RDP 2014-11: Exchange Rate Movements and the Australian Economy 6. Conclusion

In this paper, we have analysed the aggregate and sectoral impact of exchange rate shocks in Australia. While the broad direction of the aggregate responses to exchange rate movements are predictable from economic theory, our results quantify these responses. Our results confirm that the mining, manufacturing, personal services and other business services industries are particularly sensitive to exchange rate movements, while social services output is somewhat less affected. Although exchange rate shocks can have a large effect on economic activity, these shocks explain only a small proportion of the volatility of Australian macroeconomic variables. Instead, most exchange rate movements, at least over the medium- and long-run, are a response to more fundamental economic changes, and the resulting movements in the real exchange rate are a stabilising influence on the economy.

We then use our model to examine how the Australian economy might have evolved under alternative exchange rate scenarios and alternative scenarios for international influences on recent exchange rate movements. These results reinforce the need to determine the source of real exchange rate movements, as well as their size and magnitude, in order to gauge the effect of the exchange rate on the economy. Our results suggest that, even if the nominal exchange rate had remained constant over the past decade, the real exchange rate would still have appreciated. However, this appreciation would have been accompanied by substantially higher inflation without a noticeable increase in the pace of economic growth. In contrast, if the terms of trade boom had not occurred, the real exchange rate would not have appreciated. But, despite a weaker exchange rate, the Australian economy would not have grown more rapidly.