Exchange rates

Exchange rate

• price of one country's currency in terms of another country's currency.

• changes in exchange rate make a significant difference for international purchases

US- Australia exchange rate trend

• In April 2026, 1 AUD = USD 0.72

• In April 2025, 1 AUD = USD 0.60

• In April 2024, 1 AUD = USD 0.64

• In April 2023, 1 AUD = USD 0.68

• In April 2022, 1 AUD = USD 0.74

• In April 2021, 1 AUD = USD 0.78

Foreign exchange rate market

• market where currencies of different countries are bought and sold to carry out international transactions

• consists of two groups e.g. foreign exchange market between AUD and USD

  • those demanding US dollars - an Australian importer of US goods; and

  • those demanding Australian dollars - an American buyer of Australian goods

• price of the currencies are determined by forces of supply and demand

Demand for the AUD can go up if

• high overseas demand can make export prices increase e.g. commodity prices increase due to China’s boom

• interest rate differential

  • cause fall in supply of AUD if Australia’s interest rate is higher than US- investors will pull their money back from US and put it into Australian banks

  • cause simultaneous rise in demand of AUD

• investment e.g. mining boom caused high volume of foreign investment

• if export prices fall due to more efficient production, or if there’s high export quality→ more global demand

2 methods to determine exchange rate/ price of a country’s currency

1. Floating exchange rate

• Market forces of supply and demand are allowed to freely set the value

• Australia adopted a freely floating exchange rate in 1983

• favored by economists since changes in demand and supply will be reflected by price changes- avoids shortages and surpluses by leaving markets to adjust to changes in market conditions

• floating exchange rate is an example of a competitive market where the price fluctuates in response to changes in the demanded supply of the currency.

1. Fixed exchange rate

• Artificially setting the price at a fixed rate

• value of currency maintained at the same rate for longer periods of time

Trade weighted index

• basket of currencies weighted according to their importance in trade flows with Australia

• used to measure the effective value of an exchange rate against a basket of currencies

• less volatile

Relationship between BoP and exchange rate

The exchange rate and the balance of payments are tightly linked because all international transactions require currency exchange.

• The balance of payments (BoP) records all transactions between Australia and the rest of the world, including goods, services, income, and financial flows.

• The exchange rate is the price of the Australian dollar (AUD) in terms of another currency and enables these transactions to occur.

• Therefore, movements in the BoP directly influence the demand and supply of AUD, which determines the exchange rate.

Demand and supply for the AUD

Think of the foreign exchange market like any other market:

• Demand for AUD → pushes the AUD up (appreciation)

• Supply of AUD → pushes the AUD down (depreciation)

Sources of demand for the AUD

Demand for Australian dollars comes from foreigners needing AUD:

• Exports of goods and services (e.g. iron ore, education, tourism).

• Income receipts from overseas (e.g. dividends from foreign investments, interest).

• Capital inflow (foreign investment into Australia, e.g. buying Australian property, shares, or bonds).

Example:

A Chinese company buys Australian iron ore → must convert yuan or USD into AUD → increases demand for AUD → AUD appreciates.

Sources of Supply for AUD

Supply of Australian dollars comes from Australians needing foreign currency:

• Imports of goods and services (e.g. cars, electronics).

• Income payments to overseas (e.g. profits paid to foreign investors).

• Capital outflow (Australian investment abroad, e.g. buying US shares).

Example:

An Australian firm imports computers from the US → converts AUD into USD → increases supply of AUD → AUD depreciates.

Role of currency contracts

• Around two-thirds of exports and half of imports are priced in USD.

• This increases the importance of foreign exchange markets because currencies must be converted.

Two key transaction flows:

• Export transaction (AUD demand):

  US buyer pays in USD → Australian exporter converts USD into AUD → demand for AUD rises.

