Australia has allowed market forces to determine the value of its currency, the Australian dollar (AUD), since its float in 1983. However, extreme volatility in global commodity markets has led to significant fluctuations in the AUD. Is it time the Reserve Bank of Australia shifted its primary focus from interest rates to managing the exchange rate directly in order to shield its domestic manufacturing sector from commodity-driven volatility?
Conventionally, Australian monetary policy has targeted inflation using the cash rate. This has left the exchange rate to adjust freely. If Australia were to actively manage its exchange rate, it could look to Singapore for guidance. The Monetary Authority of Singapore (MAS) does not use interest rates; instead, it targets the exchange rate of the Singapore dollar against a trade-weighted basket of currencies. This has successfully stabilised inflation and supported stable trade flows for a highly open economy.
However, managing an exchange rate is not without its costs. Achieving a target exchange rate in an economy with highly mobile global capital requires massive foreign exchange interventions, which can distort domestic money supply and require the accumulation of vast reserves. Critics also argue that abandoning a floating exchange rate removes a critical 'automatic stabiliser' that helps the Australian economy adjust to global shocks. While a managed currency could provide stability for exporters, it risks stripping the central bank of its ability to set interest rates appropriate for domestic economic conditions, such as the housing market.
Extract C (lines 3–5) asks: 'Is it time the Reserve Bank of Australia shifted its primary focus from interest rates to managing the exchange rate directly in order to shield its domestic manufacturing sector from commodity-driven volatility?'
Using the data and your knowledge of economics, evaluate the view that Australia should focus its monetary policy on managing the exchange rate rather than targeting domestic interest rates to improve its macroeconomic performance.
310 exam-style questions on AQA A Level Economics 2.6 The international economy (A-level only), covering 2.6.1 Globalisation, 2.6.2 Trade, 2.6.3 The balance of payments, 2.6.4 Exchange rate systems, and 2.6.5 Economic growth and development. Each one has a worked solution and a mark scheme showing where the marks go.