Capital Flows and Exchange Rate Determination

This paper attempts to examine the effects of increased capital mobility on exchange rate determination in Australia. In particular, it examines the issue of whether increased capital mobility has made the exchange rate so responsive to short-term financial market considerations that it no longer responds to longer-term fundamentals. The findings of the paper are consistent with the stylised facts of the international experience of floating exchange rates. The paper concludes that short-term capital flows are very interest sensitive but that the extent of this sensitivity is difficult to show empirically. Over the longer term, it appears that inflation differentials explain part of the movement of the nominal exchange rate. However, there have also been large movements of the real exchange rate. These fluctuations have been associated with shifts in Australia’s terms of trade and commodity prices. The paper finds that commodity price shocks also explain some of the short-run volatility of the exchange rate. This long-run and short-run link between the exchange rate and commodity prices is one of the distinguishing features of the Australian dollar. Finally, it was difficult to find and quantify any systematic link between the current account and the exchange rate. The paper concludes with a discussion of some of the policy implications of highly mobile capital. It is noted that in a country with a floating exchange rate and perfectly mobile capital, there is scope for a conflict between internal and external balance, particularly if there is high inflation and current account deficits. The paper notes that monetary policy should primarily be directed towards lowering the rate of inflation rather than achieving a particular exchange rate objective for current account purposes. This is particularly true when the currency is subject to export price shocks since exchange rate movements help to buffer the impact of those shocks.