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Can the Australian exchange rate still be considered a commodity based currency?

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Abstract

The Australian dollar is considered a commodity-based currency, with the high level of primary commodity exports in Australia’s trade balance given as an explanation. Key studies have concluded that Australia’s terms of trade are a primary driver of the real exchange rate based on a comparative advantage trade model. These studies have been undertaken at an aggregate level where changes in the terms of trade have been assumed as a given. Since the Australian economy was deregulated in the early 1980s, there have been dramatic changes in the structure of the economy. Australia’s trading activity has grown and now contributes more within the domestic economy. Similarly the structure and contribution of key imports and exports has also evolved. Furthermore the role of the traded goods and services balance and the income balance within the Australian current account balance has also changed, with a significant change occurring in 2003/04. The purpose of this paper is twofold. Firstly it establishes whether the relationship between the Australian exchange rate and terms of trade has changed in response to changes in the role of the traded goods and services sector within the Australian current account balance. Secondly the paper disaggregates the movements in the terms of trade to establish what role its various components have on the wider relationship between the Australian exchange rate and the terms of trade. The paper concludes that despite substantial changes in the structure and nature of the current account balance and the traded goods and services sector, the Australian exchange rate still responds to changes in the terms of trade as if it is still a commodity-based currency and economy.

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