← Topic 2: Australia's Place in the Global Economy
How does Australia engage with the global economy and what is its position relative to other economies?
Examine the determination of the Australian dollar exchange rate including the influence of demand for and supply of the Australian dollar, the foreign exchange market, and the influence of speculation and Reserve Bank intervention
A focused HSC Economics Topic 2 answer on the AUD exchange rate. Defines floating, fixed and managed regimes, draws the foreign exchange market with demand and supply, identifies the seven major determinants of the AUD, and works through the effects of a depreciation on trade, inflation and the BoP.
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What this dot point is asking
NESA wants you to explain how the AUD exchange rate is determined under a floating regime, draw the foreign exchange market, identify the determinants of demand and supply for the AUD, and discuss the role of the RBA. Expect a 6 to 8 mark short answer requiring a diagram.
The answer
Exchange rate regimes
The exchange rate is the price of one currency expressed in terms of another. Three regimes:
- Floating exchange rate. Determined by market forces of demand and supply. Australia floated the AUD in December 1983.
- Fixed exchange rate. Pegged to another currency or basket. The Hong Kong dollar is fixed against the USD.
- Managed exchange rate. A central bank intervenes to keep the rate within bands but allows some movement. China runs a managed float of the renminbi.
The trade-weighted index (TWI) is the AUD's value against a basket of currencies weighted by trade share. It is a better measure of the AUD's overall value than any single bilateral rate.
The foreign exchange market
The foreign exchange market for AUD has:
Demand for AUD (downward sloping in AUD price), coming from:
- Foreign buyers of Australian exports (iron ore, coal, LNG, education, tourism).
- Foreign investors making FDI into Australia.
- Foreign portfolio investors buying Australian shares and bonds.
- Speculators expecting AUD appreciation.
- The RBA when intervening to defend the AUD.
Supply of AUD (upward sloping in AUD price), coming from:
- Australian buyers of imports.
- Australian investors making FDI overseas.
- Australian portfolio investors buying foreign shares and bonds.
- Speculators expecting AUD depreciation.
- The RBA when intervening to weaken the AUD.
Equilibrium price (the AUD exchange rate) is where demand equals supply.
Diagram
The standard diagram has the AUD price (USD per AUD) on the y-axis and quantity of AUD on the x-axis. A rightward shift in demand for AUD (or leftward shift in supply) raises the equilibrium price (appreciation). A leftward shift in demand (or rightward shift in supply) lowers it (depreciation).
Determinants of the AUD
Seven major drivers:
- 1. Commodity prices and the terms of trade
- Australia's exports are commodity-intensive. A rise in iron ore prices raises foreign demand for AUD. The AUD/USD correlates strongly with the terms of trade (correlation coefficient roughly 0.7 over the past 20 years).
- 2. Interest rate differentials
- When Australian interest rates are higher than overseas, foreign investors demand AUD-denominated assets. The "carry trade" is a major source of AUD demand. The RBA-Fed rate differential is a key driver.
- 3. Expectations and speculation
- Currency traders speculate on AUD movements based on macro data releases (US Fed announcements, ABS inflation, RBA decisions). About 90 percent of daily forex turnover is speculative rather than trade-related.
- 4. Economic conditions in Australia vs trading partners
- Strong Australian growth relative to overseas attracts capital inflow and supports the AUD.
- 5. Domestic inflation relative to trading partners
- Persistent higher Australian inflation reduces the AUD's purchasing power, putting downward pressure on the nominal rate (purchasing power parity).
- 6. Political and risk factors
- Geopolitical shocks affect risk-on or risk-off sentiment. The AUD is a "risk-on" currency: it weakens during global crises (March 2020 fall to USD 0.55) and strengthens during global recoveries.
- 7. Reserve Bank intervention
- The RBA holds foreign exchange reserves to intervene if the AUD is "disorderly" (extreme volatility). Direct intervention is rare; the RBA last intervened heavily in 2008.
Effects of an appreciation
On the current account.
- Exports become more expensive in foreign currency. Volume falls, so export earnings fall (BOGS deteriorates).
- Imports become cheaper in AUD. Volume rises, so import payments rise (BOGS deteriorates).
