ECON204 Lecture Notes - Lecture 10: Exchange Rate, Capital Control, Free Trade

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17 May 2018
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Topic 10
Openness has three distinct dimensions:
Openness in goods markets. Free trade restrictions include tariffs and quotas.
Openness in financial markets. Capital controls place restrictions on the ownership of
foreign assets.
Openness in factor marketsthe ability of firms to choose where to locate production, and
workers to choose where to work. Immigration from low-wage countries is a hot political
issue in countries ranging from Germany through to Australia.
Australia
Huge spike caused by soaring wool prices
Exports and imports averaged 20% & 17% of GDP from 1900-50. After the commodity boom
of the 1950s, the ratios fell below 15% in 1960, but grew steadily to 21% & 20% in 2017.
In 2017, 56% of Australian exports of goods and services are mining & agricultural
commodities; 21% services. 79% of imports were manufactures. Thus Australia is sensitive to
world commodity prices
The behaviour of exports and imports in Australia is characterised by the following:
In the first half of the 20th century, exports usually exceeded imports and so Australia had
trade surpluses. This was why Australia had a high relative standard of living (which you saw
in Chapter 10).
The trade deficits in the 1980s
The current trade surplus to GDP reached 0.1% in 2017, thanks to the mining boom in the
last decade.
Exports and Imports
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The main factors behind differences in export ratios are geography and country size.
Countries can have export ratios larger than the value of their GDP because exports and imports may
include exports and imports of intermediate goods.
Consumption
Domestic consumers must decide not only how much to consume and save, but also whether to buy
domestic or foreign goods.
Central to the second decision is the price of domestic goods relative to foreign goods, or the real
exchange rate.
Nominal Exchange Rates
The definition of the nominal exchange rate we use is the price of the domestic currency in terms of
the foreign currency (eg US$/A$)
An appreciation of the domestic currency is an increase in the price of the domestic currency
in terms of the foreign currency, which corresponds to an increase in the exchange rate.
A depreciation of the domestic currency is a decrease in the price of the domestic currency
in terms of the foreign currency, or a decrease in the exchange rate.
When countries operate under fixed exchange rates, that is, maintain a constant exchange rate
between them, two other terms used are:
Revaluations, rather than appreciations (infrequent increases in the exchange rate)
Devaluations, rather than depreciations (infrequent decreases in the exchange rate)
Nominal Exchange rate between $AUD and $USD since 1969
It was constant at 1.12 until 1972 --- Australia had a fixed exchange rate in that period.
It appreciated sharply in 1974 to 1.49 due to the surge in energy and other commodity
prices.
It then depreciated from 1975 to 2001, with a few swings to its all-time low of .48.
There was a trend of increase from 2002 to 2012. It’s peak as 1.09 in 2011, and October
2017 is .78.
There are large fluctuations in the exchange rate.
Real Exchange Rates
The real exchange rate is the price of a outry’s goods in terms of aother outry’s goods.
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 
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Real exchange rates () are index numbers and give useful information only on relative change.
An increase in the relative price of domestic goods in terms of foreign goods is called a real
appreciation, which corresponds to an increase in the real exchange rate, .
A decrease in the relative price of domestic goods in terms of foreign goods is called a real
depreciation, which corresponds to a decrease in the real exchange rate, .
Remarks:
The nominal and the real exchange rates can move in opposite directions.
Year to year movements in the real exchange rate are typically small compared to the often
sharp movements in the nominal exchange rate.
Multilateral Exchange Rates
Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are
exchange rates between several countries.
For example, to measure the average price of Australian goods relative to the average price of goods
of Australian trading partners, we use the Australian share of import and export trade with each
country as the weight for that country, or the multilateral real Australian exchange rate.
Multilateral = trade-weighted = effective real exchange rate.
The nominal and real multilateral exchange rates are highly correlated.
The large depreciations in the mid-1980s and mid-1990s were followed by recoveries. These swings
are large enough to have significant effects on the trade deficit and economic activity.
Since 2002, there was significant appreciation until 2012 - assoiated ith Australia’s iig oo-
but has since depreciated to 2005 levels.
Foreign Exchange
The purchase and sale of foreign assets implies buying or selling foreign currencysometimes called
foreign exchange.
Openness in financial markets allows:
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Document Summary

Free trade restrictions include tariffs and quotas: openness in financial markets. Capital controls place restrictions on the ownership of foreign assets: openness in factor markets the ability of firms to choose where to locate production, and workers to choose where to work. Immigration from low-wage countries is a hot political issue in countries ranging from germany through to australia. Australia: huge spike caused by soaring wool prices, exports and imports averaged 20% & 17% of gdp from 1900-50. After the commodity boom of the 1950s, the ratios fell below 15% in 1960, but grew steadily to 21% & 20% in 2017. In 2017, 56% of australian exports of goods and services are mining & agricultural commodities; 21% services. Thus australia is sensitive to world commodity prices. The behaviour of exports and imports in australia is characterised by the following: In the first half of the 20th century, exports usually exceeded imports and so australia had trade surpluses.

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