Leslie Massey
Australia has had a floating exchange rate since 1983. This means that the Australian dollar's value is determined by market forces of supply and demand for foreign exchange. Floating the Australian dollar was a significant economic reform that helped the country flourish as an open economy. It severed the link between the balance of payments and monetary policy, allowing the Reserve Bank of Australia (RBA) to set monetary policy independently to manage inflation and output. While the floating exchange rate has contributed to macroeconomic stability, it has also resulted in larger and more frequent fluctuations in the currency compared to fixed exchange rate regimes.
| Characteristics | Values |
|---|---|
| Year of floating the Australian dollar | 1983 |
| Previous exchange rate regime | Fixed exchange rate |
| Pegged to | British pound, then the US dollar, then a moving peg in relation to a basket of currencies |
| Current exchange rate regime | Floating exchange rate |
| Current status of the Australian dollar | Sixth most-traded currency in the foreign exchange market |
| Advantages of a floating exchange rate | Cushioning economies from shocks, allowing monetary policy to be focused on targeting domestic economic conditions, severing the link between the balance of payments and monetary policy, contributing to a decline in output volatility, controlling inflation, controlling monetary policy, controlling interest rates |
| Disadvantages of a floating exchange rate | Exchange rate volatility, difficulty for firms to manage |
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What You'll Learn
Floating exchange rate history
The history of floating exchange rates is tied to the collapse of the Bretton Woods system, which established a gold standard for currencies in 1944. Under this system, a currency's value was tied to a fixed amount of gold, with the US dollar serving as the reserve currency. However, in 1971, the US government decided to discontinue maintaining the dollar exchange rate, leading to the collapse of the Bretton Woods system by 1973. This event marked a significant shift towards floating exchange rates, as currencies were now allowed to float freely.
During the 1970s, the world economy experienced a series of shocks, including oil crises, high inflation, and recessions. These events created an unstable environment for financial regulators, and central banks struggled to stabilise their currencies. As a result, support grew for the idea of letting supply and demand in the world currency markets freely determine the value of a currency, which is known as a fully floating exchange rate.
In the 1980s, several countries transitioned to floating exchange rates. Notably, in 1983, Australia moved to a floating exchange rate under the newly elected Labor government, with Bob Hawke as Prime Minister and Paul Keating as Treasurer. This decision was made amidst economic turmoil, including a lingering recession and high unemployment. The Australian dollar was devalued by 10%, creating a significant inflow of currency. The floating exchange rate regime contributed to macroeconomic stability and allowed the Reserve Bank to implement independent monetary policies.
Since the adoption of floating exchange rates, there has been a debate between choosing a floating or fixed exchange rate. A floating exchange rate allows a country's monetary policy to focus on other goals, such as stabilising employment or prices. It also enables a country to dampen the effects of shocks and foreign business cycles. However, a fixed exchange rate offers greater stability and certainty, which may be preferable in certain situations.
While modelling historical movements in exchange rates can be challenging, efforts to model the Australian dollar exchange rate in the post-float era have been relatively successful in explaining medium-term movements. The floating exchange rate has resulted in higher exchange rate volatility but has likely contributed to a decline in output volatility. Overall, the transition to a floating exchange rate has had significant implications for Australia's economic policies and continues to be a crucial aspect of its monetary system.
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Pros and cons
Australia has had a floating exchange rate since 1983, when the Labor government devalued the Australian dollar by 10%. This decision was made in response to the economic turmoil of the 1970s and early 1980s, which saw high unemployment and a lingering recession in Australia.
Floating exchange rates are determined by market forces of supply and demand for foreign exchange. This means that when demand for a currency is high, its value increases, and vice versa. Floating exchange rates can result in larger and more frequent fluctuations compared to fixed or "pegged" rates, where a currency's value is tied to that of another.
Pros of a Floating Exchange Rate
A floating exchange rate gives a country's central bank maximum flexibility in implementing independent monetary policy. This means that changes in world prices no longer have a direct effect on domestic prices, breaking the mechanical link between them. A floating rate can also contribute to macroeconomic stability by cushioning economies from shocks.
Floating exchange rates are considered a sign of financial maturity by the International Monetary Fund. They can be particularly beneficial when a country's economy is strong and its fiscal policy is sound. In addition, a floating rate can help counterbalance the influence of external shocks and can play an important role in smoothing the impact of terms-of-trade shocks.
Cons of a Floating Exchange Rate
One of the main disadvantages of a floating exchange rate is the potential for greater volatility in the currency's value. This can make it difficult for a country's central bank to stabilise the currency and manage its value. Small countries, in particular, may struggle to depend on a floating currency as depreciation may not result in cheaper goods in world markets.
A floating exchange rate can also make financial transactions more unpredictable and difficult to manage. In addition, the government has less control over the value of the currency, which may increase the risk of adverse capital market events.
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Impact on the economy
Australia has had a floating exchange rate since 1983. This means that the value of the Australian dollar is determined by market forces of supply and demand for foreign exchange within world currency markets.
