Why is the Australian dollar weaker than the American dollar?

The Aussie dollar was floated below parity with the USD on the 12th of December, 1983. It traded at $0.9175 US that day. By 1985 it had fallen below 70 US cents, then it ranged from 60 to 80 US cents up till 2000 when it depreciated sharply, falling below 50 US cents by 2001. It then entered a long bull run, and eventually traded around parity through 2011 and 2012. It has, of course, depreciated sharply over the past few years.

I can only make an educated guess about why it fell to a persistently lower level soon after the float: Australia had significantly higher inflation than the US during the 1980s. Volcker’s disinflation had already run its course by the time the Aussie dollar floated, but Australia was still struggling with its inflationary demons. The Aussie dollar reached a trough of around 60 cents in 1986 just as CPI inflation peaked at over 9% p.a.

Why do I blame inflation rather than more commonly cited drivers of exchange rates? It is true that, being a commodity exporter, the terms of trade is an important driver of our exchange rate. When our commodities attract high prices, companies buy Australian dollars to build mines and supporting infrastructure. The demand from the resulting flow of capital drives up the Aussie dollar. This can explain much of the appreciation in the Australian dollar during the recent mining investment boom. But, there was no significant or persistent decline in the terms of trade during the mid-80s compared to the sort of swings we often see. Another driver of exchange rate movements is differentials in real interest rates between countries. All else equal, one country’s real rates rising faster than others’ tends to cause its currency to appreciate against theirs due to the carry trade. But, real interest rates were at about the same level in the two countries. So, that leaves me with inflation (if anyone has an alternative explanation, I’d be interested to hear it.)

I think this explanation is supported by the fact that the depreciation in the AUD/USD exchange rate was mirrored in the trade-weighted index (a theoretical exchange rate between the Aussie dollar and a basket of foreign currencies weighted by their share of our trade. See the chart below.) This suggests that the depreciation was driven by a problem in the Australian economy rather than something happening in the USA.

The recent (from 2013) depreciation can be blamed on a large decline in the terms of trade, the end of the mining investment boom and the US Federal Reserve raising rates (although its policy is still arguably looser than ours) while Australia’s policy rate is on hold.

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heherg

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