Australia is Making Its Money Worth Less — Here's Why

This week the Reserve Bank of Australia (RBA) cut interest rates to a record low of 2.5%. The RBA has now cut Australian interest rates by a total of 2.25% since 2011, and the move comes as a mining boom that undergirded Australian economic growth over the past decade is coming to an end, leaving behind a flagging economy. The RBA's position is that the cuts are "appropriate to encourage sustainable growth in the economy," and "necessary to support demand." 

For the U.S., a weaker Australian dollar will mean a decrease of U.S. exports to Australia, the 11th largest importer of U.S. goods in 2012. Indeed, the results of the consistent devaluation of the Australian dollar are already visible: U.S. exports to Australia have already decreased from US$12,558 million in May 2012 to $10,372 million in May of 2013 — a 17.4% difference. In turn, this could have a negative impact on the United States' overall trade balance, and therefore deteriorate the already ailing trade deficit of the American economy.

So it's worth asking as all this happens, how does devaluation policy actually work? And most importantly, why do countries choose to devalue their currency?

The truth is that countries that operate under a floating exchange regime, like Australia or the U.S., actually have no direct control over their exchange rates. Instead, economists mess around with other tenets of the economy over which they actually have control. In the Australian case, as with most if not all Western countries nowadays, economists mess around with benchmark interest rates. By lowering or increasing the interest rate of a country, central banks are able to indirectly influence exchange rates trends as they deem fit under the circumstances.

The basic causal mechanism behind this is simple: Higher interest rates offer lenders in an economy a high return relative to other countries. As a result, higher interest rates tend to attract foreign capital and thus appreciate the exchange rate, as demand for the country's currency increases. Lower interest rates work in the opposite direction, causing demand for a country's currency to decrease and therefore leading to a devaluation of the exchange rate.

So why would a country choose to decrease its interest rates in an attempt to devalue its currency? There are many reasons. The first reason has to do with a country's trade balance. Countries with devalued currencies are generally able to export more (as their products become relatively cheaper in the world market), and import less (as world-market products become more expensive for domestic consumption). As a result, devaluation generally leads to an improvement in a country's trade deficit. The second reason has to do with the aggregate demand of an economy, or the total demand for goods and services in an economy. Lower interest rates increase the borrowing power of consumers, and therefore boost domestic consumption. Similarly, lower interests rates can also reduce unemployment, since businesses are able to borrow more money and therefore hire more employees. 

All of these factors were considered in the RBA's decision to pursue a policy of lower interest rates and exchange rate devaluation in Australia, and it may not be the last time we hear about the RBA lowering interest rates. Indeed, economists at UBS in Sydney wrote in a research note that "if we don't see some improvement in the leading indicators of the economy, such as job ads and business conditions," the central bank "will likely have some further work to do either late this year or early 2014."