction is denominated. To buy the currency they desire, they supply $As in exchange.
Alternatively, when foreigners buy Australian goods and services (exports) and/or Australian financial assets they require $A. They purchase them in the forex market by supplying their own currency in exchange. This creates a demand for $As.
An excess demand for $A (demand greater than supply) puts pressure for the $A to appreciate in price relative to other currencies. If there is an excess supply of $A (supply greater than demand), the $A depreciates.
What happens when the exchange rate changes?
A depreciation of the $A (as the reference currency) leads to:
- Foreign goods becoming more expensive in terms of their $A price, which should lead to a fall in the quantity of imports demanded, if nothing else changes.
- The price that foreigners must pay in their currency for Australian goods falls, which should lead to a rise in the quantity of exports demanded, if nothing else changes.
An appreciation of the $A leads to:
- Cheaper foreign goods in terms of their $A price, which should lead to a rise in the quantity of imports demanded, if nothing else changes.
- Foreigners having to pay higher prices, for a given $A price for Australian-produced goods. This should lead to a fall in the quantity of exports demanded, if nothing else changes.
Trade deficits
A trade deficit means that increasing quantities of, for example, Australian dollars are being accumulated by foreigners. In return, foreigners have supplied goods and services (imports) to Australian residents.
Clearly, the foreigners have allowed Australia to run a trade deficit because they wanted to accumulate financial assets denominated in Australian dollars. The alternative would have been to spend the Australian dollars they acquired through their exports to buy Australian goods and services (that is, to buy Australian imports).
Financial Transactions
The simple supply and demand approach based on trade movements do not fully explain exchange rate determination in the real world. In reality, financial transactions are many orders of magnitude greater than those associated with trade.
The demand for a country’s financial assets will play a big role in determining exchange rates. Most of the demand for, say, the Australian dollar is not for the currency, per se, but rather for Australian dollar-denominated financial and real assets. Likewise, most of the global demand for the US dollar is not for purchases of US goods and services but rather for financial assets denominated in $US that can be held as earning assets in diversified portfolios.
This is why a country like the US can run persistent trade deficits, and a country like Japan can run persistent trade surpluses, without persistent pressure on exchange rates.
International competitiveness
We often want to know whether local goods and services are becoming more or less competitive with respect to goods and services produced overseas. Another concept - the real exchange rate – helps us in that respect.
It depends on two factors:
- Movements in the nominal exchange rate; and
- Relative inflation rates (domestic and foreign).
The following conclusions can be drawn:
- If foreign and local prices are unchanged, then a depreciating (appreciating) nominal exchange rate, results in local goods becoming relatively cheaper (dearer) than foreign goods.
- If the nominal exchange rate is constant, and foreign prices are rising faster (slower) than local prices, then local goods are becoming relatively cheaper (dearer) than foreign goods.
The real exchange rate measures the combined impact of these two influences.
A rise in the real exchange rate, which signals that a nation has increased its international trade competitiveness, can occur if:
- The nominal exchange rate depreciates; and/or
- Foreign prices rise more than local prices, other things unchanged.
A fall in the real exchange rate, which signals that a nation has decreased its international trade competitiveness, an occur if:
- The nominal exchange rate appreciates; and/or
- Foreign prices rises less than local prices, other things unchanged.
Nations often attempt to improve their international competitiveness by slashing wages, thinking this will reduce production costs and domestic prices relative to rest of world prices.
But this strategy not only undermines total spending but may also damage productivity through a decline in workplace morale. In that case, unit production costs rise, and the strategy becomes self-defeating.
Robust research evidence supports the notion that, by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity which yields improvements in a country’s international competitiveness.
