Write an assignment about Australian Exchange Rate Analysis


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Demand and supply models of exchange rate determination


Falling commodities prices have slammed the currencies of resource and agriculture-heavy economies, including Australia, where analysts are forecasting the dollar to weaken further, possibly to US65¢.

Major fund manager BlackRock is forecasting a continued slide to US70¢ by the end of the year.Capital Economics went further, anticipating an even faster fall to US65¢ by the end of 2016.

On Friday the Australian dollar was trading at US74¢, down 1.51 per cent in the past week.

The currencies of commodity-heavy economies such as Australia are the worst-performing this year as falling commodity prices pressuring similar countries New Zealand and Canada to cut interest rates as markets ready for them to continue to drop.


While Australia grapples with lower key commodity value such as iron ore, deteriorating commodity prices forced the Bank of Canada to lower its benchmark to 0.5 per cent in a bid to stimulate the economy on Thursday night.


New Zealand is also expected to cut rates again, from 3.25 per cent to 3 per cent as dairy prices continue to decline.


“The dollars of Australia, New Zealand and Canada have been three of the worst-performing major currencies so far this year. Despite the fact that they have already fallen a long way, we expect them to weaken further,” Capital Economics John Higgins said.


Commonwealth Bank chief currency strategist Richard Grace said the declining commodity prices were creating huge and sustained impact on the dollar and economy.


“The dollar is very sensitive to commodity prices,” Mr Grace said. “Commodity prices and terms of trade are the clearest long-run indicators for the Australian dollar and economy.”


He added interest rates were likely to stay low or be cut again as the Reserve Bank of Australia (RBA) dealt with below-trend gross domestic product and softer domestic demand that is placing upwards pressure on unemployment.


If the dollar declines too far, Australia’s terms of trade could become so steep that businesses cut back on importing new technologies, influencing their international competitiveness, which flows through to employment concerns.


“Capital imports have been falling for a few years because mining investment has slowed so much,” Mr Grace said. “We’ve not seen a threshold with the dollar crossed yet, but it would be difficult for retailers to raise prices amid upward pressure on unemployment.”


Commodity prices are likely to continue to decline. Last week, the International Monetary Fund revised down its forecast for global growth, indicating the glut of commodities is likely to push prices down as demand slows.


“Financial markets are pricing in about an 80 per cent chance of an additional interest rate cut [in Australia] by February 2016,” Mr Grace said.


Capital Economics is anticipating an interest rate cut of 0.5 per cent to 1.5 per cent by the RBA before the March 2016.


While Australia, Canada and New Zealand are preparing to cut rates, the United States and United Kingdom are likely to raise rates later this year, which would cause a further decline in value for the Aussie.


The greenback reached a six-week high at the end of the week as the European Central Bank announced liquidity boosting measures for Greece.


From the article titled ‘Australian dollar’s next stop? US65¢ predicted as commodity prices decline’ (Australian Financial Review July 17, 2015), answer the following questions.

(a) Briefly summarise the main issues discussed in this article?


(b) Using Demand and Supply model of exchange rate determination briefly explain how AUD is determined in the forex market, and what factors influence its fluctuations.


(c) Using exchange rate data from Reserve Bank of Australia and graphs (monthly data of last three years) analyse the movement of AUD relative to that of the US dollar? Is it in line with the world commodity price movement during this period? Are there any other factors contributing to this behaviour of the Australian dollar?


(d) Do you think that the AUD will fall as low as US 65C by the end of 2016? Justify your answer. What advantages do you think Australia will have in such a scenario?


(e) If the market rate is US 65C then what action could the Reserve Bank of Australia take in order to maintain the exchange rate at US 70C, and what side effects might this action have on the Australian economy? Do you think that such actions would be effective?

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