The determination of the exchange rate under a floating system, the factors that cause appreciation and depreciation, the effects of exchange rate movements on the domestic macroeconomic goals and on external stability, and the meaning and measurement of external stability

What this dot point is asking

VCAA wants you to explain how a floating exchange rate is determined, identify the factors that cause it to appreciate or depreciate, trace the effects of exchange rate movements on the macroeconomic goals, and define and measure external stability. Expect short-response and 6 to 10 mark extended responses, often with a foreign exchange demand and supply diagram.

The answer

The exchange rate defined

The exchange rate is the value of the Australian dollar (AUD) expressed in terms of another currency (or a basket of currencies). Australia has a floating exchange rate: since 1983 the AUD has been set by demand and supply in the foreign exchange market, not fixed by the RBA.

• The bilateral rate is the AUD against one currency (for example AUD/USD).
• The Trade-Weighted Index (TWI) is the AUD against a basket of trading-partner currencies, weighted by trade share.

Determination under a floating system

The exchange rate is the price that equates the demand for AUD with the supply of AUD on the foreign exchange market.

Demand for AUD comes from foreigners wanting Australian dollars to:

• Buy Australian exports.
• Invest in Australia (capital inflow, buying Australian assets).
• Hold AUD because of favourable interest rates or expectations.

Supply of AUD comes from Australians wanting foreign currency to:

• Buy imports.
• Invest overseas (capital outflow).
• Travel and pay foreign obligations.

Equilibrium is where the demand and supply of AUD intersect. A rise in demand (or fall in supply) causes an appreciation; a fall in demand (or rise in supply) causes a depreciation.

Factors that cause appreciation and depreciation

1. Commodity prices and the terms of trade. Higher prices for Australian exports (iron ore, coal, gas, LNG) raise export revenue and demand for AUD, causing appreciation. The terms of trade are a key driver of the AUD.
2. Interest rate differentials. If Australian interest rates rise relative to overseas rates, capital flows in to earn the higher return, raising demand for AUD (appreciation). This is the exchange rate channel of monetary policy.
3. Overseas economic conditions. Strong growth in trading partners (especially China) raises demand for Australian exports and the AUD.
4. Relative inflation rates. Lower Australian inflation than trading partners improves competitiveness, supporting the AUD over time.
5. Confidence and speculation. Expectations of future movements drive short-run capital flows. Global "risk-off" episodes often see the AUD fall as a relatively risky, commodity-linked currency.
6. Capital flows and investment. Foreign direct and portfolio investment into Australia raises demand for AUD.

Effects of exchange rate movements

A depreciation (lower AUD):

• Exports become cheaper for foreigners (X rises); imports become dearer for Australians (M falls). Net exports rise, raising AD, growth and employment.
• Imported goods and inputs cost more, raising imported (cost-push) inflation.
• Net effect: supports growth and full employment, works against low and stable inflation.

An appreciation (higher AUD):

• Exports become dearer for foreigners (X falls); imports become cheaper (M rises). Net exports fall, dampening AD, growth and employment.
• Imported goods cost less, easing imported inflation.
• Net effect: dampens growth and employment, supports low and stable inflation.

External stability defined

External stability is a macroeconomic goal of maintaining Australia's external accounts at a sustainable level, so that the size of foreign liabilities and the current account does not threaten the economy's ability to meet its international obligations or undermine confidence in the AUD.

It is measured by:

• The current account balance (as a percentage of GDP). The current account records trade in goods and services (the balance on goods and services) plus net primary income (mostly interest and dividends on foreign investment) and net secondary income.
• Net foreign debt and net foreign liabilities (as a percentage of GDP). The accumulated stock owed to the rest of the world.
• The net income deficit (the servicing cost of foreign liabilities).

A persistent large current account deficit financed by rising foreign liabilities can be a concern; a sustainable position is one that markets are willing to finance without a loss of confidence.

Australia's external position

Australia historically ran current account deficits, financed by capital inflow to fund investment that exceeded domestic saving. From around 2019 the strong terms of trade and high commodity export prices produced periods of current account surplus, an unusual development. The position fluctuates with commodity prices and global demand, so always cite the latest ABS Balance of Payments release for current figures.

A floating exchange rate is itself a key automatic mechanism for external adjustment: if the current account deteriorates, reduced demand for AUD tends to depreciate the currency, which improves competitiveness and helps correct the imbalance over time.

Examples in context

Example 1. The terms of trade and the AUD

During commodity booms, surging iron ore and coal prices lift Australia's export revenue and the demand for AUD, pushing the currency higher. When commodity prices fall, the AUD typically depreciates. This tight link between the terms of trade and the AUD is one of the most reliable patterns in the Australian economy.

Example 2. Interest rate differentials in 2022 to 2024

During the global tightening cycle, the US Federal Reserve raised rates faster than the RBA at times, narrowing or reversing the interest rate differential in the US's favour. This weighed on the AUD against the USD, muting the exchange rate channel of Australian monetary policy. Check the latest RBA exchange rate data for current levels.

Example 3. Depreciation as a shock absorber

When global demand weakens and Australia's export prices fall, the resulting depreciation cushions the economy: exporters receive more AUD per unit sold and import-competing industries gain competitiveness, helping support growth and employment without policy action.

Try this

Q1. Explain what causes the Australian dollar to appreciate under a floating exchange rate. [3 marks]

• Cue. An increase in demand for AUD or a decrease in supply, driven by factors such as higher commodity prices and terms of trade, higher relative interest rates, stronger overseas demand, or favourable expectations.

Q2. Explain how an appreciation of the AUD affects the goal of low and stable inflation. [3 marks]

• Cue. Imports become cheaper, lowering the price of imported goods and inputs (imported inflation falls); reduced net exports also ease demand-side pressure, so an appreciation tends to lower inflation.

Q3. Define external stability and identify two indicators used to measure it. [4 marks]

• Cue. Maintaining the external accounts at a sustainable level so foreign liabilities and the current account do not threaten the economy or confidence in the AUD; indicators include the current account balance as a percentage of GDP and net foreign debt/liabilities as a percentage of GDP.