Question

Because of the strength of long-run Asian demand for its mineral exports, markets conclude that the Australian real exchange rate will have to be permanently higher. Australian monetary policy is already much tighter. Suppose Australia now discovers vast new mineral deposits that will take five years to begin to exploit. What further effect, if any, will this have on the evolution of Australia's exchange rate? Illustrate in a diagram.

Short answer

The discovery of new mineral deposits will likely lead to a short-term appreciation of the Australian dollar due to market anticipation of increased future exports.

Step-by-step solution

Understanding the Premise

Australia is experiencing strong long-run Asian demand for its mineral exports, leading markets to believe that the Australian real exchange rate must be permanently higher. Additionally, Australia's monetary policy is already tighter.

Identifying the Change

Australia discovers vast new mineral deposits, which will become economically significant in five years. This discovery is expected to influence expectations about future economic growth and exports.

Analyzing Immediate Effects

Even though the new mineral deposits will not be exploited for five years, the discovery immediately affects expectations about future increases in Australian mineral production. This can lead to anticipatory appreciation of the Australian dollar as the market adjusts to the expected future boost in exports.

Effect on Exchange Rate

Markets, expecting higher future exports, will likely drive up the Australian dollar in the short term, even before actual exports increase. This is based on expectations of increased future income and foreign currency inflow.

Using a Diagram

In diagrams of currency supply and demand, represent this anticipatory appreciation by shifting the demand curve for Australian dollars to the right, even before the five years is up. The anticipated future increases in exports cause market participants to demand more Australian dollars now.

Key concepts

Foreign Exchange Markets

Foreign exchange markets are where currencies are traded globally. These markets operate 24/7, facilitating international trade and investment. When participants in these markets expect changes in a country's economic conditions, they adjust their trading strategies accordingly. In the case of Australia, if new mineral deposits are discovered, market participants may believe the economy will benefit in the future. As a result, the demand for Australian dollars might increase, causing the currency to appreciate even before the minerals are extracted. This is because traders are acting on their expectations of future economic growth.

The anticipation of future events like increased exports often leads to changes in currency values. Traders might buy a currency now if they predict it will be more valuable later. This is why news and speculation can have significant short-term impacts on exchange rates. Ultimately, foreign exchange markets balance supply and demand for different currencies based on these expectations.

Monetary Policy

Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates. It is a key tool for influencing economic activity. In Australia, tighter monetary policy means that the central bank might be raising interest rates to curb inflation or to stabilize the economy. Higher interest rates often attract foreign investment, since investors seek better returns.

A tight monetary policy can lead to an appreciation of the national currency, as it becomes more attractive to foreign investors looking for higher yields. Consequently, this can lead to a stronger exchange rate. In the context of the exercise, even before the vast new mineral deposits are mined, the already tight monetary policy in Australia may be making the Australian dollar more valued internationally. Hence, anticipations of future economic benefits, combined with a tight monetary stance, amplify currency appreciation pressures.

Mineral Exports

Mineral exports form a substantial part of Australia's economy, contributing significantly to gross domestic product (GDP) and trade balance. When the world anticipates an increase in Australia's mineral exports due to new discoveries, expectations about Australia's economic future can shift. As exporting these minerals brings in foreign currency, markets speculate how these future cash inflows will affect exchange rates.

The expected increase in exports may boost the Australian dollar's value as traders anticipate future demand for these minerals. Thus, even before these hidden mineral deposits are tapped, their discovery creates immediate financial ripples. Economic agents expect the increased availability of resources to lead to higher production levels, which could result in a higher real exchange rate for Australia, reinforcing the anticipatory appreciation seen in the exchange markets.

Economic Expectations

Economic expectations play a pivotal role in the dynamics of exchange rates. These are essentially predictions made by traders, businesses, and investors about the future economic conditions of a country. Such expectations are premised on new information, like Australia's recent mineral discovery, which can significantly shape currency market behavior.

When traders expect that the economy will strengthen due to future export growth, they are likely to adjust their portfolios to include more holdings of the Australian dollar. This can cause the currency to appreciate in the short term, even if the actual economic benefits are years away. The speculative nature of economic expectations thus has immediate effects, as it drives demand for the currency based on forecasts of increased income and foreign exchange inflows, highlighting the intrinsic link between expectations and monetary outcomes.