The link between exchange rates and monetary policy

The exchange rate of the Australian dollar (A$) has risen four cents against the US dollar (US$) in a few days. This was much against expectations and against the performance of other currencies against the US$.

This has significant implications for the Australian economy. The end of the mining investment boom and the fall in commodity prices have hit Australia hard. Fortunately the exchange rate has acted as a shock absorber and reduced the impact of these momentous changes in just a few years.

Following the end of the mining boom the Australian dollar weakened. This meant that the prices of Australian non-mining goods fell for the rest of the world and non-mining exports received a boost. This sector had suffered during the period of the high A$:US$ exchange rate and is now filling the gap left by commodity exports.

Commodities are traded in US$. So as the price of commodities fell, which they did significantly, at least the US$'s earned bought more A$ than they did before. This partly offset the price fall.

This has allowed the Australian economy to adjust rather more easily than would have been the case with a fixed exchange rate. (This shock absorber effect due to asymmetric shocks is well documented.)

The recent rise of the A$ puts the recovery at risk. The Reserve Bank of Australia (RBA) is now under pressure to cut interest rates even further (presently at a record low of 2%) and reduce the demand for the A$. Such action might return the A$ to the US70c mark where price competitiveness can be maintained.

SBS cover the story here

This story is relevant to VCE and IB students equally. VCE students need to understand the movement of the exchange rate and the influence it can have on achieving economic goals and policy. For IB exchange rates are an integral part of their study of the international economy and the link between exchange rates and monetary policy is an example of the constraints on policy making and the limits of monetary policy in particular.