Explain how a floating exchange rate is determined by demand and supply, the causes of appreciation and depreciation, and the effects of exchange rate movements on the economy

What this dot point is asking

SCSA wants you to explain how the floating AUD is determined, identify what shifts demand and supply, and analyse the effects of appreciation and depreciation on trade, inflation, the current account and growth. Expect a forex diagram and a short or extended response.

The foreign exchange market

Since the dollar was floated in December 1983, the exchange rate is set by the interaction of demand for and supply of Australian dollars in the foreign exchange market, with no day-to-day RBA target.

Demand for AUD

The demand curve for AUD slopes downward (a lower AUD makes Australian assets and goods cheaper, raising quantity demanded). Demand comes from foreigners who need AUD to:

• Buy Australian exports (iron ore, coal, LNG, education, tourism).
• Invest in Australian assets (direct and portfolio investment).
• Speculate on a rising AUD.

Supply of AUD

The supply curve slopes upward. Supply comes from Australians who sell AUD to obtain foreign currency to:

• Buy imports.
• Invest abroad or pay interest and dividends to foreign lenders.
• Speculate on a falling AUD.

The equilibrium exchange rate is where the demand and supply curves intersect. On a diagram, the vertical axis is the price of AUD (for example in USD) and the horizontal axis is the quantity of AUD traded.

Causes of appreciation and depreciation

An appreciation (rise in the AUD) follows an increase in demand for AUD or a fall in supply. A depreciation (fall in the AUD) follows a fall in demand or a rise in supply. Key drivers:

• Commodity prices and the terms of trade. Higher iron ore and energy prices raise export revenue and demand for AUD, appreciating the dollar. This makes the AUD a "commodity currency".
• Interest rate differentials. If the RBA cash rate is high relative to the US Federal Reserve and other central banks, foreign capital chases higher returns, raising demand for AUD. In 2022 to 2024, US rate rises that outpaced RBA rises weighed on the AUD.
• Relative inflation and growth. Stronger Australian growth and confidence attract investment.
• Expectations and speculation. Around 60 percent of forex turnover is speculative; sentiment can move the rate sharply.
• Global risk sentiment. The AUD is a "risk-on" currency that tends to fall during global financial stress.

Effects of exchange rate movements

Appreciation (higher AUD)

• Exports become more expensive in foreign currency, reducing export competitiveness and volumes.
• Imports become cheaper, raising import volumes and lowering imported inflation.
• The balance on goods and services tends to worsen (after the J-curve lag).
• Helps the RBA fight inflation by lowering import prices.
• Hurts trade-exposed industries (mining, agriculture, tourism, education).

Depreciation (lower AUD)

• Exports become cheaper and more competitive, raising export volumes.
• Imports become dearer, encouraging import substitution but adding to imported inflation.
• The balance on goods and services tends to improve over time.
• Acts as an automatic shock absorber: when commodity prices fall, the AUD usually falls too, cushioning export industries.

The J-curve

After a depreciation, the balance on goods and services may worsen before it improves. In the short run, contracts are fixed and volumes are slow to adjust, so the higher cost of imports dominates. Over time, volumes respond and the balance improves, tracing a J-shape.