How are currency values and trade flows recorded?
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, set by demand and supply in a floating system. The balance of payments records a country's transactions with the rest of the world.
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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.
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.
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.
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.
Exam-style practice questions
Practice questions written in the style of SACE Board exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
2022 SACE Stage 21 marksState 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 23 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 22 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 24 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.