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The Exchange Rate and the Current Account

Other papers at this Conference (particularly Pitchford and Blundell-Wignall, Fahrer and Heath) examine the factors that determine the exchange rate. This paper explores how the exchange rate impinges on the separate components of the current account in the short run and the part it plays in longer-term balance of payments adjustment. In particular, it examines both the effect of the exchange rate on imports and exports and considers the role of the exchange rate in adjusting the economy to underlying structural changes. The Australian economy since 1980 is an ideal ‘test bed’ for this. During this period: • there was an important change of policy regime (the floating of the exchange rate in December 1983); • the underlying current account deficit increased markedly compared with earlier periods, suggesting that there were important structural changes; and • there was a wide short-term variation in the current account deficit, which exceeded 6 per cent of gross domestic product (GDP) three times in the decade. The variety and extent of the experience should provide the opportunity to draw some conclusions about the role of the exchange rate. The distinction between short-term shocks and responses, on the one hand, and the longer-term adjustments to structural changes, on the other, provides a theme that will be important in analysing the variety of experience. The main forces driving the short-term movements in the current account were terms of trade changes and investment shocks. Large swings in the terms of trade played a central role in the activity cycles during the period and their impact shows clearly in the current account. While these terms of trade swings were large, they were generally reversed and provide evidence that, within a long-term steady, secular decline in the terms of trade, the larger fluctuations are temporary. There