Factors Affecting the Exchange Rate of Aud/Usa

Analysis about factors affecting Australian Dollar US Dollar exchange rate (2006- Q1 2010) Project Report Final Project in Banking and Finance (FP 238) Raffles College of Higher Education I. Introduction 2. 1. Background Most of the country in the world will have export and import and they will use money to pay for it. Each country will have their different unit of money, which is called as currency. Currency is a medium that is used in the world to be the media as payments. Each country have their own currency, some small country are using the same currency as their surroundings e. . USA – US Dollar (USD); Germany, Spain, Greece, etc. – Euro (EUR); UK – Poundsterling (GBP); Singapore – Singapore Dollar (SGD); Australia – Australia Dollar (AUD). Therefore one currency will be related to the other currency in the other country, in other word, if country A is facing recession, all country that is located near country A will be facing the same problem and not only the surrounding, but for those country who have import and export agreement with country A will be affected as well.

Therefore there is always a fluctuation in the exchange rate. This fluctuation will fluctuate every time, even in a second, it might have fluctuates. Fluctuation in the exchange rate is divided into upward market trend (bull market) which indicate that a currency of a country is getting stronger compare to the other countries’ and downward market trend (bear market) which indicate that a currency of a country is getting weaker compare to the other countries’. “The exchange rate fluctuates. Sometimes it rises and sometimes it falls.

A rise in the exchange rate is called an appreciation of the dollar, and a fall in the exchange rate is called a depreciation of the dollar. ” (Parkin, 2010). 2. 2. Statement/ Problem to investigate There are many types of investment, one of it, is Foreign Exchange (Forex). This Foreign Exchange investment is done by exchanging one currency to other currency and sells it back, this investment is categorized as profitable investments, which means you can gain profit from it, but in reality it turns out the other way, many investors are making huge losses.

Most of the investors only look at the trend from a graph then they will do the investment, this is why many investors making huge losses, they should not only look at the trend from a graph, but they must aware that there are other factors that is affecting the exchange rate such as the interest rate, inflation, GDP, monetary and fiscal policy, etc. and the exchange rates of a country will change because of these several factors. In this report the several factors will be discuss using the Australia and USA contexts. 2. 3. Objective

By knowing the problem that investors are not aware about the factors, therefore the objective of this report is to analyze the factors that are affecting the Australia Dollar US Dollar exchange rate and from reading this report, it hopes that it can create and awareness for those investors who are going to invest (buy, sell) in Australia Dollar and US Dollar in Foreign Exchange. II. Theory of Foreign Exchange 3. 4. Hard Currency and Soft Currency In investing in Foreign Exchange Rate/ Currency, the terms for “buy” and “sell” is well known.

The investors will put their position into a “buy” position if the investors expect that the price of that currency will increase (going up) and they will put their position as “sell” position if they expect that the price will decrease (going down). In buy and sell the currency, the investors will buy and sell the currency that they want to invest their money in. The currency in the world is divided into two types, first one is called “Hard Currency” and the second one is called “Soft Currency”.

Hard Currency is a currency that is often use as the media of payment in international transaction, because this currency is quite stable. This Hard Currency usually come from developed country such as USA – US Dollar (USD), Japan – Yen (JPY), UK – Poundsterling (GBP), etc. “Hard Currency is Stable, convertible currency (such as the Euro, US dollar, or Yen) or that enjoys the confidence of investors and traders alike. Hard currencies serve as means of payment settlements because they do not suffer from sharp exchange rate fluctuations. (Business Dictionary, 2010). Soft Currency is a currency that is “weak” and not stable therefore this currency is rarely use as the media as payment in the international transaction. This currency usually comes from developing country such as Indonesia – Rupiah (IDR), etc. “Soft Currency is a Currency belonging to a small, weak, or wildly fluctuating economy and which, therefore, is not in favor with foreign exchange dealers. ” (BusinessDictionary, 2010). 3. 5. Types of Exchange Rate Systems in the world

There are 3 types of exchanging rate systems that is used in different part of the world which is Fixed Exchange Rate System, Floating Exchange Rate system which is including Freely Floating and Manage Float and Pegged Exchange Rate System. 1. Fixed Exchange Rate System. This exchange rate system was used in the Bretton Woods era, which is an article of agreement that was signed by 29 countries and inside the agreement there is a statement that said foreign exchange rate between countries in the IMF must be fixed.

