Policy Impact

External Stability

Although monetary policy is no longer used to directly influence Australia’s external stability, this was not always the case. In the late 1980’s it was believed that tightening the monetary policy stance would help to lower the level of demand for imported goods and services, and in so doing the balance on current account would be improved. This approach proved to be flawed in two ways. First, the impact on demand for domestic goods and services was much more dramatic, and as a result the Australian economy experienced a recession in the early 1990’s. The second problem was that higher interest rates resulted in an appreciation of the Australian dollar, and as such imported goods and services actually became more affordable.

Today, economists are far more aware of the significance of relative interest rates in determining the value of the currency. When our interest rates are high relative to those available in other countries, investors will seek to benefit from higher returns by investing in our overnight money market. To do so they will need to purchase Australian dollars; demand for our currency will increase, and therefore our currency will appreciate. This will have a flow on impact on the current account deficit.

For example, during 2003 the US central bank (the Federal Reserve) decreased interest rates several times in at attempt to off-set lower levels of business and consumer confidence that developed in the wake of terrorist attacks. At the same time, the RBA began to suggest that Australian rates would soon rise from 4.75%, where they had been for some time. In November 2003, the cash rate in Australian increased to 5.0%, and in December we experienced a second 25 basis point increase. These two changes to the cash rate combined to make the difference between the available rates in Australia and the USA more significant than it had been for some time, and as a result investment in the overnight money market in Australia increased. This in turn resulted in a significant appreciation of the Australian dollar which continued into the first half of 2004.

However, monetary policy can have a far more direct influence on the value of the Australian dollar. You may recall that interest rates represent just one of the tools available to the RBA. A second tool is direct intervention in the foreign exchange market. By buying and selling Australian dollars in the foreign exchange market, the RBA is able to directly influence the value of our currency. Through the normal course of operations, the RBA will have some interaction in this market, however it is possible for the bank to increase their involvement to either restrict or increase supply of AUD.

For example, in 2007 the Australian dollar increased to over US85 cents. At the time it was believed that this represented a value that was “too high”, because export orientated businesses (such as the tourism sector) were beginning to suffer. As a result, the RBA intervened to stabilise the value of the dollar at that time. They did this by selling Australian dollars on the foreign exhange market. The increase in supply effectively stopped the dollar from appreciating any further.

Intervention in this way will also affect the other measures of external stability. When our dollar appreciates we are more able to meet our financial commitments overseas. As such, the ability of the Australian economy to repay net foreign debt improves. On the other hand, an appreciating Australian dollar may have detrimental affect on the current account deficit, as our exports will no longer be as internationally competitive. When assessing policy approach it is important to examine the changes relative to what actually happened in the Australian economy at that time.

Current Page: External Stability