An exchange rate is the ratio at which a country's currency exchanges for the currency of another country. Exchange rates are typically expressed as the foreign currency equivalent of one unit of domestic currency. The exchange rate between Australia and the United States for example was $A1.00 = $US0. , (as of 2.12.99). The exchange rate is determined by the demand for, and supply of, that currency in terms of other currencies.

The major trading countries of the world use a system of floating exchange rates. Under this system, exchange rates are determined by the free market forces of supply and demand. In other words, the rate moves freely in response to competitive market forces. Demand and supply are determined in terms of overseas currencies. Those who have foreign currency and want to buy dollars with it provide the demand for Australian dollars. These include overseas people who want to buy our exports, tourists coming here, overseas people wanting to lend money here, or buy shares or property here, overseas firms setting up branches here or expanding them, and those who pay us for various services, such as rep

High inflation rates in Australia relative to those of our major trading partners mean that imported goods are cheaper than domestically produced goods. As Australian consumers switch their demand from local goods to imports, the supply of Australian dollars increases and the currency depreciates. The reverse occurs with low inflation rates. A rise in the level of income in Australia relative to those in other countries leads to an increase in the demand for imported goods. A currency depreciation occurs as the supply of Australian dollars rises. On the other hand, a fall will result in a currency appreciation. As consumer preferences change in favour of foreign goods and services, the demand for imports increases. The supply of Australian dollars on foreign exchange markets also increases and the currency depreciates.

The supply of Australian dollars on foreign exchange markets depends primarily on the economic activities of Australian residents. Just as foreigners must pay for our exports with Australian dollars, we must use the relevant foreign currency to pay for imported goods. An increase in demand for imported goods by Australian consumers adds to the supply of Australian dollars, and the currency depreciates. On the other hand, a fall in demand for imported goods reduces the supply of Australian dollars, causing a currency appreciation.

Consumer preferences and tastes change over time. Naturally, any change in the preferences of overseas consumers for our exports affects our exchange rate. If overseas consumers preferences change in favour of Australian-made goods, then demand for our currency to pay for these goods increases. This, in turn, causes an appreciation of the Australian dollar, and vice-versa in preferences c

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