In this type of exchange rate, they will have fixed exchange rate, so they will not bother about the market equilibrium. The demand and supply are important because it will decide the equilibrium, but in this type of exchange rate system, the changes in the demand and supply will no longer affect the exchange rate. The reason for having fixed exchange rate is to create a stable exchange rate that will help to facilitate trade and investment flows between countries. This exchange rate system is not used by any country in the world. . In the Floating Exchange Rate systems, there are 2 types which is Freely Floating Exchange Rate System and Managed/ Controlled Exchange Rate System. Freely Flexible (Freely Floating) Exchange Rate System. In this exchange rate system, the currency is left freely floating and the rate is determined by the demand and supply in the market. “Value is determined by the supply and demand of the currency and there are no set standards regarding intervention that need to be observed” (ForexRealm, 2010).

In a simple word, if there is higher demand for a currency, it can make the currency to appreciate, lower demand for a currency, it can make the currency to depreciate. On the other hand, the increase in supply of a currency can make the currency to depreciate, and decrease in the supply of a currency can make the currency to appreciate. “Since 1971, economies have been moving towards flexible exchange rate systems although only relatively few currencies are classifiable as truly floating exchange rates. ” (Weerapana, 2003- 2004).

The example of country that is using freely flexible exchange rate system is USA, Canada, Australia, Britain, and the European Monetary Union. Managed/ Controlled Exchange Rate System. A managed exchange rate system is a mixture between fixed exchange rate system and freely flexible exchange rate system. This system is unlike the fixed exchange rate system where it doesn’t allow the market to freely determine the value of the currency based on the demand and supply of the market, and this system is unlike the freely flexible exchange rate where the central bank does not have full authority to control the exchange rate.

In this system the central bank becomes a key participant in the foreign exchange market. In this system the fluctuation of the exchange rate is left freely floating but in the range that is desired by the Central Bank. In this system, the Central Bank will interfere if the exchange rate is above or below the desired exchange rate range by buying and selling domestic (the country’s own currency) and foreign currency (other countries’ currency) in order to keep the exchange rate close or in the range of the desired range values.

There are many countries are using this system, one of it is Singapore, this country use this system so that the government can control the exchange rate because Singapore is a country that is based on their import, so they need to maintain their currency so that those countries that is exporting to Singapore do not find the Singapore currency (SGD) too expensive. 3. Pegged Exchange Rate System. Based on the name of the exchange rate system, this exchange rate system is determined by pegging the currency of one country to another country’s currency. This system is applied by some countries in Africa who peg their currency to France Currency (FRF) and other countries that peg their currencies to GBP USD and SDR. ” (Hamdy, 2007). “Many smaller economies have pegged their currency with that of countries with larger economies that they consider to be economic liaisons. Many of the Caribbean nations, like Jamaica, have chosen to peg their currencies to the U. S. dollar. ” (ForexRealm, 2010). III. Factors Analysis The factors of fluctuating exchange rate is because of the macro economy in the country and each country will have different macro economy in terms of the number of the factors, e. . the difference in the inflation rate, interest rate, etc. , therefore for the purpose of this report, all of the data and analysis will be using Australia and US since both of the country are using freely flexible (freely floating) exchange rate systems. As what has been mention above, Australia and USA are using freely floating system on their exchange rate, which means that the fluctuation is based on the demand and supply in the market. The cause of the fluctuation is not only based on the market’s demand and supply, but it can come from the country itself.

The factors that come from the country itself that can create the exchange rate to fluctuate as well are inflation, interest rate, and GDP of the countries. Not only that, but the respond of each government in each country on the time before and after crisis time will be different as well, because it depends on the effect of the crisis to the country whether the country is badly affected or just slightly affected. 4. 6. Inflation and Interest Rate 4. 7. 1. Inflation Rate One of the internal factors that can cause the exchange rate to fluctuate is inflation rate.

Inflation can be considered as the most important economic factors in the world, especially for those countries that is export oriented. Simple definition for inflation is the price of goods increase. “Inflation refers to a general rise in the level of prices throughout the economy. ” (Sloman, 2007). Although inflation is the general rise in the prices level throughout the economy, but with inflation it means that the economy of a country is growing. ” In the long run, the rate of inflation will be determined by two factors: the rate of money growth and the rate of economic growth. (Grauwe and Poland, 2005). There are 2 figures in the appendices list that shows the graph of inflation rate which is Figure 1: inflation rate in Australia and Figure 2: inflation rate in USA. In figure 3 in the appendices list, which is the combination of Figure 1 and Figure 2, we can see that on the inflation rate graph from September 2008 to December 2008, it was a very steep decrease for both Australia and USA, especially USA, this happened because in the middle of September 2008, to be exact is September 15th, 2008, Lehman Brothers Holdings Inc. eclare bankruptcy, the filed for Chapter 11 bankruptcy protection. “The largest bankruptcy in history was of the US investment bank Lehman Brothers Holdings Inc. , which listed $639 billion in assets as of its Chapter 11 filing in 2008. ” (Wikipedia, July 22nd, 2010). US’s inflation rate is badly affected by the bankruptcy of Lehman Brothers because the bankruptcy cause the financial crisis, recession, therefore there was deflation instead of inflation.

