The exchange rate

The demand for Australian dollars is derived from:

1. Australian exports of goods and services

2. Foreign investment into Australia

Demand and Supply curve

Same as normal

y-axis is price of AUD 1 in USD

x-axis is qty of AUD

Factors that will shift the demand curve for AUD

• Relative price levels

• World real GDP

• Foreign preferences for Australian goods and services

• Relative interest rates

• Commodity prices

• Expectations and speculations

Relative price levels (demand)

If inflation in other countries is higher relative to Australia, then Australian goods and services will become relatively cheaper increasing demand for AUD.

World real GDP (demand)

If higher economic growth increases real GDP in Australia’s main trading partners, then the real incomes of foreign citizens will increase, increasing demand for AUD.

Foreign preferences for Australian goods and services (demand)

If Australian goods become more popular then demand for AUD increases

Relative interest rates (demand)

Interest rates reflect the return on financial assets.

So when Australia’s interest rates are higher than another, then Australia’s financial assets will be more attractive, this will increase demand for AUD.

What is the interest rate differential? (demand)

The difference between the Australian interest rate and the foreign interest rate

The higher the interest rate differential, the greater the demand for Australian assets and dollars

Commodity prices (demand)

The Australian dollar is known as a commodity currency.

If the commodity price increases due to higher demand then the value of Australia’s exports will increase and so will the demand for AUD

Expectations and speculations (demand)

Many foreign exchange traders are speculators - buying based on expectations about the likely movement of a currency.

If foreign traders believe that the Australian dollar is likely to rise in the future, then they will demand more AUD to take advantage of the lower price.

The supply of Australian dollars is derived from:

1. Australian imports of goods and services

2. Australian investment abroad

Factors affecting the supply of Australian dollars

• Relative price levels

• Australian real GDP

• Australian preferences for foreign goods and services

• Relative interest rate

• Expectations and speculation

Relative price levels (supply)

If inflation rate is lower in other countries relative to Australia, then foreign goods and services will be more attractive to Australians who may increase their demand for foreign goods and increase supply.

Australian real GDP (supply)

Higher domestic economic growth will increase Australia’s real GDP increasing national income. This will increase demand for imported goods and services and increase the supply of Australian dollars.

Australian preferences for foreign goods and services (supply)

If foreign goods become more popular with Australian residents, then the demand for imports will increase and the supply of AUD will increase.

Relative interest rates (supply)

Interest rates reflect the return on financial assets.

If the Australian interest rate differential decreases, then you will want to purchase foreign assets which will increase the supply of Australian dollars

Expectations and speculations (supply)

If Australian currency traders believe that US dollar will rise they will sell AUD and buy USD increasing the supply of AUD