RDP 9010: Volatility of the Australian Dollar Exchange Rate 5. Volatility of the Australian Dollar Relative to Other Asset Prices

It is widely argued that, ceteris paribus, interest rates should be less volatile (and exchange rates more volatile) under a floating exchange rate regime than under a relatively fixed exchange rate regime. Under a fixed system, the impact of foreign exchange flows is reflected, in the first place, in changes in the central bank's holdings of official reserves. The counterpart is changes in domestic liquidity and short-term interest rates. Under a floating system, the shocks are absorbed through movements in the exchange rate, unless the central bank chooses to intervene in the currency market. A change to a more flexible exchange rate regime should, therefore, result in less volatility in interest rates and greater volatility in exchange rates. Graphs 1 and 2 illustrate this, showing the volatility of the Australian dollar and domestic short-term interest rates in the three years prior to floating the exchange rate and in the six years since.

Table 6 shows the volatility of the interest rate on 90-day bank bills and various measures of the Australian dollar exchange rate. Clearly, the increase in exchange rate volatility between the early 1980s and the post-float period has been accompanied by a reduction in interest rate volatility.

Following the approach taken by Frenkel and Mussa (1980), Table 6 also shows the volatility of the Australian dollar together with the volatilities of three other asset price indicators, namely, the All Ordinaries Share Price Index, the yield on 10-year government bonds, and the price of gold measured in SDRs. Focusing on the post-float period, the Table shows that, of the five asset prices, the Australian dollar was the least volatile in 1984, 1986 and 1987, while in 1989 its volatility was exceeded only by the volatility of the All Ordinaries Index. In the period 1984–1989, only the yield on long-term government securities has exhibited lower volatility than the Australian dollar, probably reflecting the infrequent adjustment of inflationary expectations and lower interest rate volatility more generally.