- Net effect on BOGS depends on the Marshall-Lerner condition (sum of export and import elasticities must exceed 1). For Australia, the condition holds, so appreciation worsens BOGS.
On inflation.
- Imported goods become cheaper, reducing the AUD price of tradables.
- The RBA estimates that a 10 percent appreciation cuts headline CPI by 1 to 2 percentage points over 2 years.
On the capital account.
- A higher AUD makes Australian assets more expensive for foreign buyers; FDI inflow may slow.
- Servicing costs on foreign-currency-denominated debt fall.
On economic activity.
- Falling export and import-competing volumes reduce GDP growth in the short run.
- Lower imported inflation gives the RBA scope to lower rates, supporting activity.
Effects of a depreciation
The mirror image:
- Exports more competitive, imports more expensive.
- Net exports rise (J-curve: BOGS initially deteriorates as import prices rise faster than volumes adjust, then improves).
- Imported inflation rises (the AUD passes through to CPI with a lag of 2 to 4 quarters).
- Servicing costs on foreign-currency debt rise.
RBA intervention
The RBA can intervene in the foreign exchange market by buying AUD (to support the rate) or selling AUD (to weaken it). The RBA holds around AUD 70 billion in foreign exchange reserves. Intervention is rare because the floating rate generally absorbs shocks well; the RBA last intervened heavily during the 2008 GFC to stabilise the AUD.
Recent AUD movements
The AUD/USD has ranged from a low of USD 0.55 (March 2020 COVID shock) to a peak of USD 1.10 in mid-2011. It has traded in a USD 0.62 to 0.70 range through much of 2024-25, reflecting:
- High terms of trade (supportive).
- US-Australia interest rate differential (US rates higher than Australian rates: bearish for AUD).
- China growth concerns (bearish for AUD via iron ore demand).
Common HSC traps
- Drawing the supply curve as horizontal
- It is upward sloping. Australians supply more AUD to the forex market when the AUD price is higher (because foreign goods are cheaper in AUD terms).
- Treating appreciation as unambiguously bad
- Appreciation hurts exporters but helps consumers and reduces inflation. Markers reward balanced analysis.
- Ignoring expectations and speculation
- They drive most short-term AUD movement.
Past exam questions, worked
Real questions from past NESA papers on this dot point, with our answer explainer.
2023 HSC6 marksExplain how an appreciation of the Australian dollar would affect the Australian economy. Use a diagram in your response.Show worked answer →
A 6 mark response needs a labelled foreign exchange diagram, the definition of appreciation, and at least three effects with explicit cause-and-effect chains.
- Define
- An appreciation is a rise in the AUD price expressed in foreign currency (or a rise in the trade-weighted index, TWI). Under Australia's floating exchange rate, appreciations are caused by shifts in demand or supply for the AUD.
- Diagram
- Draw the foreign exchange market with the AUD price (USD per AUD) on the vertical axis and quantity of AUD on the horizontal axis. Show the initial equilibrium and a rightward shift in demand for AUD (or leftward shift in supply) producing a new higher equilibrium price.
- Effect 1: Exports become less competitive
- Australian exports (iron ore, education, tourism) become more expensive in foreign currency, so export volumes fall. This worsens the BOGS and may shrink the current account surplus.
- Effect 2: Imports become cheaper
- Import-competing producers face tougher competition; consumers pay less for imported goods. Net exports fall.
- Effect 3: Lower imported inflation
- A 10 percent appreciation cuts imported tradables inflation by roughly 3 to 5 percentage points (RBA pass-through estimates). This reduces headline CPI.
Effect 4: Lower interest payments on foreign debt denominated in foreign currency. Australian net foreign liabilities of around 55 percent of GDP, of which about 30 percent is foreign-currency denominated, become cheaper to service in AUD terms.
Effect 5: Wealth effect. Australians holding foreign assets see their AUD-converted value fall; Australian investors get cheaper foreign assets.
Markers reward (1) a labelled diagram, (2) the definition, (3) at least three effects with cause-and-effect chains, (4) one figure (TWI or pass-through estimate).
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