Causes of a Decrease in Demand for the Australian Dollar and the Impact of a Sustained Depreciation on Australia’s Balance of Payments

Explain the causes of a decrease in demand for the Australian dollar and the impact of a sustained depreciation on Australia’s balance of payments performance.

One of Australia’s problems is that it is a small economy and relies largely on financial inflows to deal with its large external imbalances. This has made the Australian currency a ‘hot money’ currency, which has been subject to several periods of intense speculation. Speculative trade in the Australian dollar is substantially larger than trade that is directly related to the exchange of goods and services. The problems of excessive speculation and volatile currencies have become major global economic issues during the globalisation era, with many countries experiencing large swings in their currencies.

In an open economy, like Australia’s, the value of the exchange rate can change substantially in response to economic developments. One of the most important influences on the exchange rate is the performance of the balance of payments. But just as the balance of payments influence the value of the dollar; the value of the dollar can also influence the balance of payments – as well as several other areas of the economy.

Under a floating exchange rate the quantity of Australian dollar supplied must always equal the quantity demanded. This means that the net outflow of funds on the current account (supply) will equal the net inflow of funds on the capital and financial account (demand). Changes in the current account will influence the exchange rate and the capital and financial account, for example, if the value of imports increased, while exports remain unchanged, it would consequently result in a deterioration of the current account deficit (CAD). This would also cause an increase in the supply of the Australian dollar as importers will be selling more Australian dollars in order to buy foreign currency, thus resulting in a depreciation of the currency. Because of this depreciation in the...