It goes the same thing for Australia, their inflation rate also decrease, because they also faced crisis, but since Lehman Brothers was in USA, not in Australia, therefore Australia is not badly affected, but since USA is the most largest economy in the world therefore if USA is facing problem, most of the countries in the world will be affected as well. From September 2009 to December 2009, the inflation rate was having very steep increasing, because of the Emergency Economic Stabilization. The Emergency Economic Stabilization Act of 2008 (Division A of Pub. L. 110-343, enacted October 3, 2008), commonly referred to as a bailout of the U. S. financial system, is a law enacted in response to the subprime mortgage crisis authorizing the United States Secretary of the Treasury to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, and make capital injections into banks. ” (Wikipedia, August 21st, 2010).

As what have been mentioned above, inflation can affect the exchange rate in Australia and USA and every country in the world, because inflation is the increase in the price of goods, it means it will affect the import and export of a country, where the import and export of a country need domestic currency and foreign currency in order to pay and receive for the goods to and from other countries. The effect of inflation rate on the fluctuation of the exchange rate of AUD and USA can be explained using the theory of Purchasing Power Parity. Purchasing power parity is the situation where the exchange rate between two currencies represents the difference between the price levels in the two countries. ” (Pearson Education, 2005). The explanation for this theory is based on the law of one price, where it states that price of a same product in two different countries will have the same value if the currency is converted into the same currency. “The Law of One Price says that identical goods should sell for the same price in two separate markets.

This assumes no transportation costs and no differential taxes applied in the two markets. ” (Maxi-Pedia, 2010). The theory of PPP is not realistic, because it does not take other factors such as inflation into consideration. Therefore there is PPP relative, which consider inflation as well. ef = | 1 + Ih| -1| | 1 + If| | (Hamdy, 2007). The formula above is the formula for Purchasing Power Parity relative, where the ef = Percentage change of foreign and home currency exchange Ih = Inflation Rate Home Country If = Inflation Rate Foreign Country Dusd| Ih > If –> ——–>| | Saud| | | | | Daud | Ih < If –> | ——–>| | | Susd | If the Inflation Rate Home Country is higher than the Inflation Rate Foreign Country, the demand for the foreign country, in this case, US will be the foreign country and Australia will be the home country, will increase and the supply of the home country will increase which will create the AUD depreciate against the USD. This happen because when the demand for USD increase, Australian will buy USD using AUD, therefore the supply of AUD will increase and AUD will depreciate.

On the other hand, if the Inflation Rate Home Country is lower than the Inflation Rate Foreign Country, the demand for AUD, as the home country, will increase and the supply of the USD, as the foreign country, will increase. This can happen because, when the inflation increase, people will tend to sell the currency, in this case, Australian will sell the USD that they have since the inflation in USA is higher than the inflation in Australia. Therefore they will sell USD and buy back AUD, which will cause the AUD appreciate against the USD.

After using data from 17 periods, and using Microsoft excel to calculate the correlation, the correlation between inflation rate and exchange rate is negative, which means that they have negative relationship, so when the inflation increase, the exchange rate will decrease, vice versa, when the inflation decrease, the exchange rate will increase. | 4. 7. 2. Interest Rate Why information about the interest rate in a country is an important factor for the foreign exchange traders? One of the main reasons is the fluctuation of the interest rate, both increase or decrease, of the two countries can affect both of the countries’ currency.

First of all, what is interest rate? “An Interest Rate is very well described as the price a borrower pays for the use of money he does not own, and has to return to the lender who receives for deferring his consumption, by lending to the borrower. ” (articlesbase, 2010). Which means that interest rate is the price that you, as the borrower, need to pay to the lender which is the principal amount plus the interest. There are 2 figures in the appendices list that shows the graph of interest rate which is Figure 4: interest rate in Australia and Figure 5: interest rate in USA.