• Import transaction (AUD supply):

  Australian buyer converts AUD into USD → sends USD overseas → supply of AUD rises

How BoP affect exchange rate

Any change in BoP components shifts demand/supply for AUD:

• Increase in exports → ↑ demand for AUD → appreciation

• Increase in imports → ↑ supply of AUD → depreciation

• Increase in foreign investment → ↑ demand for AUD → appreciation

• Increase in Australian investment overseas → ↑ supply of AUD → depreciation

Factors affecting the exchange rate

• interest rate differential

• commodity prices

• other factors:

• relative inflation rates

• domestic economic growth

• world economic growth

interest rate differential

• if interest rates in the United States rise relative to Australia, then there will be a decrease in capital inflow to Australia and an increase in capital outflow.

• This means that the D(AUD) will decrease and at the same time the S(AUD) will increase causing a strong currency depreciation.

Commodity prices

When the terms of trade increases, the D(AUD) increases and the currency appreciates. international capital flows -if investors believe Australia to be a relatively more attractive destination for their funds compared to other economies then D(AUD) will increase and the Australian dollar would appreciate.

relative inflation rates

• inflation reduces the competitiveness of industries in the traded goods sector.

• A high inflation rate relative to other countries is likely to decrease the exchange rate - the D(AUD) will decrease while the S(AUD) will increase movements in the terms of trade

domestic economic growth

strong economic growth in Australia will lead to an increase in demand for imports, which will increase the S(AUD) causing a currency depreciation; but at the same time, a stronger economy will attract foreign investment which will increase the D(AUD) increasing the exchange rate.

world economic growth

• an increase in global GDP (esp. China), increases world commodity prices which increases the D(AUD) and appreciates the currency;

• The Australian dollar is known as a 'commodity' currency since most of our exports are resources.

Effect of currency depreciating

• It benefits exporters because Australian goods and services become cheaper for overseas buyers, which can increase foreign demand for exports.

• It hurts importers because imported goods and raw materials become more expensive, raising costs for businesses that rely on overseas inputs.

• It is likely to increase the trade balance because exports may rise while imports fall, improving net exports.

• It has an expansionary effect on the economy because higher net exports add to aggregate demand and can lift overall spending.

• It benefits domestic producers who compete with imports, since imported products become relatively more expensive and local alternatives may become more attractive.

• It can also reduce the purchasing power of consumers, since imported goods such as cars, petrol, household appliances, and overseas travel become more expensive.

• A depreciating currency can be inflationary because higher import prices may flow into the consumer price index, while stronger spending from higher net exports can also add to demand pressures

Appreciation of the currency

• It harms exporters because Australian goods become more expensive for overseas buyers, which can reduce international demand.

• It increases the purchasing power of Australian consumers reduces the prices of overseas goods to Australian consumers, making imports cheaper and more affordable.

• It hurts domestic manufacturers because cheaper imports may attract consumers away from locally produced goods.

• It benefits businesses that sell imported products, such as department stores, white-goods retailers, and electronics retailers, may benefit because they can buy stock at lower prices.

• It benefits Australians travelling overseas usually benefit from an appreciating dollar because it reduces the cost of foreign travel, accommodation, and spending.

• It is likely to decrease the trade balance because exports may fall while imports rise, weakening net exports.

• It has a contractionary effect on the economy because lower net exports reduce aggregate demand and can slow economic growth.

• It helps reduce inflation because imported goods and imported inputs become cheaper, which can place downward pressure on the general price level.

Summary of effects of movements in the exchange rate

Depreciation of the currency:

• Price of exports: Decreases (cheaper for foreign buyers).

• Price of imports: Increases (more expensive for domestic buyers).

• Competitiveness: Improves for domestic producers competing with imports.

• Trade balance: Likely improves (exports rise, imports fall).

• Real GDP: May increase due to higher net exports.

• Inflation: May rise due to higher import costs and demand pressures.

Appreciation of the currency:

• Price of exports: Increases (more expensive for foreign buyers).

• Price of imports: Decreases (cheaper for domestic buyers).

• Competitiveness: Worsens for domestic producers competing with imports.

• Trade balance: Likely worsens (exports fall, imports rise).

• Real GDP: May decrease due to lower net exports.

• Inflation: May fall due to cheaper imports and lower input costs.