RDP 8908: Capital Flows and Exchange Rate Determination I. Introduction

The aim of this paper is to look at the effects of increased capital mobility on exchange rate determination. In particular, it attempts to address the question of whether exchange rates have become so responsive to financial market influences that they do not respond over the short and medium term to the needs of external balance of payments adjustment.

This subject has been discussed often over the last decade or so, but has attracted renewed interest lately. In large part, this is because of experience over the last 18 months where the exchange rates of the major surplus countries – Germany and Japan – have tended to fall, while that of the major deficit country – the United States – has risen. The discussion below attempts to review the Australian experience within this framework. Most of the paper concentrates on the period since the Australian dollar was floated in December 1983. It attempts to analyse the extent to which movements in the exchange rate can be explained by broad economic factors, such as relative inflation rates, the current account deficit and the terms of trade, and the extent to which they are due to financial variables, such as relative interest rates. Before doing this, however, it is necessary to fill in some of the institutional background.