In figure 6 in the appendices list, which is the combination of Figure 4 and Figure 5, we can see that starting from September 2008 until now, the interest rate for both Australia and USA are decreasing except for Australia, which start to increase again on September 2009 until now and this was because of the bankruptcy case of Lehman Brothers Holding Inc. The interest rate in Australia and USA was decreased in order to boost their economy so that they can come out from the financial recession. In the recession, companies become unproductive and businesses are not growing which can affect the economic growth of a country.

Not only that, even the bank also might face liquidity problem, liquidity problem can happen because in recession time, the depositors, which is the lender, will withdraw their money from bank, one of the reason is they afraid that the bank where they put their money in will go bankrupt because of the recession. It these thing happen, logically the bank will increase the interest rate so whoever wants to take loan need to pay higher interest. But if the government or the central bank let the bank to increase the interest rate, the country will collapse (bankrupt), because no growth at all.

Therefore it will be better for the government to push the interest rate lower the before the recession, this is done in order to make the companies to borrow money from the banks so that they can be more productive and at the end the economy of that country can grow as well. Then after the economy of a country is getting better then the interest rate can be bring up again. After using data from 17 periods, and using Microsoft excel to calculate the correlation, the correlation between interest rate and exchange rate is ositive, which means that they have positive relationship, so when the interest rate increase, the spot exchange rate will increase. Vice Versa, when the interest rate decreases, the spot exchange rate will decrease. This thing can happen because when the interest rate is increase, the traders that hold US dollars will starts to sell their US Dollar and start to buy Australian Dollar, supply for USD increase and demand for AUD increase, therefore the AUD will appreciate against the USD. 4. 7. Monetary and Fiscal Policy Every government in the world is using monetary policy in order to control the economy in their own country. Monetary policy is the process of managing a nation’s money supply to achieve specific goals—such as constraining inflation, achieving full employment or more well-being. ” (WordIQ, 2010). There are three tools in monetary policy that is been used by the government in the world in order to control the economy in the nation, which are Open Market Operations, Discount Rate, and Reserve Requirements. Open Market Operations is the tool that is use most often. This can be done by the central bank in each of the country, in Australia will be Reserve Bank of Australia, and in USA will be Federal Bank of America.

The RBA will always buys and sells the Australian government securities in the financial markets which in results can have influence to the economy. When the RBA sell government’s securities, public and banks will start to buy it which will cause the supply of money in the market decrease, they will buy it because government’ securities can be considered as low risk investment sometimes can be considered as zero risk, because the government will be able to pay back, unless the whole country will go bankrupt.

On the other hand, when RBA starts to buy back the government’s securities, RBA is providing more supply of money into the market, by buy back the government’s securities and pay money. By using this tools, if the RBA buy back the government’s securities, the supply of money in market will decrease, which will cause the Discount Rate is the special lending rate that the central bank gives to the banks when the banks want to borrow from them.

If the rate is higher, it will make borrowing become less attractive to banks, and if the rate is lower, bank will be attracted to borrow which will increase their reserves Reserve Requirements Pengaruh monetary policy terhadap xchange rate itu apa?? Fiscal Policy Tax – tax income naek, income turun, purchasing power turun, demand terhadap goods n services turun, deflation happens, therefore exchange rate appreciate Pengaruh pajak ke exchange rate itu apa?? 4. 8. GDP Gross Domestic Product is the total market values of goods and services produced by workers and capital within a nation’s borders during a given period (usually 1 year). ” ( Wordnetweb, 2010). In other word, GDP is the total values of good and services that are produced in a country during a given period. This is the reason why the total GDP for USA is much higher than the total GDP for Australia. “The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country’s economy.

It represents the total dollar value of all goods and services produced over a specific time period – you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year. ” (Investopedia a Forbes Digital Company). Since the gap of total GDP between Australian and USA is too wide (One is in billion units (USA) and the other one is in million units (Australia)), therefore we are going to discuss the total GDP in Australia.

From the Figure 8 in the appendices we can see that on December 2008, the total GDP in Australia was not growing, it even face degrowth, this can happen because of the financial crisis, the bankruptcy files of Lehmann Brothers. Since degrowth is not good, therefore the Australian government take initiative to decrease the interest rate for loans, therefore every firms are more willing to take a loan in order to finance their daily productivity.

And we can see the results of lowering the interest rates in Figure 8 in the appendices list as well, where the total GDP in Australia from March 2009 onwards starts to grow again until today. * The effect of GDP on Australia’s exchange rate IV. The Expected Results and Conclusion The expected results by doing this report is to create awareness for the investors so that they will look at the economy in the country that they want to do Foreign Exchange (trading currency). In this part, I will do future projection based on the report analysis whether the Australia Dollar will be stronger or weakened against US Dollar.

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