The Australian dollar exchange rate: determinants and effects (HSC Economics Topic 2)

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).

Definition (2 marks). An appreciation is a rise in the price of the Australian dollar (AUD) expressed in a foreign currency, or a rise in the trade-weighted index (TWI), under a floating exchange rate. It is caused by a rightward shift in demand for AUD or a leftward shift in supply of AUD.

Supply curve (1 mark). Upward sloping. As the AUD price rises, Australians supply more AUD to the foreign exchange market, because foreign goods and assets become relatively cheaper in AUD terms, encouraging more imports and overseas investment.

A common error is drawing supply as horizontal or downward sloping; only demand for AUD slopes downward.

Award 1 mark per determinant correctly named WITH a fitting reason (up to 4 of the following).

Commodity prices / terms of trade

Higher iron ore or LNG prices raise foreign demand for AUD to pay for Australian exports.

Interest rate differentials

Higher Australian interest rates relative to overseas attract foreign capital seeking higher returns (the "carry trade"), raising demand for AUD.

Speculation and expectations

Traders buy or sell AUD based on expected future movements, and speculative flows make up the large majority of daily forex turnover.

Relative economic growth

Stronger Australian growth relative to trading partners attracts capital inflow, supporting the AUD.

Relative inflation

Persistently higher Australian inflation than trading partners reduces the AUD's purchasing power, creating downward pressure (purchasing power parity).

RBA intervention

Rare direct buying or selling of AUD by the Reserve Bank to calm disorderly conditions.

Full marks need four DISTINCT determinants each linked to a clear direction of effect on demand or supply.

A 5-mark "describe and explain" rewards (i) an accurate reading of the pattern with figures and direction, and (ii) an explanation using named determinants linked to each move, not a generic restatement.

Describe the trend (about 2 marks). The AUD/USD fell sharply to a low of about USD 0.55 in March 2020, then recovered strongly to about USD 0.75 by mid-2021, before falling back to about USD 0.62 by October 2022. It has since traded in a narrower band, around USD 0.65 to 0.66 through mid-2024 to mid-2026 - a V-shaped shock and recovery followed by relative stability at a lower level than the 2021 peak.

Explain with determinants (about 3 marks). The March 2020 fall reflects the COVID-19 "risk-off" shock: the AUD is a risk-sensitive currency, so global panic and a commodity demand shock drove capital OUT of AUD assets (supply of AUD rose, demand fell). The 2021 recovery reflects a rebound in commodity prices (iron ore) and global risk appetite, raising demand for AUD. The fall into October 2022 reflects the US Federal Reserve raising interest rates faster than the RBA, narrowing or reversing the interest rate differential in the US's favour and reducing capital inflow to AUD assets. The subsequent stabilisation around USD 0.65 to 0.66 reflects an easing of that gap alongside continued, though moderating, Chinese demand for Australian commodities.

Marking spine: accurate trend with figures and direction (2), at least two determinants correctly linked to specific movements (2), explicit cause-and-effect (demand/supply of AUD) rather than just naming factors (1). A description with no determinants, or determinants never tied to the data, caps at 3. (Figures are an illustrative ExamExplained dataset modelled on the RBA's published AUD/USD series; treat as indicative, not an exact quote.)

A 6-mark "explain... using a diagram" needs the causal chain from the interest rate change through the forex market to the new equilibrium, with a correctly labelled diagram.

The mechanism

If the RBA raises the cash rate while the US Federal Reserve holds steady, the interest rate differential widens in Australia's favour. Foreign investors seeking higher returns increase demand for Australian dollar denominated assets (bonds, deposits) to capture the "carry trade" spread, raising demand for AUD in the foreign exchange market.

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. The initial equilibrium E0 sits where D0 meets S0. The rise in Australian interest rates shifts DEMAND for AUD rightward to D1 (more foreign capital seeking AUD assets), producing a new equilibrium E1 at a higher AUD price - an appreciation. Label both curves, both equilibrium points, and the new higher price on the vertical axis.

Consequence

The appreciation makes Australian exports less price-competitive and imports cheaper, so net exports tend to fall, while imported inflation eases as import prices in AUD fall.

Marking spine: correct direction of the interest rate differential (1), correct identification of demand (not supply) as the curve that shifts (1), a correctly drawn and labelled diagram showing the rightward demand shift and higher equilibrium price (2), at least one flow-on consequence explained (2).

An 8-mark "analyse" needs a diagram, the mechanism causing the depreciation, MULTIPLE effects (trade, inflation, debt servicing, growth) each explained through a cause-and-effect chain, and a judgement about the net impact.

