The RBA gets its hands dirty

in , ,

Australia has a floating exchange rate. This means that the market forces of demand and supply determine the value of the $A. No-one can set an exact value for the $A.

But people still try to change the value of the $A.

The Reserve Bank of Australia (RBA), Australia’s central bank, intervenes in foreign exchange markets (the markets where foreign currencies are bought and sold).

Let’s take two scenarios. Let’s say the RBA thinks the $A is too high. The value of the $A is making exports too expensive (as buyers must purchase $A to buy Australian exports) and so they are less internationally competitive.

[International competitiveness is the ability of a nation to effectively sell its exports on world markets. If your exports are cheaper, it’s easier to sell them and so you are more internationally competitive.]

So, the RBA thinks the $A is too high. In this case, it will sell the $A and buy foreign currency instead. This will increase the supply of the $A and cause the currency to depreciate, hopefully to the level the RBA desires.

The second scenario is where the RBA thinks the $A is too low. In this case, the RBA will buy $A and sell foreign currency, which will increase demand for the $A and cause the currency to appreciate.

In this process, the RBA is intervening in the ‘clean float’. In economic terms, the RBA is ‘dirtying the float’. This represents direct intervention by the RBA to change the value of the $A.

Here’s a limitation. To dirty the float, the RBA needs large foreign currency reserves to push up the $A. This is because of the massive amount of $A traded each day. If the RBA’s reserves run dry, the central bank might struggle to support the value of the $A and the value of the local currency could fall rapidly.

Check out my video on this issue too.

AS A STUDENT, HOW CAN I USE THIS INFORMATION?

  • Be clear that Australia does not have a perfectly clean float

  • When you’re talking about exchange rates, make sure you mention that the RBA intervenes (when needed) to affect the value of the $A...and that this process is known as dirtying the float

  • Be ready to discuss the limitations of dirtying the float, namely the large amount of foreign currency reserves required to affect the value of the $A