Exchange Rates

Syllabus: Australia's Place in the Global Economy → Exchange rates.

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Measurement of relative exchange rates

An exchange rate is the price of one currency in terms of another.

Bilateral rates are quoted against a single currency, so AUD/USD of about 0.70 in mid-2026 means one Australian dollar buys around 70 US cents. The trap is that a bilateral rate tells you about Australia relative to one economy only. The AUD can rise against the US dollar and fall against the yen in the same week, so a single bilateral rate is not a measure of the currency's overall value.

The Trade Weighted Index measures the AUD against a basket of the currencies of Australia's major trading partners, each weighted by its share of Australia's trade. It is the better measure precisely because it captures overall value rather than value against one partner, and because weighting by trade share means movements against major partners count for more than movements against minor ones. When a question asks about the exchange rate's effect on the economy, the TWI is the relevant measure.

One caution: the TWI is an index, so its level means nothing except relative to its base period. Always talk about the change rather than the number on its own.

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Factors affecting demand for and supply of Australian dollars

The AUD trades on the foreign exchange market and its price is set by demand and supply.

Demand comes from anyone who needs Australian dollars: foreigners buying Australian exports, foreigners investing here through direct or portfolio capital inflow, speculators expecting the AUD to appreciate, and the RBA when it buys AUD.

Supply comes from anyone selling them: Australians buying imports, Australians investing overseas, speculators expecting a depreciation, and the RBA when it sells.

What shifts them

Commodity prices and the terms of trade are the dominant influence. Higher commodity prices raise export income and increase demand for AUD, which is why the AUD is described as a commodity currency and why it moves with Chinese industrial demand.

Interest rate differentials matter next. When Australian rates sit high relative to overseas, foreign investors buy Australian assets for the higher return, which increases demand for AUD. That is the carry trade, and it is the exchange rate channel of monetary policy.

Relative inflation rates work more slowly. Higher Australian inflation erodes international competitiveness, which reduces demand for exports and therefore for the currency.

Expectations and speculation can dominate everything else in the short run, since the large majority of foreign exchange turnover is speculative rather than trade-related.

Beyond those, relative growth rates, political stability and global risk sentiment all play a part. The AUD is treated as a risk-on currency, so it tends to fall whenever global investors turn cautious.

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Changes in exchange rates

An appreciation is a rise in the value of the AUD under a floating rate.

A depreciation is a fall.

Get the terminology right, because it signals whether you understand the regime. Under a floating rate the words are appreciation and depreciation, since the market moves the rate. Under a fixed rate they are revaluation and devaluation, since a government moves it deliberately.

NESA's 2025 examiners reported that responses confused the effects of depreciation with those of appreciation. Write the direction in the margin before you start.

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Determination of exchange rates

Floating

The rate is set by market demand and supply with no government intervention. Australia floated in December 1983.

The advantages start with automatic adjustment. A falling terms of trade depreciates the currency, which cushions export income, making the float a built-in shock absorber. It also delivers monetary policy independence, since the RBA can set the cash rate for domestic conditions instead of defending a peg. And it removes the need to hold large foreign reserves.

The costs are volatility and uncertainty for exporters and importers, who have to hedge; speculation that can push the rate away from fundamentals; and rapid depreciation importing inflation.

Fixed

The government sets the rate and defends it by buying or selling its own currency.

It offers certainty for trade and investment, and a check on domestic inflation where the peg is to a low-inflation currency. Against that it requires large foreign reserves, subordinates monetary policy to defending the peg, and allows the rate to become badly misaligned, which invites a speculative attack.

Managed

Intermediate arrangements exist between the two, including a crawling peg and a dirty float where the currency floats but the central bank intervenes to smooth movements. Australia's arrangement is technically a float with occasional intervention.

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The influence of the Reserve Bank

Even under a float the RBA can influence the rate, through two mechanisms that students routinely merge.

Direct intervention means buying or selling AUD in the foreign exchange market. To support the currency the Bank buys AUD using foreign reserves, increasing demand. To lower it, the Bank sells AUD, increasing supply. Intervention is now rare and is used to correct disorderly markets rather than to target a level, and the RBA's stated position is that it does not try to hold the rate anywhere in particular. Dirtying the float is intervention accompanied by an announcement, intended to shift expectations as well as the rate.

Monetary policy is the second mechanism and by far the more powerful. Changing the cash rate alters the interest rate differential and therefore capital flows, which moves the exchange rate. But the exchange rate is a by-product here, because the cash rate is set for domestic conditions rather than for the currency.

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Effects of exchange rate fluctuations

A depreciation

Exports become cheaper in foreign currency terms, so export volumes rise. Imports become more expensive in AUD terms, which encourages expenditure switching towards domestic substitutes. Net exports rise, adding to aggregate demand and, through the multiplier, to real GDP and employment.

None of it happens immediately, though, which is the J-curve.

In the short run, contracted import volumes are relatively price-inelastic, so the higher AUD cost of the same physical imports dominates and the trade balance worsens. Only once volumes respond does it improve.

On inflation, a depreciation raises the AUD price of imported consumer goods, capital equipment and intermediate inputs, most significantly fuel, which is priced in US dollars. That is imported inflation, and it feeds through business input costs into second-round effects on domestic prices.

This is live right now. With the AUD around US$0.70, headline inflation at 3.8% and trimmed mean at 3.6% over the year to June, both above the RBA's 2 to 3% band, further depreciation would compound the pressure that drove three consecutive cash rate increases to 4.35% by May 2026.

On the balance of payments, the AUD servicing cost of foreign-currency debt rises, worsening the net primary income deficit, while foreign-currency assets held by Australians rise in AUD value. That is the valuation effect, and it cuts both ways.

An appreciation

The reverse throughout: exports less competitive, imports cheaper, downward pressure on inflation, and a squeeze on export and import-competing industries. The 2024 Section IV question asked exactly this, about the impacts of an AUD appreciation on individuals, firms and government.

Since these questions are usually framed by sector, it is worth holding the pattern in a table:

	Depreciation	Appreciation
Exporters	Gain competitiveness	Lose competitiveness
Import-competing firms	Protected	Squeezed
Importers and consumers	Pay more	Pay less
Travellers abroad	Worse off	Better off
Inflation	Upward pressure	Downward pressure
Foreign debt servicing	More expensive	Cheaper

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What the exam does with this

Exchange rates carry Section II questions almost every year and full extended responses regularly, including 2020 Q25, 2022 Q25 and 2024 Q28.

Five things to get right.

Draw the forex diagram, and only the panel the question needs. If the question names a cause, that tells you which curve moves. Label the axes correctly, with US$ per A$ on the vertical and quantity of Australian dollars on the horizontal.

Keep appreciation and depreciation straight, because the examiners flagged exactly this in 2025.

Use the J-curve whenever a question links a depreciation to the balance of payments. It is the difference between a good answer and a complete one.

Separate the two RBA mechanisms, direct intervention and monetary policy, and say that they are separate.

Give both sides. A depreciation helps exporters and hurts consumers through imported inflation, and naming who gains and who loses is exactly what a question about the impact on the economy is asking for.

Related notes: Australia's Balance of Payments · Monetary policy · External stability · The diagram guide