Since 1983, Australia has operated under a floating exchange rate system, meaning that the market factors of supply and demand are the determinants of the exchange rate. Understanding the factors that shape these forces is important for businesses, investors, and policymakers, as they impact the value of the Australian dollar and, consequently, the country's economic performance.

What Factors Affect the Demand and Supply of AUD?

The exchange rate of the Australian Dollar (AUD) is influenced by the following factors:

Interest Rates

When Australian interest rates are relatively higher compared to other countries, foreign investors are attracted to Australian financial assets, as they offer a higher return. This increased demand for Australian assets leads to a corresponding demand for the Australian dollar, as investors need to acquire the currency to make their investments. The following supply and demand graph demonstrates this exchange rate shift. This type of graph can be useful in your HSC economics essays.

Conversely, when there is a decrease in Australian interest rates, the opposite occurs. Because Australian financial assets offer a lower return, the demand for Australian dollars is reduced, thus decreasing their exchange rate.

Economic Growth and Stability

The stability of the Australian economy is key to influencing the demand for the Australian dollar. A growing economy, characterised by increasing GDP, low unemployment, and stable inflation, instils confidence in investors and attracts foreign capital. As Australia has maintained a relatively strong economic performance over the past few decades, it has contributed to the sustained demand for the Australian dollar.

Commodity Prices

As a major exporter of commodities, such as iron ore, coal, and agricultural products, Australia's currency is closely tied to global commodity prices. When commodity prices are high, it increases the terms of trade, and foreign buyers need more AUD to purchase these commodities, driving up its value. Conversely, when commodity prices fall, the demand for the Australian dollar may weaken.

However, this can lead to an economic concept termed 'Dutch disease'. Dutch disease is an economic phenomenon where a boom in one export sector (usually natural resources) leads to negative effects on other sectors of a country's economy. It typically occurs when a country discovers or begins exporting a valuable resource, causing its currency to appreciate. This stronger currency makes other exports less competitive internationally, potentially leading to a decline in manufacturing and other non-resource sectors.

Government and RBA Policies

Government and Reserve Bank of Australia (RBA) policies also impact the AUD through fiscal and monetary policy channels. Government fiscal policies and public debt levels can also influence investor perception and thus the demand for the currency. Furthermore, when the RBA engages in expansionary monetary policy, such as lowering interest rates or implementing quantitative easing, it increases the supply of Australian dollars in the market. As a result of this, there is a depreciation in Australian currency.

Conversely, when the RBA adopts a contractionary stance, it reduces the supply of the currency, thus causing an appreciation of Australian currency. The following graph, which can be used in your economic essays, displays the effects of a contractionary monetary policy stance.

As the graph shows, a decrease in the supply of Australian dollars increases their price. This is because the scarcity of the currency has increased, making it harder for international investors to obtain any.

Speculation and Market Sentiment

Market sentiment and speculation can cause short-term fluctuations in the AUD. Investor perceptions about Australia's economic outlook, political stability, and global economic conditions can lead to speculative trading, impacting the currency's value. If a country's economy is expected to boom, investment increases, resulting in an increased demand for Australian dollars. As a result, there is an appreciation of AUD. Conversely, a speculated decline in an economy's outlook has the inverse effect.