This, in turn, will increase demand for non-tradable goods and services produced in Australia.
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In order to meet the increased demand for their products, Australian firms will have to hire more workers, which will increase employment and lower the unemployment rate in Australia. In principle, a depreciation of the exchange rate will increase inflation in two ways. First, the prices of imported goods and services will increase, contributing to inflation.
Second, the expansion of aggregate demand and increase in employment will cause an increase in wages and other costs that are inputs to production and may be passed on to prices more generally, which will also contribute to higher inflation. Should these factors contribute to excessive inflation, the Reserve Bank may need to tighten monetary policy in order to achieve its inflation target.
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In practice, there is typically a lag between an exchange rate movement and its effect on economic activity and inflation. In the discussion above we have assumed exchange rate changes are immediately reflected in the prices of imported goods and services. But firms selling imported items often price them in Australian dollars, so it is up to the firm selling the item to decide when to pass on the higher cost from the depreciation to those buying the product. Exchange rates are volatile, and firms may be reluctant to change their prices until they are sure that an exchange rate movement will not reverse.
Even after prices adjust, it may take time for households and firms to adjust their spending patterns. The extent and timing of the responses will also depend on how easy it is for households and firms to substitute between goods and services produced in Australia and goods and services produced overseas.
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Most estimates suggest that it takes between one and three years for exchange rate movements to have their maximum effect on economic activity and inflation. When considering the implications of exchange rate movements for economic activity what matters is the change in the volume, or quantity, of exports and imports. In determining the consequences of exchange rate movements for the balance of payments, however, it is the value — that is the prices as well as the quantity — of exports and imports that matters.
Once again, we use the example of a depreciation of an Australian dollar to describe these effects. The direct effect of an exchange rate depreciation is to increase the price of imports relative to exports, which will tend to decrease the value of net exports exports less imports and widen the current account deficit.
However, the indirect effects of an exchange rate depreciation increase the volume of exports and reduce the volume of imports. This will tend to increase net exports and diminish the current account deficit. These two effects differ in their timing. The direct effect of an exchange rate depreciation occurs immediately, while the indirect effects on export and import volumes typically occur with a lag. Because of this, in the short run, an exchange rate depreciation is likely to reduce the value of net exports.
But over time, as export and import volumes start to respond, an exchange rate depreciation is likely to increase the value of net exports. Exchange rate movements also affect the other major component of the current account — the net income deficit. An exchange rate depreciation will increase the cost to Australian residents of servicing foreign debt that is denominated in foreign currency.
This is because the amount of Australian dollars required to purchase the foreign currency needed to pay the interest owed on the debt has increased. This increases net income outflow and widens the current account deficit.
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On the other hand, an exchange rate depreciation will increase the income that Australian residents receive on their foreign asset holdings, as the returns on those assets are now larger in terms of Australian dollars. This reduces net income outflow and narrows the current account deficit.
Although Australia's foreign liabilities exceed its foreign assets, a large proportion of the foreign liabilities are denominated in Australian dollars so that a depreciation of the Australian dollar will actually tend to diminish Australia's net income deficit. This is because the interest owed on the foreign liabilities is not affected by the change in the exchange rate but the returns on the foreign assets are. An exchange rate depreciation has an additional effect on the balance of payments through valuation effects on Australia's net foreign liabilities.
Valuation effects occur because a depreciation of the Australian dollar increases the value in Australian dollars of assets and liabilities denominated in foreign currency. In this model, the U. Figure An expected exchange rate increase means that if investors had expected the pound to appreciate, they now expect it to appreciate even more.
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Likewise, if investors had expected the dollar to depreciate, they now expect it to depreciate more. Alternatively, if they had expected the pound to depreciate, they now expect it to depreciate less.
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Likewise, if they had expected the dollar to appreciate, they now expect it to appreciate less. This change might occur because new information is released. For example, the British Central Bank might release information that suggests an increased chance that the pound will rise in value in the future.
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The reason for the shift can be seen by looking at the simple rate of return formula:. This could be represented as a shift to the right on the diagram from A to B. Once at B with a new expected exchange rate, one could perform the exercise used to plot out the downward sloping RoR curve. The result would be a curve, like the original, but shifted entirely to the right.
Consider the economic change listed along the top row of the following table. In the empty boxes, indicate the effect of the change, sequentially, on the variables listed in the first column.