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.

Trans Pacific Partnership deal signed - what does it mean?

The Trans Pacific Partnership (TPP) was signed in New Zealand on Thursday. It creates a free trade area that accounts for 40% of world trade and 800 million people.

Economists know that when trade barriers are reduced there will be more specialisation, more trade and higher real income. On the whole people will become better off. So why are there so many protests against the PTT?

The problem with removing protection from domestic industries (by removing tariffs in the case of the PTT) is that expensive domestic production is replaced by cheaper overseas production (known as trade creation). This is good for consumers, but bad for workers who earn their living in the previously protected sectors. While overall society is better off the pain of the deal is concentrated on a few.

There will be some losers outside of the TPP. Those who now find themselves uncompetitive because they continue to pay tariffs on their exports to TPP members. This 'trade diversion' is, according to studies, quite small.

The TPP is a significant change to world trade. The BBC page below links to a number of others that explore the new Free Trade Area, which includes Australia. The winners and losers are explained and the details of the deal are explored.

The BBC front page is here

This story is relevant to both IB and VCE Economics. 

VCE students should look at this and be able to explain the pros and cons of the deal and be able to explain how it will affect the standard of living in Australia.

IB students should be able to apply the theory of trade to the TPP. There are numerous opportunities to find good IA source material.

Australian dollar strength - just a short term improvement?

Exchange rates movements are very difficult to predict. The reason is that there are many short term influences that cause volatility and long term influences that determine a  'fundamental value' for a currency.

This week the Australian dollar has strengthened against the US dollar (US$). A relief for the many Australian travellers abroad? Maybe not. All currencies have got stronger against the US$ so Australians will only see a real difference if visiting the US itself.

In the short run the demand and supply of currencies is influenced by a number of factors, which can change quickly, such as commodity prices and interest rates. Once the market takes the view that a currency's value will change the speculative forces that are brought to bear make that change inevitable - at least for a while.

In the long run the theory of 'purchasing power parity' suggests that a currency's exchange value should reflect how many real goods and services will actually buy and the rate moves to equate that purchasing power. So the long run trend is set and the short run variations move around that.

If the theory of purchasing power parity applies to Australia then with the end of the mining boom Australia's dollar should have depreciated against other currencies since 2012. This is because Australians will be worse off as a nation.

The article from The Age looks at some of the recent influences on the Australian dollar. An excellent case study in demand and supply factors affecting exchange rates.

The Age article is here

This article has particular relevance to IB students  for exchange rates and is a possible IA article  For VCE students the article also provides essential reading on the influence of the exchange rates of economic goals and the standard of living.

A monthly routine - statistics and decisions

The state of the Australian economy is something VCE Economics students have to understand. For those starting Unit 3 and 4 this year then you have to know the data for the last three years and follow developments this year.

This is because not only can the questions in the exam include that data, but the exam will require students to use statistics in their answers. So it is your responsibility to keep track of them.

Why not just learn the statistics prior to the exam? That may work, but if you are following developments closely then you will gain a deeper understanding of what they mean and the significance of changes. This will help improve your answers and help you move up the rankings. Remember it is the top 10% who get 40+.

Another group of people who follow the statistics closely are the Reserve Bank of Australia (RBA). They have responsibility for keeping inflation between 2 and 3% and they adjust interest rates in order to do this.

Changes in interest rates (monetary policy) take 18 months to two years to affect the inflation rate. Therefore the RBA must look carefully at trends in the data, such as unemployment, the exchange rate, wage costs and domestic and foreign demand in order to predict future inflation and so policy changes. This makes them an excellent source of information on the data and they provide a commentary on the state of the Australian economy.

Each time the RBA make a decision on interest rates (once a month) they issue a statement. Make a habit of reading this and understanding what they are saying. The article from The Age below guides you though the latest one by putting it into plain English.

The RBA also provide a useful 'Chart Pack' undated around once every three months which provides excellent information.

The Age report is here

The RBA 'Chart Pack' can be found here

The Standard of Living

VCE Economics really has one aim. To explain what influences the Standard of Living of Australians. All that you learn can be related to this.

Unfortunately it is not at all clear what 'standard of living' means and you will profit from gaining a good understanding of this early.

There are two ways of looking at the standard of living:

Material standards of living - judged by how many goods and services the population can consume

Non-material standard of living - which relates to the wider quality of life. For example living in the UK means coping with the awful weather month in month out, while the pleasures of Melbourne's climate, whatever you may think of it, means you have a better quality of life. Leisure time and the quality of activities, levels of pollution, stress levels and so on all contribute to non-material living standards.

But how can we measure Standard of Living? As non-material living standards are important GDP alone is not enough. Indeed GDP has many shortcomings and at the very least needs to be converted to Real disposable GDP per capita.

There have been several attempts to measure the standard of living, the Human Development Index is the best known, but Australia has made its own attempt with the Genuine Progress Indicator.

Stiglitz on the problems with GDP here

The Standard of Living vs Quality of Life here

OECD Better  Life Index here

Email me at mark.russell43@hotmail.com for some notes in word format