Unit 1
Unit 2
Economic Markets
The Foreign Exchange Market
At first glance it might seem strange that there is a market for our money. After all, if you were asked how much $1 is worth, you would be quite right in answering “one dollar”! Closer inspection will reveal that the market for foreign currency is actually one of the most active in the global economy.
For example, consider this fact – one Australian dollar might be worth exactly that much to you, but it would be expressed in a very different way by a person living in New Zealand. That person might say that one Australian dollar is worth $1.10 to them, but they would be talking in New Zealand dollars. In other words, it is possible to express the value of one currency in terms of another. We refer to this as an exchange rate. In other words, a person in New Zealand can “buy” one Australian dollar by spending NZ$1.10. On the other hand, a person in Australia can buy NZ$1.10 when they offer AUD $1.00.
So far in Economics you have seen the prices are determined by the forces of supply and demand, and so you won’t be surprised to discover that this is also true when you are thinking about the price (or exchange rate) for the Australian dollar. When there is an increase in demand for the Australian dollar, it will be worth more on the foreign exchange market. We refer to this as an appreciation of the Australian dollar. On the other hand, a depreciation of the Australian dollar could happen when there is a fall in demand for the currency, or if there is a sudden increase in the supply of dollars in the market.
Demand for the Australian Dollar
Demand for our currency is created when a person or business in another country decides to purchase some of our currency. There are lots of reasons that this might be necessary.
For example, if a business in China wants to buy some of our iron ore, it is unlikely that the seller will be willing to accept payment in yuan. To overcome this, the buyer will need to offer to pay in Australian dollars. (It is also possible that the contract will be written in a third currency like US dollars. However, as these dollars will eventually be sold for Australian dollars anyway, we will avoid this complication for now.) In other words, if Australian exports are attractive to overseas buyers, then they will create demand for our currency. This is one of the reasons that it is so important that we are able to produce goods and services that are competitive in the international market.
It is also possible that someone overseas will want to invest in the Australian economy. This could happen when the Australian sharemarket looks like it will increase in the near future. It could also happen if banks are paying higher interest rates on savings in this country than are available in other countries. Watch the news and you will notice that when an interest rate increase is announced the Australian dollar will usually appreciate on the same day, while a cut to the cash rate will generally coincide with a fall in the value of the currency.
Supply of the Australian Dollar
When the supply of the Australian dollar increases on the foreign exchange market, it is likely that the currency will depreciate. It is easy to understand factors that will increase the supply of Australian dollars; if people or businesses in this country want to buy foreign currency, they will need to trade Australian dollars to make this possible. Each time they do this, they will also be increasing the supply of Australian dollars on the foreign exchange market.
On a very small level, if you choose to travel overseas, you might decide to buy some foreign currency before you go. This will act to increase the supply of Australian dollars. It is unlikely that you will notice any difference in the exchange rate though, as the amount traded by one individual will be very small relative to the total value of exchanges in one day.
Each time we buy products from overseas, or invest in shares or businesses in other countries, we are increasing the supply of Australian dollars on the foreign exchange market. If a country is suddenly seen as a “risky” place to invest, international investors will remove their money quickly. This can cause a rapid depreciation of a floating currency, such as the Australian dollar.
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