QCE Economics - Unit 3 - International trade

Exchange Rates and the Forex Market | QCE Economics

Learn fixed, managed and floating exchange rates, AUD demand and supply, appreciation, depreciation and exchange rate impacts for QCE Economics.

Updated 2026-05-18 - 8 min read

An exchange rate is the price of one currency in terms of another currency. If AUD 1 buys USD 0.68, the Australian dollar has a value of 68 US cents. Exchange rates matter because international trade requires payments across currencies.

The foreign exchange market, or forex market, is where currencies are bought and sold. In QCE Economics, you use demand and supply diagrams to explain why the AUD appreciates or depreciates.

Exchange rate systems

| System | How the rate is determined | Strength | Limitation | |---|---|---|---| | Fixed | Government or central bank fixes the currency to another currency or value | Predictability for traders | Requires reserves and can create internal instability | | Managed | Market forces set the rate, but the central bank may occasionally intervene | Allows flexibility with some smoothing | Intervention may be costly or only temporary | | Floating | Demand and supply determine the rate | Absorbs external shocks and allows monetary policy independence | Volatility creates risk for exporters and importers |

Australia has had a floating exchange rate since December 1983. That means the AUD moves when demand for, or supply of, Australian dollars changes.

Under a fixed system, the government or central bank must be willing to buy and sell currency to defend the chosen rate. This can support trade planning because firms face less currency uncertainty. The trade-off is that the central bank may need large foreign reserves, and the fixed value may become inconsistent with market conditions. If a country fixes its currency too high, exports can become uncompetitive and the balance of payments can weaken. If it fixes too low, import prices and inflation can rise.

A managed exchange rate is mainly market-determined, but the central bank may enter the market to smooth disorderly movements. If the AUD were appreciating rapidly, the Reserve Bank could sell AUD and buy foreign currency, increasing AUD supply. If the AUD were depreciating rapidly, it could buy AUD and sell foreign currency, increasing AUD demand. This does not guarantee a target value; it attempts to reduce excessive volatility.

A floating system allows the exchange rate to move as an automatic adjustment mechanism. It gives monetary policy more independence because the central bank does not need to set interest rates mainly to defend a fixed currency value. The cost is uncertainty: exporters, importers and investors face exchange-rate risk.

Trade Weighted Index

The Trade Weighted Index, or TWI, measures the AUD against a basket of currencies from Australia's major trading partners. Each currency is weighted according to its importance in Australia's trade. This is useful because a bilateral rate such as AUD/USD may move differently from the AUD's average movement against all major trading partners.

For example, the AUD could appreciate against the US dollar but depreciate against several Asian trading partner currencies. The TWI gives a broader indicator of Australia's external price competitiveness.

Demand for the AUD

Demand for AUD is created when foreigners need Australian dollars. This happens when money flows into Australia.

| Demand factor | Why it increases demand for AUD | |---|---| | Exports of goods | Foreign buyers need AUD to pay Australian producers for commodities, agriculture or manufactured goods. | | Exports of services | Tourists, international students and overseas clients need AUD to buy Australian services. | | Foreign investment into Australia | Investors buy AUD to purchase Australian shares, bonds, property or direct business assets. | | Higher relative interest rates | Australian financial assets become more attractive, encouraging capital inflow. | | Stronger commodity prices or terms of trade | Export receipts rise, especially for resource exports, increasing demand for AUD. | | Speculation | Traders may buy AUD now if they expect it to appreciate later. | | Income flows into Australia | Interest, dividends or wages paid to Australian residents may require AUD conversion. |

If demand for the AUD increases, the demand curve shifts right and the AUD appreciates.

Supply of the AUD

Supply of AUD is created when Australians sell Australian dollars to buy foreign currencies. This happens when money flows out of Australia.

| Supply factor | Why it increases supply of AUD | |---|---| | Imports of goods | Australians sell AUD to obtain foreign currency for imported vehicles, machinery, fuel or consumer goods. | | Imports of services | Overseas travel, freight, insurance and digital services require payment in foreign currency. | | Australian investment overseas | Australian investors sell AUD to buy foreign assets. | | Lower relative interest rates | Capital may flow out if overseas returns become more attractive. | | Income payments overseas | Dividends, profits and interest paid to foreign owners or lenders create currency outflows. | | Speculation | Traders may sell AUD if they expect it to depreciate. |

If supply of the AUD increases, the supply curve shifts right and the AUD depreciates.

Four common forex shifts

The forex market uses the same price mechanism logic as other markets: demand and supply shifts create a new equilibrium exchange rate. In diagrams, the vertical axis is the exchange rate, such as USD per AUD, and the horizontal axis is the quantity of AUD traded.

| Shift | Likely cause | Effect on AUD | |---|---|---| | Demand for AUD increases | Export receipts rise, foreign investment increases, Australian interest rates become relatively attractive or speculators expect appreciation | AUD appreciates | | Demand for AUD decreases | Export demand falls, commodity prices fall, foreign investors lose confidence or speculators expect depreciation | AUD depreciates | | Supply of AUD increases | Imports rise, Australians invest overseas, overseas travel rises or income payments to foreign investors increase | AUD depreciates | | Supply of AUD decreases | Imports fall, Australians invest less overseas or fewer AUD are sold for foreign currency | AUD appreciates |

Shortage and surplus reasoning helps explain the movement. If demand for AUD increases at the old exchange rate, buyers want more AUD than sellers provide, creating upward pressure on the AUD price. If supply increases at the old exchange rate, sellers offer more AUD than buyers want, creating downward pressure on the AUD price.

Appreciation and depreciation

Appreciation means the AUD increases in value under a floating exchange rate. Depreciation means it decreases in value.

| AUD appreciation | AUD depreciation | |---|---| | Imports become cheaper for Australians | Imports become more expensive for Australians | | Exports become more expensive for overseas buyers | Exports become cheaper for overseas buyers | | Imported inflation pressure may fall | Imported inflation pressure may rise | | Foreign-currency debt becomes easier to service in AUD terms | Foreign-currency debt becomes more expensive in AUD terms | | Exporters may lose competitiveness | Exporters may gain competitiveness |

The effects also differ over time.

| Movement | Short-run effect | Possible long-run adjustment | |---|---|---| | Appreciation | Importers and consumers gain purchasing power; exporters may receive fewer AUD for each unit of foreign revenue | Import-competing firms face more pressure, export industries may cut costs or shift toward quality and non-price competitiveness | | Depreciation | Exporters gain price competitiveness; importers face higher input costs and consumers face higher import prices | Net exports may rise if demand responds, but inflation and foreign-currency debt servicing can worsen |

Terms of trade

The terms of trade compare export prices with import prices:

$ \text{Terms of trade index}=\frac{\text{Export price index}}{\text{Import price index}}\times 100 $

If Australia's export prices rise relative to import prices, the terms of trade improve. This can increase export receipts, national income and demand for the AUD. Commodity prices are especially important for Australia because resources are a large share of exports.

Floating exchange rates and external shocks

A floating exchange rate can insulate the economy from external shocks. Suppose world demand for Australian exports falls. Export receipts fall, demand for AUD falls and the AUD depreciates. The depreciation makes exports cheaper to overseas buyers and imports more expensive to Australians, partly cushioning the fall in net exports.

This does not remove the shock. It adjusts relative prices so the economy absorbs some pressure automatically.

Worked example

Quick check

Sources

• QCAA Economics subject page
• QCAA Economics 2025 syllabus
• Reserve Bank of Australia: Exchange rates and their measurement
• Reserve Bank of Australia: Historical data