What Causes the Australian Dollar to Fluctuate and What Effect Does It Have?

You can’t turn on the news or flick through the Sunday paper without seeing something about the current value of the Australian dollar. Of course, we know it’s important to us, particularly if you like getting your hands on imported US goods, but the value of the dollar has a vast array of implications for our economy too.

And while you may think that a low Aussie dollar is all bad, it can actually have some positive effects for foreign trade at the same time.

To use a very simple example, let’s say that Australia exports really, really great potatoes for $100 a kilo. The US freaking love our potatoes, so they are a regular importer and at the time, the exchange rate is $AU1 for $US1. Easy. The US gobble as many delicious, ground dwelling taters that they can get their Donald Trump loving hands on.

But then the Australian dollar takes a little punch in the face and drops to a value of $US0.90. The US are stoked, because now they can import our incredible potatoes at a lower price. Bonza!

While this sounds bad for us, it can actually be a benefit in some ways. Being able to import our goods for a lower price increases the international competitiveness of our stuff, which will usually result in a higher output of stock, translating to higher potato revenue. Of course, in this situation, the goods that we like to import from other countries with a stronger currency are gonna start costing us more.

On the other side of the coin (see what I did there?), a rise in the value of the Australian dollar will usually result in lower exports, as the US will probably look for their potato fix elsewhere to save money, but makes importing goods cheaper for us. It’s all about balance.

The value of currency can also influence inflation and interest rates, something we’ll touch on shortly.

So what causes the value of currencies to fluctuate? There are many technical reasons that economists love to argue over, but it’s important to remember that the experts are wrong more than you’d think. That being said, most of them agree on the following six factors.


Inflation rates


Inflation, as the name suggests, is the increase in price for goods and services. A country with a low inflation rate will usually see the value of their currency rise.

When inflation goes up, the buying power of that country’s money goes down. To go back to our delicious potatoes, if $100 buys you one, but the inflation rate is 2% annually, the same potato will cost you $102 in a year’s time. This will drive the value of that currency down.

When inflation is cray.


Interest rates


Also known as the cash rate or monetary policy, the interest rate of a country’s central bank (their main bank) decides the rate at which interest is charged to commercial banks (like our Westpac, Commonwealth etc.) on overnight loans.

Increases to interest rates result in the strengthening of that country’s currency, as foreign investors are likely to take advantage of higher returns on investments. Basically, higher rates create more demand for that currency, increasing its value.


Current account deficits


This means that a country is spending more on imports than it’s making from its exports, meaning it then needs to borrow money from other countries to finance the deficit.

As you probably guessed, this results in a decline in the value of their currency.


Level of public debt


Countries that run a bloody huge budget deficit to fund public projects, while stimulating to the local economy, will often deter foreign investors.

The reason being that large debts encourage inflation, and a high rate of inflation, as you read earlier, will lower the value of the currency in question. If foreign investors are vampires, then low interest rates are their garlic. They hate that shit.


 Terms of trade


This is the difference in the price of exported goods and the cost of imported goods. If a country is running positive terms of trade, it means that they’re getting a higher price for their exports compared to what they’re paying for their imports.

In general terms, the better they do with their terms of trade, the stronger their currency will be due to the overall revenue being made.


Stability


Political stability and economic growth play a big role in investor confidence. Stable countries with positive growth will perform the best, while those in the midst of political turmoil will see their currency decline.

Potential investors want steady returns on their money, but something like political upheaval has a good chance of spooking those who are already invested to pull out, in turn, decreasing the value of that currency.

It’s important to note that the economy is a super complex beast, so there a lot of other technical factors that come into play when we’re talking about currency fluctuation. This is intended to be an entry level explanation of the reasons that economists widely agree on, but if you’re interested in learning more, I’d absolutely encourage you to do so! Investopedia is a great place to start.

Feature image: Aaron Tyler