With a floating exchange rate, such as Australia’s, supply and demand factors largely determine the dollar’s equilibrium price. The exchange rate is sensitive to changes in both demand and supply, which can cause changes in the equilibrium exchange rate. Another factor, which can affect the supply and demand of Australian dollars, is intervention in the market by the Reserve Bank of Australia.
The demand for Australia’s currency in the foreign exchange market (Forex) is a derived demand. It is derived from the demand for a country’s exports of goods and services and its assets.
In simple terms, people who may have a demand for the Australian dollar could include:
Foreigners wanting to purchase Australian exports
International tourists visiting Australia
International investors wishing to purchase Australian shares or property
International firms setting up branches or expanding in Australia
Speculators and investors who think the value of the Australian dollar will rise in hope of making a profit.
The demand for the Australian dollar will be affected by a number of factors. These factors are:
The Size of financial flows into Australia The size of financial flows into Australia from investors who wish to invest in Australia and need to convert their currency into AUD will affect demand for the dollar. The level of capital inflow will be affected by the level of Australian interest rates relative to overseas interest rates as well as the level of confidence in the Australian economy. If Australia has relatively higher interest rates and stronger confidence, then this will encourage capital inflow and increase demand for the AUD. Using this theory, the Australian dollar at the present looks to be in a relatively strong position.
Interest rates are beginning to rise (official interest rate has recently been risen 0.25 points to 4.5% and is expected to raise to 5.25% by September this year, with economic growth expected to be around 3.75% in 2002/03.) Also increasing the confidence in future economic growth is the recent budget. The 2002/03 budget released on 14th May 2002 was a deficit budget. This means that the government has spent more than it has earned. This is an injection of money into the Australian economy and will stimulate economic activity and growth.
Price Expectations Expectations of a future appreciation of the AUD will increase the demand for the AUD by speculators as they expect to make a profit from buying the dollar now and selling at a later date at a higher price.
The Demand for Australian Exports The demand for Australian exports varies for a variety of reasons. One reason is changes in commodity prices. Another is the terms of trade. These two variations tend to have an immediate impact on the AUD. A rise in commodity prices and an improvement in the terms of trade are generally expected to improve the Current Account Deficit (CAD). This will often result in an increase in the value of the AUD because of the expectation that the CAD will improve over the short to medium term.
The demand for Australian exports is also influenced by the level of international competition and the Australian inflation rate relative to other countries. If Australian firms are competitive in the world market and Australia’s inflation rate remains low, it means that Australia’s exports will be cheaper to foreigners, making them more attractive to buy.
Changes in world income levels will also influence the overseas demand for Australian exports. The demand for Australia’s commodity exports in particular are highly dependent on the levels of income of Australia’s trading partners. When the world economy is in a period of upturn, demand and prices for Australian exports will rise.
Also affecting world demand for Australian exports are simply the tastes and preferences of overseas consumers for Australian exports.
An increase in demand for Australian dollars generally causes the value of the currency to appreciate. A supply and demand curve is shown over the page, demonstrating an appreciation of the dollar.
The supply of Australia’s currency is also derived. It is derived from the demand of Australia’s residents for foreign goods, services and assets.
People who could possibly create a supply of Australian dollars are:
Australians who want to buy imports from overseas
Australian tourists going overseas
Australian banks and firms lending or investing money overseas
Australians paying for various services from overseas such as repaying loans or paying interest on loans
Speculators and investors
The supply of Australian dollars will be affected by a number of factors. These factors are:
The size of financial flows out of Australia The level of financial flows out of Australia will also be determined by the domestic interest rates relative to overseas as well as international confidence in Australia and other economies. If Australian interest rates are relatively lower and the confidence in the Australian economy has deteriorated, capital outflow will increase, thus increasing the supply of AUD. At the present, interest rates are at low levels, however they are expected to rise in the near future as economic confidence and growth are relatively high. This means there will not be a large increase in the supply of Australian dollars.
Price Expectations Speculators and investors in the foreign exchange market who expect the value of the AUD to decrease will sell AUD so as to minimise losses. This will increase the supply of AUD and contribute to the anticipated depreciation.
The domestic demand for imports Australian importers who buy from overseas need to sell AUD in order to obtain foreign currencies to pay for the imports. The level of domestic income will largely determine the demand for imports. When the domestic economy is growing, output employment and income are rising, so the demand for imports will also rise which will then increase the supply of AUD. If people have more income they may choose to purchase goods from overseas which are considered to have ‘prestige’.
The domestic inflation rate and competitiveness of domestic firms that are in competition with imports will also influence the level of demand for imports. If Australia’s domestic inflation rate is higher and its firms are relatively uncompetitive, then imports will be cheaper than products produced in Australia and demand for imports will rise.
Also, tastes and preferences of Australian consumers change over time, and an increase in the desirability of goods and services produced overseas will increase supply of AUD on the foreign exchange market.
When supply of the dollar increases, there is generally a depreciation of the value of the currency.