An exchange rate is the price of one currency in terms of another. Australia has a floating exchange rate, so the value of the $A is set in the foreign exchange market by the demand for and supply of Australian dollars.
Measuring the exchange rate
A single rate (e.g. AUD/USD) is a bilateral rate. The trade weighted index (TWI) measures the $A against a basket of trading-partner currencies, weighted by trade share — a broader gauge of the dollar's value.
Determination and movements
Demand for $A comes from foreigners buying our exports, investing here, and tourism inflows; supply of $A comes from Australians buying imports, investing abroad, and outbound tourism. The intersection sets the rate. When demand rises (or supply falls), the dollar appreciates; the opposite is a depreciation.
Factors that affect the exchange rate
Interest-rate differentials (relative to other countries), commodity prices and the terms of trade, the relative rate of inflation, expectations and speculation, and the state of the current account all shift demand or supply for the $A.
The BOP–exchange-rate link, and effects
Transactions in the balance of payments are the source of currency demand and supply, so the BOP and the exchange rate are tightly linked. An appreciation makes exports dearer and imports cheaper (tending to worsen the trade balance, lower imported inflation); a depreciation does the reverse.
Trace shifts on the model together, always naming the cause and the effect.
Predict the movement
For each event, state whether demand for or supply of $A changes, the direction the curve shifts, and whether the dollar appreciates or depreciates:
- A surge in iron ore prices lifts export revenue. (demand ↑ → appreciation)
- Australian households dramatically increase overseas online shopping. (supply ↑ → depreciation)
- Global investors lose confidence and pull capital out of Australia. (demand ↓ / supply ↑ → depreciation)
1. Using the demand and supply model, explain and illustrate the effect on the $A of a rise in global demand for Australian exports. Label the shift and the new equilibrium.
2. Explain how a fall in Australia's cash rate (relative to overseas rates) would affect the exchange rate, referring to demand and/or supply for the $A.
3. Outline the effects of an appreciation of the $A on exporters, importers and imported inflation.
4. Explain what the trade weighted index measures and why it can be more useful than a single bilateral exchange rate.
5. Explain the link between a rise in Australia's terms of trade and the value of the $A.