In a floating exchange rate regime the price of the dollar, like any other market-determined price, depends on the relevant forces of supply and demand. But what are the relevant forces of supply and demand in the foreign exchange market?
To try to answer this question, let us consider, for illustration, the factors that determine the relationship between the Australian dollar and the Japanese yen. The Japanese require dollars to pay for their imports of goods and services from Australia and to fund any investment they may wish to undertake in this country. Assume that they obtain these dollars on the foreign exchange market by supplying (selling) yen in return. So the Japanese demand for dollars (mirrored by the supply of yen) is determined by the exports to Japan and our capital inflow from that country.
On the other side of the market, the Australian demand for yen is determined by our need to pay for imports from Japan, and for any capital investment that we undertake there. We buy those yen by supplying Australian dollars in return. Thus the supply of dollars (mirrored by the demand for yen) is determined by our imports from Japan and our capital outflow to that country.
In summary, then, the demand for Australian dollars reflects the behavior of our exports and capital inflow, while the supply of dollars reflects the behavior of our imports and capital outflow. In other words, transactions on the foreign exchange market echo the international trade and financial transactions that are summarized in the balance of payments. Within the balance of payments, the relationship between our exports and imports of goods and services is captured by the balance of current account, while the relationship between capital inflow and capital outflow is captured by the balance of capital account. The activities of international currency speculators affect the exchange rate directly through their impact on capital flows.
The distinguishing characteristic of a floating exchange rate system is that the price of a currency adjusts automatically to whatever level is required to equate the supply of and demand for that currency, thereby clearing the market. The logic of the relationship between our international transactions and the supply and demand for currencies implies that this market-clearing, or ‘equilibrium’, price also produces automatic equilibrium in the balance of payments. That is, the balance of current account (whether positive, negative, or zero) must be precisely offset by the balance (negative, positive, or zero) of the capital account. Under floating exchange rates these outcomes are achieved automatically without the need for government intervention. By contrast, under fixed exchange rates balance of payments equilibrium is not the normal condition.
These characteristics of the floating exchange rate mechanism have important implications both for the nature of our relationship with the global environment, and for the policy options available to the authorities in managing the economy. Let us now consider some of these.
International Transmission of Economic Stability
A flexible exchange rate acts as a kind of shock absorber that helps to insulate us against overseas disturbances. This is because the relationship between our international transactions and the foreign exchange market runs in both directions. Let us suppose, for example, that recession in the Japanese economy leads to a decline in the demand for Australian exports. In itself, this will tend to reduce economic activity in Australia. But this tendency will be offset by an associated depreciation of the dollar, which will induce an expansion of exports, a contraction of imports, and perhaps an increase in net capital inflow, all of which will help to cushion the Australian economy against recession. An analogous mechanism would operate to reduce the impact of an initial decline in Japanese investment in Australia. Both cases illustrate the role of exchange rate flexibility in insulating our economy to some degree against international economic instability. By the same reasoning, floating exchange rates also help to diminish the international transmission of our own domestic economic instability.