Falling Interest Rates and the Exchange Rate

Falling interest rates can have an unexpected impact on other economic variables. (Unexpected for non-economists, that is).

If the Reserve Bank undertook expansionary monetary, either by reducing the cash rate or by using open market operations to lower interest rates in Australia, then consumption and investment would both rise. (Remember, a significant proportion of household consumption is based on borrowing. If interest rates fall, the amount households can borrow will increase - ''more lending : more spending'' in a simple phrase.)

Business will also increase the level of its own investment as well. After all, businesses are also borrowers.

Increases in lending, and then spending, will stimulate demand. Production will rise for the goods and services used by both households and firms. This can lead to an increase in Aggregate Demand that can have an inflationary impact on our economy. We can show this effect in an AS-AD diagram : the price level rises from Pe to Pe1, as a result of the increase in Aggregate Demand from AD to AD1,

Gross Domestic Product will rise from Y_e to Y_e¹. As production rises, unemployment will fall, as firms take on additional labour to fulfil this increase in orders. Whether or not the increase in inflation does occur depends on where Australia is, in terms of the business cycle.

If the economy is already experiencing ''boom'' conditions, there may not be ''unutilised'' capacity that can be quickly drawn into production. Firms may not be able to keep production up to the level of demand. Firms will increase prices, taking advantage of this unsatisfied demand : demand pull inflation will occur.

If economic growth is already running strongly, there may be shortages of skilled labour or of vital raw materials.

Owners of this resources (the ''factors of production'') may take the opportunity to increase the prices they charge. This will increase the costs of production for firms. These firms will pay the higher prices for necessary inputs, but they will also increase their own prices. That is, firms will pass on the price rises to consumers. The Aggregate Supply curve will shift to the left, from AS to AS1, We can show this effect in an AS-AD diagram : the price level rises from Pe to Pe1.

The price level will increase, again. Australian consumers will substitute imported goods for locally made production (after all, the locally made goods are rising in price). This will cause a fall in sales by Australian firms, who will respond by decreasing production, and decreasing their demand for labour. Gross Domestic Product will fall.

Twenty per cent of Australia's total production is exported. If inflation starts to rise in Australia, then the cost of production of our exports will also rise. Sales of our exports will fall; our former buyers will simply buy from another supplier, whose prices haven't risen. Falling export sales means there will be a decrease in demand for the Australian dollar. Our exchange rate will depreciate.

As the level of imports rises, more Australian dollars will be supplied on our Forex market. The importer will be paid in Australian dollars; but he or she requires their own currency. More sales in Australia will mean more Australian dollars they can supply. These importers may find that demand for Australian dollars is less than the supply of Australian dollars on the foreign exchange market. To gain foreign currency, the importer will decrease the price they are asking to exchange Australian dollars into Yen or US dollars. (Investigate the diagram carefully. The importer wanted 67 cents U.S. for every Australian dollar they had. Now, they are willing to accept 66 cents U.S. for an an Australian dollar. The importer has lowered his or her price.

Demand for the Australian dollar will also fall, as foreign investment in this country falls. A large proportion of foreign investment in Australia is short term portfolio investment, often in short term debt. If interest rates in Australia fall, then these foreign investors will not be able to get the level of interest income they did before. They will sell their short term debt, and take their money overseas, where they will get higher interest rates than they can get here. To do this, they will supply Australian dollars on the foreign exchange market. To gain foreign currency, they, too, will decrease the amount of foreign currency they will trade for an Australian dollar.

Now, all this doesn't have to happen.

If our economy is experiencing a downturn in economic growth, shortages of skilled labour and raw materials may not occur when production rises. Increases in production may not lead to demand pull or cost push pressures. A reduction in interest rates may not lead to an inflationary problem. The prices of exports will not rise, so our economy may still grow (we will continue to export the same if not more goods and services).

However, the fall in interest rates may still cause an increase in spending on imports, and capital outflow. This could mean a a fall in the exchange rate, and increases in the prices of imports.

What would happen, though, if the Government was able to introduce microeconomic reform, through improvements in structural policy?

Structural policy has two components : incomes policy and industry policy.

Incomes policy is aimed at improving the productivity of the labour force. Productivity growth occurs when output per unit of labour increases. The Australian government is using enterprise bargaining as its major tool of incomes policy.

The Government wants the labour force to adopt new methods and to adopt new skills, methods and production techniques. The call is to worker smarter, not harder.

If the work force can increase its output per day by, say, 5%, then employers can afford to pay workers, say, 3% more in wages. The impact of higher wages is not inflationary, since the workers are producing more goods and services. Firms do not have to increase prices; they have more production to sell, and they do not have to pass on the extra wage cost. The wage rise can be absorbed by the greater increase in production.

If aggregate demand increases for goods and services (seen as the shift in the AD curve from AD to AD1) and at the same time the costs of production fall (seen as the shift of the AS curve from AS to AS1), then production will rise and average prices will fall.

The net impact of changes in both Aggregate Demand and in Aggregate Supply is to increase production and income and to lower prices. This will lead to an increase in exports, and possibly a decrease in imports (as Australian made substitutes may become cheaper than the imported alternative). Production and income (that is, GDP) will move from Ye to Ye2 and the price level (that is, inflation) will fall from Pe to Pe2 Unemployment will fall, and the exchange rate will not depreciate.

This is, of course, ''economists' heaven''!