The floating exchange rate has had several impacts on the Australian economy. Firstly, it has provided a buffer against external shocks, particularly shifts in the terms of trade, allowing the economy to absorb them without generating large inflationary or deflationary pressures that tended to occur under previous fixed exchange rate regimes. This has contributed to a reduction in output volatility over the past two decades.
Secondly, the floating exchange rate has allowed the Reserve Bank to set monetary policies that are best suited to domestic conditions, rather than needing to meet a certain target level for the exchange rate. This has resulted in greater flexibility and independence in conducting monetary policy, which has been beneficial for the Australian economy.
Thirdly, the floating exchange rate has led to increased exchange rate volatility compared to the previous fixed exchange rate regimes. This volatility can affect economic activity, inflation, and the nation's balance of payments. For example, a depreciation of the Australian dollar can increase the international competitiveness of Australian exporters, as their goods and services become more affordable to foreign buyers. At the same time, imported goods and services become more expensive for Australian consumers and firms, contributing to inflationary pressures.
Additionally, the floating exchange rate has had implications for capital inflows and outflows. In the lead-up to the float, there were large capital inflows from speculators betting on an appreciation of the Australian dollar. The decision to float the exchange rate was made to address this speculative pressure.
Overall, the floating exchange rate regime has been widely accepted as beneficial for the Australian economy, providing greater flexibility, cushioning against external shocks, and enabling more effective monetary policy decisions. However, it has also introduced higher exchange rate volatility and complex dynamics affecting trade, inflation, and capital flows.
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The role of the Reserve Bank
Australia has had a floating exchange rate since 1983, when the Australian dollar was moved to a floating exchange rate by the newly elected Labor government. This meant that the value of the Australian dollar was now determined by the supply and demand of money within world currency markets, rather than being pegged to another currency.
The Reserve Bank of Australia (RBA) is the country's central bank and banknote-issuing authority. It has played a significant role in the transition to a floating exchange rate and continues to be a key player in the country's monetary policy and foreign exchange market.
Historically, the RBA had to deal with a fixed exchange rate regime, where the Australian economy 'imported' inflation from the country to which the exchange rate was pegged. This restricted the bank's ability to implement independent monetary policies. However, with the floating of the exchange rate, the RBA gained more flexibility and autonomy. It could now allow changes in world prices to influence domestic prices and set monetary policies that are best suited to domestic conditions.
One of the primary roles of the RBA is to control inflation levels within a target range of 2-3% by managing the unemployment rate. This is achieved through various tools, including the official cash rate. Additionally, the RBA provides services to the Australian government and other central banks and official institutions. It also holds assets such as gold and foreign exchange reserves, estimated to be worth A$101 billion.
The RBA's role in the foreign exchange market is crucial. While the floating exchange rate is generally determined by market forces, the RBA can intervene in rare occasions of market disorder or more frequently in managed floating regimes to limit exchange rate volatility. The RBA's actions in the foreign exchange market can influence the country's inflation rate and overall economic stability.
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Australia's currency today
Australia's official currency is the Australian dollar, which is also the legal tender in three independent sovereign Pacific Island states: Kiribati, Nauru, and Tuvalu. It is subdivided into 100 cents and is abbreviated as A$ or AU$ to distinguish it from other dollar-denominated currencies.
Australia has had a floating exchange rate since 1983, when the newly elected Labor government, led by Prime Minister Bob Hawke and Treasurer Paul Keating, moved the Australian dollar from a fixed exchange rate to a floating one. This decision was made in response to the economic turmoil of the 1970s and early 1980s, which included a global recession, increasing inflation, and high unemployment rates.
The floating exchange rate means that the value of the Australian dollar is determined by market forces of supply and demand for foreign exchange within world currency markets, rather than being pegged to another currency. This has resulted in greater flexibility and contributed to macroeconomic stability, allowing the country to better withstand economic shocks.
However, a floating exchange rate has also led to larger and more frequent fluctuations in the currency. The Australian dollar hit a record high in 2011 at $1.1080 against the US dollar but has since experienced declines, trading at around $0.63 to $0.68 as of 2024.
The Australian dollar is the sixth most-traded currency in foreign exchange markets as of 2024, and its popularity is attributed to factors such as high interest rates in Australia and the relative freedom of its foreign exchange market.
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Frequently asked questions
Yes, Australia has had a floating exchange rate since 1983.
Before 1983, Australia maintained a fixed exchange rate. The Australian pound was initially pegged to the British pound at a 1:1 ratio. From 1931, the Australian pound was devalued to a peg of 16 shillings sterling. From 1946 to 1971, Australia maintained a peg under the Bretton Woods system, which fixed the US dollar to gold. The Australian dollar was effectively pegged to sterling until 1967, when Australia effectively left the sterling area. From 1967 to 1971, the Australian dollar retained its peg to the US dollar. After the breakdown of the Bretton Woods system in 1971, Australia converted to a fluctuating rate against the US dollar.
A floating exchange rate gives the central bank more flexibility and control over monetary policy. It also contributes to macroeconomic stability by cushioning economies from shocks. Additionally, it allows a country to focus its monetary policy on targeting domestic economic conditions.