Band 6 PLAN.

Thesis: A sustained AUD depreciation reshapes the Australian economy unevenly: it supports trade-exposed industries and growth but raises imported inflation and the AUD cost of foreign-currency debt, so its net effect depends on the state of the domestic economy and the RBA's policy response.

Diagram: Foreign exchange market, AUD price (USD per AUD) on the vertical axis, quantity of AUD on the horizontal axis. A depreciation is shown as a leftward shift in demand for AUD (or a rightward shift in supply), moving equilibrium from E0 to a lower E1.

Argument 1 - trade competitiveness improves (BOGS). Mechanism: a lower AUD makes Australian exports cheaper in foreign currency and imports more expensive in AUD, so export volumes rise and import volumes fall over time (assuming the Marshall-Lerner condition holds, which it does for Australia). Evidence/nuance: the J-curve means the balance on goods and services can initially WORSEN, because existing contracts mean import volumes are sticky in the short run while import prices in AUD jump immediately; the improvement in BOGS appears with a lag of around 6 months to 2 years.

Argument 2 - imported inflation rises. Mechanism: a weaker AUD raises the AUD price of imported consumer goods, fuel and intermediate inputs, feeding into headline CPI with a pass-through lag of around 2 to 4 quarters. This can push inflation above the RBA's 2 to 3 percent target band, constraining the RBA's ability to cut the cash rate even if domestic demand is soft.

Argument 3 - foreign debt servicing costs rise. Mechanism: Australia carries substantial net foreign liabilities; the AUD cost of servicing foreign-currency-denominated debt and interest payments rises when the AUD depreciates, worsening the primary income component of the current account.

Counter-weight / judgement: the depreciation is expansionary for growth and employment in trade-exposed sectors (tourism, education, agriculture, manufacturing import-competitors) and partly self-correcting, since higher net exports and inflation both work to eventually stabilise the currency; but if the depreciation is driven by falling terms of trade rather than by RBA rate cuts, the inflationary cost can dominate the growth benefit, especially with the cash rate around 3.6 percent in mid-2026 (illustrative ExamExplained, based on the RBA's published cycle) leaving limited room to ease further without breaching the inflation target.

Model paragraph (Argument 2). The clearest domestic cost of a sustained AUD depreciation is imported inflation. As the AUD falls, the AUD price of imported fuel, consumer electronics and intermediate inputs rises directly, and this pass-through reaches the Consumer Price Index with a lag of roughly two to four quarters as retailers and wholesalers adjust prices. Because monetary policy targets headline CPI within a 2 to 3 percent band, a depreciation-driven inflation impulse can force the Reserve Bank to hold or even raise the cash rate at a time when trade-exposed industries would otherwise want lower rates to complement their improved competitiveness - a genuine policy tension rather than an unambiguous gain.

Marker's note: markers reward a diagram with the correct shift and labelled axes; MULTIPLE effects (trade/BOGS with the J-curve caveat, inflation with a lag, debt servicing, growth) each with an explicit cause-and-effect mechanism; current, dated Australian context (the cash rate context, 2026); and a calibrated judgement rather than a list of "good and bad" points with no synthesis. A response with only one effect, or no diagram, cannot reach the top band.

A 6-mark "evaluate" needs the mechanism of intervention, an assessment of its effectiveness, and a clear judgement, not just a description of what intervention is.

Mechanism

The RBA can intervene in the foreign exchange market directly by buying AUD (using foreign exchange reserves to add to demand for AUD, supporting the price) or selling AUD (adding to supply, weakening the price), shifting the relevant curve in the forex market diagram.

Case for limited effectiveness

Daily global foreign exchange turnover dwarfs the scale of RBA reserves (around AUD 70 billion), so direct intervention can only shift the price at the margin and mainly works by signalling intent rather than by sheer volume; sustained one-way pressure from private capital flows will usually overwhelm it.

Case for targeted effectiveness

Intervention is not designed to fix the long-run rate, but to calm genuinely "disorderly" or dysfunctional short-term conditions (extreme volatility, illiquidity) where a signal of RBA presence can restore orderly two-way trading, as during the 2008 Global Financial Crisis.

Judgement

Intervention is best judged as a narrow, occasional tool for market functioning rather than a lever for controlling the exchange rate's level or trend; the RBA relies far more on the cash rate (an indirect influence via interest rate differentials) than on direct intervention, and has intervened heavily only rarely, most notably in 2008.

Marking spine: mechanism correctly described (buying/selling AUD, reserves) (2), at least one argument for and one against effectiveness (2-3), an explicit judgement rather than "it depends" with no conclusion (1).