Exchange rates and balance of payments (SACE Stage 2 Economics)
“Explain how exchange rates are determined and how transactions are recorded in the balance of payments.”
An exchange rate is the price of one currency in terms of another. Under Australia's floating system it is set by the demand for and supply of the Australian dollar. The balance of payments is the record of all transactions between Australia and the rest of the world, split into the current account and the capital and financial account.
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What this dot point is asking
You need to explain how a floating exchange rate is determined, what causes it to appreciate or depreciate, the effects of those movements, and the structure of the balance of payments.
Exchange rates
The exchange rate is the value of one currency expressed in another, for example AUD/USD. Australia has a floating exchange rate, meaning the dollar's value is determined by demand and supply in the foreign exchange market, not fixed by the government.
- Appreciation - the dollar rises in value (it buys more foreign currency).
- Depreciation - the dollar falls in value (it buys less foreign currency).
What shifts demand and supply for the dollar
Demand for the AUD rises with demand for Australian exports, higher Australian interest rates (attracting financial inflow), foreign investment into Australia, and speculation that the dollar will rise. Supply of the AUD rises with Australian demand for imports, Australians investing overseas, and lower domestic interest rates.
Suppose world demand for Australian iron ore surges and its price rises. Foreign buyers need Australian dollars to pay for it, so demand for the AUD increases and the dollar appreciates. The stronger dollar makes Australian exports dearer for foreigners and imports cheaper for Australians, partly offsetting the boom over time.
Effects of exchange rate movements
- A depreciation makes exports cheaper and more competitive abroad, and imports dearer at home. This can improve net exports but raise the price of imported goods, adding to inflation.
- An appreciation makes exports dearer and less competitive, and imports cheaper. This can worsen net exports but help control inflation by lowering import prices.
A lower dollar boosts export competitiveness and supports domestic industry and jobs, but raises the cost of imports and can fuel inflation. A higher dollar does the opposite. There is no single "good" level for the dollar - the effect depends on whether you are an exporter, importer or consumer.
The balance of payments
The balance of payments (BOP) records all transactions between Australia and the rest of the world over a period. It has two main accounts:
- Current account - records trade in goods and services (the balance on goods and services), primary income (such as interest and dividends paid and received) and secondary income (transfers). A current account deficit means more money flows out than in on these items.
- Capital and financial account - records flows of investment and borrowing, such as foreign investment into Australia and Australian investment abroad.
In principle the two accounts balance: a current account deficit is matched by a net inflow on the capital and financial account, because deficits must be financed by borrowing from or selling assets to the rest of the world.
A current account deficit (CAD) occurs when the outflows on the current account (imports, income paid abroad) exceed the inflows (exports, income received). Australia has historically run a current account deficit, financed by inflows on the capital and financial account.
How the BOP and the exchange rate connect
The balance of payments and the exchange rate are two views of the same flows. Every export sale and capital inflow recorded as a credit in the BOP also creates demand for the Australian dollar in the foreign exchange market, while every import and capital outflow creates supply of dollars. So a deterioration in the current account, driven by weaker exports, tends to reduce demand for the dollar and push it toward depreciation, while strong commodity export receipts or a surge of foreign investment lift demand and cause appreciation. Under a clean float there is no separate "settling up": the exchange rate adjusts so that the BOP as a whole balances, with a current account deficit financed by a matching net inflow on the capital and financial account. Tracing a shock through both the BOP and the dollar market is a frequent SACE extended-response demand.
Why this matters
Exchange rates and the balance of payments link the domestic economy to the global economy. The dollar's movements feed directly into the AD-AS model through net exports and into inflation through import prices, connecting this dot point to macroeconomics. Australia's reliance on commodity exports and foreign capital makes the dollar and the current account central to its economic story.
A current account deficit is not necessarily harmful. If foreign funds are financing productive investment that raises future output and export capacity, the deficit can be sustainable. The concern is only if borrowing funds consumption or becomes too large relative to GDP. Evaluate the cause of the deficit, not just its existence.
Exam-style questions
Questions in the style of SACE Board exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
2022 SACE Stage 2-style1 markState how the exchange rate is determined under a floating exchange-rate system.Show worked answer →
One mark for the determining mechanism.
Under a floating exchange-rate system, the exchange rate is determined by the demand for and supply of the currency in the foreign exchange market. The price of the currency (its exchange rate) is set where the demand for the currency equals the supply of it, with no government or central bank intervention to fix the rate. Demand comes from foreigners wanting the currency (for example to buy exports or invest), and supply comes from domestic residents wanting foreign currency (for example to buy imports).
2022 SACE Stage 2-style3 marksCountry K is a large net exporter, and external shocks have decreased the demand for and dollar value of its exports. Explain the likely impact of the decrease in the dollar value of exports on Country K's floating exchange rate (K$). Complete the diagram for the market for Country K's dollar to support your answer.Show worked answer →
Three marks: the mechanism, the outcome, and the diagram.
Mechanism (1 mark). Foreigners buy K, so the demand for K$ decreases (demand curve shifts left).
Outcome (1 mark). With lower demand and unchanged supply, the equilibrium exchange rate falls. The K$ depreciates (its value against other currencies falls).
Diagram (1 mark). On the market for K on the horizontal), show the demand curve shifting left from D to D1, with the equilibrium exchange rate falling and the quantity traded falling.
2019 SACE Stage 2-style2 marksThe balance of trade in Country A has changed between 2017 and 2019. Explain the possible effect of this change on the current account balance of Country A.Show worked answer →
Two marks: define the link and explain the directional effect.
The balance of trade (exports of goods and services minus imports) is the largest component of the current account. The current account also includes the net primary and secondary income flows (such as interest, profits and transfers).
If the balance of trade moves towards deficit (imports rising relative to exports), this worsens the current account, pushing it further into deficit, other things equal. Conversely, if the balance of trade improves (a larger trade surplus or smaller deficit), the current account balance improves. A complete answer names the trade balance as a component of the current account and states the matching direction of effect.
2023 SACE Stage 2-style4 marksCountry X has decided to implement contractionary monetary policy (raising the cash rate) to reduce demand-pull inflation. Analyse the likely impact of contractionary monetary policy on Country X's exchange rate (X to support your answer.Show worked answer →
Four marks: the interest-rate channel, the effect on demand for the currency, the outcome, and the diagram.
Higher returns attract capital (1 mark). Raising the cash rate increases domestic interest rates, making financial assets in Country X more attractive to foreign investors seeking higher returns.
Capital inflow raises currency demand (1 mark). Foreign investors must buy X increases (demand curve shifts right). The supply of $X may also fall as residents are less inclined to invest abroad.
Appreciation (1 mark). With higher demand (and possibly lower supply), the equilibrium exchange rate rises, so $X appreciates.
Diagram (1 mark). On the market for $X, show demand shifting right from D to D1 (and optionally supply shifting left), with the exchange rate rising and quantity rising. Label the appreciation.
Practise this
Sources & how we know this
- Stage 2 Economics subject outline (2025 onwards) — SACE Board
- Stage 2 Economics: external assessment — SACE Board