Thursday, February 16, 2006

Flexible exchange rates & the Australian model

The RBA Governor recently described a meeting with the Chilean Minister of Finance who, he recalled, stated Chile was pursuing an 'Australian model' of macroeconomic policy. This model consisted of four ingredients:

  • A floating exchange rate with a currency viewed as a commodity currency. (The other commodity currencies are those of Canada and New Zealand).
  • A monetary policy regime with central bank independence and inflation targetting.
  • A disciplined fiscal policy which aimed at balance or surplus medium term.
  • An internationalised currency which allowed Australians to borrow abroad in foreign currency and hedge back in Australian dollars.

The last feature is important because foreign currency exposure can create vulnerability if the Aussie dollar falters. Without it there is 'fear of floating'.

My interest centred on the emphasis the RBA and others place on effective exchange rate flexibility. The issue has risen in the last few days as the Treasury starts to think about what will happen when the current commodity boom ends, as they are convinced it will. The answer, according to David Gruen, is that a buffer of flexibility in Australia's terms of trade should give confidence that the economy can manage a fall in commodity prices without great drama .

Essentially their argument is that such a dip will devalue ther currency leading to a consequent increase in manufactured exports. The economy has successfully 'sailed through' the middle of a deflating housing bubble and mining boom with an appreciating currency and will survive a dip in commodity prices through a depreciation. In addition, Treasury claim, mergers and aquisitions among the world's big miners create potential to restrict resource supply when prices are put under pressure, thereby limiting their fall.

The general claim is that flexible exchange rates insulate Australia from external price shocks. It happened after the July 1997 Asian crisis and will happen again when the commodity cycle turns against us in the next few years. This leads to the optimistic view that Australia's expansion over the last 15 years need not come to an abrupt end when commodity prices weaken.

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