1. Chapter 9 The Balance of Payments and Exchange Rates
9.1 What is the Balance of Payments?
9.2 Reasons for Australia’s Current Account Deficit
9.3 Exchange rates
9.4 Types of Exchange Rate Systems

2. What is the Balance of Payments?
An accounting measure of the financial flows that go into and out of Australia.
A record of transactions between Australian consumers, business and governments and the rest of the world.

3. The Current Account and Capital Account
Split up into the current account and the capital account.
The current account is made up of income based items like profit, payments of wages, interest payments and exports and imports.
The capital account is made up of the transfer of savings across national borders in the form of investment.

4. The Current Account and Capital Account
The current account and the capital account must balance i.e. Current account + Capital account = 0 Australia has been running a current account deficit for nearly 30 years. Any deficit in the current account must be funded by a surplus in the capital account.

5. Funding the Current Account Deficit
To create the capital account surplus needed to fund the current account deficit, the RBA or must either sell assets or borrow from overseas.

6. Size of Australia’s Current Account Deficit
From the early 1980s, the deficit averaged around 4 per cent of GDP.
The CAD has widened further over the last five years, averaging 5¼ per cent of GDP.

7. Reasons for Australia’s Current Account Deficit
Level of Economic Growth
Higher economic growth will cause Australia to buy more imports which will increase the size of the CAD.
Net Exports (the trade balance)
Net Income
Low level of savings leads to a need for foreign investment. The interest payments on this investment are debits on the CAD
Exchange Rates

8. The Terms of Trade Terms of Trade Index = Export Price Index x 100
The terms of trade is a measure of the prices Australia receives for its exports, relative to its imports.
Terms of Trade Index = Export Price Index x 100
Import Price Index

9. Is the CAD a Problem?
In extreme circumstances a large CAD can be very problematic if the RBA runs out of reserves and has difficulty borrowing from overseas. As long as the CAD is kept to a reasonable level it should not be of great concern to policy makers.

10. Exchange rates
An exchange rate is the value of one currency in terms of another. The most common exchange rate used in Australia is the Australian dollar/US dollar exchange rate. E.g: The Australian dollar is trading at 0.97 US cents. 1 Australian dollar buys 0.97 US dollars or 97 US cents.

11. Appreciation of the Exchange Rate
An appreciation is where the value of one currency rises in value in terms of the other. If the Australian dollar appreciated from 0.97 USD to 0.98 USD, 1 Australian dollar now buys 98 US cents where before it only bought 97 US cents. Therefore, the Australian dollar is now worth more, because it can buy more.

12. Depreciation of the exchange rate
A depreciation is when the value of one currency falls against the value of another currency. If the Australian dollar depreciates against another currency it is worth less.

13. Reasons to buy and sell currency
When investing overseas.
Speculation.
When travelling overseas or purchasing products from overseas.

14. Arbitrage
Arbitrage is when there is profit to be made in the market simply due to pricing abnormalities. Exchange rates should be priced relative to each other. If they are not then there is an arbitrage opportunity. See pg. 343 for full explanation

15. The Trade Weighted Index
Measures the value of the AUD in terms of its ability to buy a basket of currencies, where the weight placed on each currency is related to its importance in Australia’s international trade. Takes into account the relative importance of our trading partners.

16. Floating Exchange rates
A floating or flexible exchange rate is one where the exchange rate fluctuates according to the forces of supply and demand.

17. Demand for AUD

18. Demand for AUD
Represents those who want to buy AUD The demand curve is downward sloping. As the AUD depreciates holders of foreign currency will get more AUD for the foreign currency they sell, which makes it more attractive for them to do so. Therefore, the lower the ‘price’ of AUD the higher quantity of AUD demanded.

19. Supply of AUD

20. Supply of AUD
The supply curve represents people who hold Australian dollars. Upward sloping supply curve because the higher the ‘price’ of AUD the more foreign currency sellers of AUD will receive for each AUD sold. Therefore, as the AUD appreciates, holders of AUD will want to sell more AUD. Therefore, the supply of AUD will increase as the ‘price’ rises.

21. Supply and Demand for AUD Together

22. Supply and Demand for AUD Together
The exchange rate of a currency under a floating rate system will be where the supply and demand for that currency intersect (equilibrium).
Any change in the supply or demand of Australian dollars will cause the Australian dollar to appreciate or depreciate.

23. Factors affecting the Demand and Supply of Australian Dollars
Interest rates
Speculation
Investment
Exports
Imports

24. Floating Exchange Rates with Intervention
Some governments or central banks covertly intervene in exchange rates in an attempt to reduce volatility. However, most central banks do not have the power to alter exchange rates significantly due to the volume of trading in FX markets.

25. Fixed Exchange Rate Systems
A fixed exchange rate a currency that is artificially fixed at a certain level of another currency (usually the US dollar). The exchange rate is held either above or below the equilibrium level. The central bank makes up for the excess supply or excess demand by buying or selling the equivalent amount of currency.

26. Exchange Rate Fixed Above Equilibrium

27. Floating vs. Fixed Rate
A fixed rate may be desirable because it can reduce volatility which helps to protect export industries. A Fixed exchange rate can constrain the central banking authority’s ability to use monetary policy. Under a floating rate system the central bank has total control over monetary policy . Central Bank does not having to worry about levels of foreign reserves required to keep the exchange rate fixed under a floating system.

28. Exchange rate system in Australia
Australia uses a floating exchange rate system. Up until 1983 Australia used an adjustable pegged exchange rate that was pegged to the US dollar. In 1983 the currency was deregulated to allow the forces of demand and supply to determine the exchange rate and give the RBA more power over interest rates.

29. Effects of Depreciation
A depreciation will make Australian exports cheaper for overseas buyers and make imports coming into Australia more expensive.
Leads to a rise in net exports which will increase economic growth and reduce the CAD.
An increase in import prices may increase inflation.
See case study – ‘Currency Wars’ pg

30. Effects of an Appreciation
An appreciation will lead to a fall in export revenue as exports become more expensive and an increase in import expenditure as imports become cheaper.
Leads to lower economic growth and a higher CAD.
Cheaper import prices may reduce inflation.

31. Winners and Losers from Movements in Exchange Rates
Exporters tend to benefit from a depreciation as their exports become relatively cheaper for international buyers but they will lose out from an appreciation. Importers tend to gain from an appreciation as it becomes relatively cheaper for Australians to buy imports, but will lose out when the AUD depreciates.