Determining exchange rates

There are a number of methods that can be used to determine an exchange rate:

a. A flexible or floating exchange rate is where the market forces of supply and demand
determine the exchange rate.
b. A fixed exchange rate is where the government determines the exchange rate for a period of
time based on the value of another country’s currency such as the US dollar.
c. A managed exchange rate is where the government intervenes in the market to influence the
exchange rate or set the rate for short periods such as a day or week.

a. Flexible (or floating) exchange rates

Under a flexible or floating exchange rate the value of a country’s currency changes frequently,
even by the minute. The market rate will depend on the demand for, and supply of, t hat currency
in the forex markets. When there is no intervention in the free market operations by a
government agency a “clean float” is said to exist.

Figure 1

The determination of the exchange rate under a floating exchange rate is shown in figure 1.

The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who
hold US dollars) are willing to purchase at each possible exchange rate.

The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those
people who hold Australian dollars) at each exchange rate.

At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and
demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 =
$US0.60, an excess supply of Australian dollars exists and market forces will force the exchange
rate down towards equilibrium.

If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation
exits and market forces will put upward pressure on the value of the Australian dollar.
 Remember that there are many different exchange rates. The following examples
illustrate how an appreciation (increase in value) or depreciation (decrease in
value) of the Australian dollar against the US dollar has been created by changes in
demand and supply conditions.

i. A currency appreciation

Figure 2

a. In Figure 2a there has been an increase in demand (DD to D1D1) for Australian
dollars. This has led to an increase (appreciation) in value of the Australian dollar
from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also
increased from 0Q to 0Q1.

The shift in the demand curve could have been caused by an increase in the
demand for Australian exports, such as coal, aluminum, beef or lamb

b. In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian
dollars. This has led to an increase in the value (appreciation) of the Australian
dollar from $US0.50 to $US0.60. However the quantity of Australian dollars traded
has decreased from 0Q to 0Q1.

This decrease in the supply of Australian dollars may have been caused by a
recession, slowing the demand for imports.
 ii. A currency depreciation

Figure 3

a. In Figure 3a there has been a decrease in demand (DD to D1D1) for Australian
dollars. This has led to a depreciation in the value of the Australian dollar from
$US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased
from 0Q to 0Q1.

The decrease in the price of Australian dollars in terms of US dollars could have
been generated by a slow down in global economic activity, so decreasing the
demand for Australian exports, or because of foreign investors lacking confidence
in the Australian economy and investing elsewhere.

b. Figure 3b indicates an increase in supply of Australian dollars with the supply curve
moving from SS to S1S1. Again the value of the Australian dollar has decreased
from $US0.50 to $US0.40 while the quantity of Australian dollars traded has
increased from 0Q to 0Q1.

The depreciation may have resulted from strong domestic economic growth
increasing the demand for imports, or from higher overseas interest rates, causing
a capital outflow from Australia.

b. Fixed exchange rates

The World Bank and the IMF were both established in 1944 at a conference of world leaders in
Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woods institutions" as they
are sometimes called, was to place the global economy on a sound footing after World War II. To
help reduce the economic instability that existed the conference favoured the use of a fixed
exchange rate system.

Under a fixed exchange rate system the value of a country’s currency is fixed by the
government or one of its agencies, for example the Reserve Bank of Australia (RBA) to another
currency for a specific time period.

This method of determining exchange rates was to dominate until the 1970s.

In Australia the dollar was fixed (pegged) from 1946 to December 1971 to the British pound and
then to the US dollar until September 1974.
From September 1974 to November 1976 the Federal Government, in an attempt to reduce the
impact of exchange rate fluctuations on the economy pegged the Australian dollar to the trade
weighted index (TWI).

Using this system the value of the Australian dollar was allowed to adjust against each currency in
the TWI. However in reality the value of the Australian dollar remained fixed for long periods of
time.

Figure 4

In Figure 4 the official exchange rate has been fixed at a level of $A1.00 = $US0.60, which is
above the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed at a level higher
than the market rate requires official intervention by the Reserve Bank of Australia.

At this level the RBA would have to buy the excess supply of Australian dollars equivalent to Q1Q2
at a price of $US0.60. To buy the surplus of Australian dollars the government would need to sell
its reserves of foreign currency.

A fixed exchange rate system does not imply that the rate will stay at that same level all the time.
The government may decide to change the rate because of adverse effects on the economy. For
example, if the currency is overvalued exporting industries will become less internationally
competitive, affecting international trade and the balance of payments and the government might
take action to devalue the exchange rate.

A devaluation of a currency occurs under a fixed exchange rate system when there
isdeliberate action taken by a government to decrease its value in the forex market.

OR

Alternatively a revaluation occurs under a fixed exchange rate system when there
isdeliberate action taken by the government to increase the value of the currency in the
forex market.
c. Managed exchange rates

A managed exchange rate occurs when there is official intervention by a government or an agency
such as the RBA to determination the value of a country’s exchange rate. Through such official
interventions it is possible to manage both fixed and floating exchange rates.

The Australia dollar was pegged to TWI from September 1974 to November 1976. Then in
November 1976, the government adopted a “managed flexible peg” or a “crawling peg
system”. Under this new method of determining exchange rates, the value of the Australian dollar
was changed relative to the TWI, not just relative to a single individual currency

The exchange rate was announced each morning by the RBA and remained at that rate until the
next morning. This system continued until the Australian dollar was floated in December 1983.

Under the floating exchange rate system the value of the Australian dollar is not specifically
targeted by the RBA. To intervene in the market and alter the exchange rate significantly in the
long run is beyond the financial ability of the RBA. This is because Australia’s le vel of foreign
reserves (gold and foreign currencies) are relatively small (A$34 billion) compared to volumes of
currency trade in the market each day.

However the RBA may decide to enter the foreign exchange market as either a buyer or seller to
stabilise any short-term fluctuation in the value of the Australian dollar. To limit a fall in the value
of the Australian dollar (depreciation) the RBA will buy Australian dollars, and to prevent a rise in
the value of the Australian dollar, the RBA will sell Aust ralian dollars in the market.

Such intervention by the RBA is known as a “dirty float”, or more correctly a “managed float”.