Question

Aussie Dollar Hit by Interest Rate Talk The Australian dollar fell against the U.S. dollar to its lowest value in the past two weeks. The CPI inflation rate was reported to be generally as expected but not high enough to justify previous expectations for an aggressive interest rate rise by Australia's central bank next week. Source: Reuters, October 28,2009 a. What is Australia's exchange rate policy? Explain why expectations about the Australian interest rate lowered the value of the Australian dollar against the U.S. dollar. b. To avoid the fall in the value of the Australian dollar against the U.S. dollar, what action could the central bank of Australia have taken? Would such an action signal a change in Australia's exchange rate policy?

Short answer

a. Australia's exchange rate policy is a floating exchange rate. Lower interest rate expectations reduced demand for AUD. b. The central bank could have signaled higher interest rates. This wouldn't change the floating rate policy.

Step-by-step solution

Understand Australia's Exchange Rate Policy

Australia operates under a floating exchange rate policy. This means the value of the Australian dollar (AUD) is determined by the foreign exchange market through supply and demand relative to other currencies.

Analyze the Impact of Interest Rate Expectations

Expectations about interest rates influence currency values. Higher expected interest rates tend to attract foreign investment, increasing demand for that currency, which in turn increases its value. In this scenario, the inflation rate was 'as expected but not high enough' to justify an aggressive interest rate rise. Therefore, investors adjusted their expectations downward, reducing demand for AUD, leading to a fall in its value against USD.

Identify Central Bank Actions to Support the AUD

To avoid the fall in the value of the AUD, the central bank could have signaled a more aggressive interest rate rise than what was anticipated. This would have increased demand for AUD as investors seek higher returns, thus supporting its value.

Assess Implications on Exchange Rate Policy

Implementing a higher than expected interest rate rise does not necessarily signal a change in Australia's floating exchange rate policy. It would instead reflect monetary policy decisions aimed at controlling inflation and stabilizing the economy. The exchange rate would still be influenced by market forces and the central bank's actions would be viewed as part of these monetary policy tools.

Key concepts

Floating Exchange Rate

Australia operates under a floating exchange rate policy. This means that the value of the Australian dollar (AUD) fluctuates based on supply and demand relative to other currencies in the foreign exchange market.

In a floating exchange rate system, several factors can influence currency value:

• Trade balances
• Inflation rates
• Interest rates
• Political stability
• Economic performance

The supply and demand forces in the market are the primary drivers of the exchange rate in such a system, without direct intervention from the government or central bank.

It's important to note that even though the currency can fluctuate, central banks sometimes intervene indirectly through monetary policy, such as adjusting interest rates, to influence economic conditions.

Interest Rate Expectations

Interest rate expectations play a crucial role in determining the value of a currency. When investors expect a country to raise interest rates, it typically leads to an increase in that country's currency value.

Here's why:

• Higher interest rates attract foreign investors seeking higher returns on investments.
• Increased demand for the country's currency to invest in its bonds and other assets.
• As demand for the currency increases, its value rises relative to other currencies.

In the case of Australia, the CPI inflation rate was 'as expected' but not high enough to justify a significant interest rate increase by the central bank. Consequently, investors adjusted their projections for interest rates downward. This decreased demand for AUD, leading to a fall in its value against the USD.

Investors' perceptions about future interest rates are crucial because they drive the demand for a currency. When expectations are altered, it can swiftly impact the currency's value.

Foreign Investment Influence

Foreign investments significantly impact a nation's currency value. When a country offers attractive investment opportunities, it tends to draw foreign capital, causing an increase in demand for the local currency.

Here are key points to consider:

• Higher interest rates usually make a country more attractive to foreign investors.
• Capital inflows mean investors need to buy the local currency, which increases its demand and value.
• Conversely, if investment yields are perceived as unattractive, demand for the currency decreases.

In Australia's scenario, the expectation of a less aggressive interest rate rise meant the country seemed less appealing to investors. This led to a reduction in the demand for the Australian dollar, causing its value to fall against the U.S. dollar. Such investor behavior underscores the sensitivity of currencies to perceived investment returns.

Central Bank Intervention

To support the value of a currency, central banks may decide to intervene through various monetary policies. Even though Australia operates a floating exchange rate, the central bank can still influence its currency's value indirectly.

Possible actions include:

• Raising interest rates to attract foreign investment and increase currency value.
• Indicating future policy moves to shape market expectations and investor behavior.

In the given situation, the Australian central bank could have signaled or implemented a more substantial interest rate hike. This action would have likely increased demand for the AUD, stabilizing or even boosting its value against the USD.

It's worth noting that such an intervention doesn't necessarily mean abandoning a floating exchange rate policy. Instead, it reflects the central bank's efforts to manage the economy through monetary tools, with the exchange rate outcome being an indirect consequence.