The Australian dollar is now freely traded and is the fifth most traded currency in foreign exchange markets. A bilateral exchange rate refers to the value of one currency relative to another. It is the most commonly referenced type of exchange rate.
Most bilateral exchange rates are quoted against the US dollar USD , as it is the most traded currency globally. An appreciation of the Australian dollar is an increase in its value compared with a foreign currency.
This means that each Australian dollar buys you more foreign currency than before. Equivalently, if you are buying an item that is priced in foreign currency it will now cost you less in Australian dollars than before. If there is a depreciation of the Australian dollar, the opposite is true. A cross rate is an exchange rate that is calculated by reference to a third currency. While bilateral exchange rates are the most frequently quoted exchange rates, a trade-weighted index TWI provides a broader measure of trends in the value of a currency.
The weights are generally based on a nation's major trading partners and the share of trade that takes place usually total trade shares, but import or export shares can also be used.
Because the TWI captures movements in the Australian dollar against the currencies of major trading partners, it can be helpful for understanding more about Australia's overall trade competitiveness. This can be particularly useful when bilateral exchange rates are moving in different directions. The TWI generally fluctuates less than bilateral exchange rates because it is measured against a basket of currencies and large movements will often partly offset each other Graph 1.
Real variables take account of the effects of price changes whereas nominal variables do not. The real effective exchange rate is a nominal effective exchange rate such as the TWI described above multiplied by the ratio of Australian prices to prices of our trading partners. Since trade competitiveness is ultimately determined by changes in the price of Australian goods and services relative to foreign goods and services, the real TWI can be a better measure of trade competitiveness than the nominal TWI.
It is often used in analytical work, whereas the other types of exchange rates are more visible in our daily lives. There are numerous exchange rate regimes under which a country may choose to operate. At one end, a currency can float freely and at the other end it is fixed to another currency using a hard peg.
There are two broad categories in this range — floating and pegged — although finer distinctions can also be used within these categories.
Under a floating exchange rate regime, the value of the currency is determined by the market forces of demand and supply for foreign exchange. This is a common type of regime among the world's major advanced economies because it can contribute to macroeconomic stability by cushioning economies from shocks and allowing monetary policy to be focused on targeting domestic economic conditions.
The exchange rate is controlled by intervening in the foreign exchange market buying and selling currency to minimise fluctuations and to keep the currency close to its target or within a narrow target band.
Usually the central bank from the economy maintaining the peg will also be forced to set interest rates at a similar level to those in the economy to which it is pegged to prevent investors shifting a large amount of funds between economies these are known as capital flows and pushing the exchange rate away from the peg.
The main advantage of a pegged exchange rate is certainty about the value of the exchange rate, which makes it simpler to trade with and invest in other economies. This can help to avoid excessive short-term volatility associated with changes in market sentiment or speculation, which can happen under a floating exchange rate.
The main disadvantage is that the exchange rate can no longer move freely to act as an automatic stabiliser and insulate the economy from large economic events. A pegged exchange rate can also encourage borrowing in foreign currency, but these debts can be difficult to repay if the exchange subsequently depreciates.
Australia has had several exchange rate regimes. Prior to the early s, Australia operated under the gold standard. The gold standard meant that currency was redeemable for gold at a fixed price. The gold standard was abandoned in the midst of the Great Depression. In , Australia pegged its currency to the British pound sterling Graph A1. This reflected the role of sterling as the primary currency used in international transactions and Australia's close economic ties with Britain.
From , the peg to sterling continued as part of a global system of pegged exchange rates, known as the Bretton Woods system. When the Bretton Woods system broke down in the early s, the major advanced economies floated their exchange rates.
The Australian dollar was made progressively more flexible from the mid s. This evolution was largely inevitable because Australian financial markets were becoming more sophisticated and integrated with global financial markets.
These developments made it increasingly difficult for the authorities to manage the large international capital flows associated with maintaining a fixed exchange rate and, consequently, the difficulty in controlling domestic monetary conditions Debelle and Plumb The crawling peg involved the Reserve Bank making regular adjustments to the level of the exchange rate informed by an assessment of economic conditions.
The Australian dollar was eventually floated in The decision had important effects on the Australian economy and how the Reserve Bank implemented monetary policy. It allowed the Reserve Bank to set monetary policy based on domestic economic conditions, which also made it possible to target inflation.
The Reserve Bank's approach to foreign exchange market intervention has evolved over the past 30 years as the Australian foreign exchange market has matured. Despite having a floating exchange rate, the Bank can still intervene in the foreign exchange market if it becomes disorderly or dysfunctional. Direct intervention refers to the Reserve Bank directly buying or selling foreign currency in the market.
This has become less frequent and more targeted over time Graph 2. But since financial markets have matured, direct intervention typically occurs when there is evidence of significant market disorder. For example, the Bank intervened during the global financial crisis to restore market liquidity and limit excessive price volatility. The effect of the Bank's presence in foreign exchange markets can itself have a significant impact on the exchange rate as it can reveal information on future policy intentions.
Some economies, particularly those with pegged exchange rates, may try to influence the exchange rate through changes to interest rates. This is referred to as indirect intervention. For example, an increase in the cash rate raises interest rates in Australia relative to those in the rest of the world. This increases returns on Australian assets relative to foreign assets , which can result in increased demand for Australian dollars as investors shift their funds into Australian assets.
As a result, an increase in the cash rate should be associated with an appreciation of the exchange rate. Currency moves can be volatile, and will be impacted by domestic and international economic and political events. The volatility of different countries will also vary significantly, depending on the economic and political circumstances of a country, and the nature of its currency regime. Even currencies that are pegged to another — and which therefore exhibit lower day-to-day volatility — can be at risk of large moves if the level at which the currency is pegged changes.
These risks will be amplified through the use of leveraged trades, where a small initial fee can result in substantial losses. Growth-oriented asset classes are likely to shine, but not equally. More from this Asset Allocation Outlook. Dan Ivascyn, Group CIO, highlights the attractive opportunities we are anticipating over the next three to five years across the global risk markets and where we are poised to deploy capital. While there is substantial uncertainty ahead, we believe the pickup in growth and supportive liquidity conditions favor emerging markets investments.
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The importance of foreign exchange markets has grown with increased global economic activity, trade, and investment, and with technology that makes real-time exchange of information and trading possible. A number of factors may influence foreign exchange rates, including the following cited by Rose :. Other money market instruments include bankers' acceptances, and securities repurchase agreements.
In addition, futures, options, and swaps markets usually involve money market instruments. Cook, Timothy Q. LaRoche, editors. Federal Reserve Bank of New York. Rose, Peter S. What makes Treasury bill rates rise and fall?
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