Appreciation & Depreciation of the Currency
What Causes Changes in Demand and Supply?
As the Australian dollar is a dirty float, in most occasions, the price of the currency is determined by market forces of supply and demand. Supply movements are determined by changes in the debit transactions of the balance of payments, such as:
Changes in imports
Changes in income debits (income sent abroad)
Changes in Australian investment abroad Demand movements are determined by changes in the credit transactions of the balance of payments, such as:
Changes in exports
Changes in income credits (income sent into Australia)
Changes in foreign investment
Appreciation of the Currency
An appreciation is where the price of one currency rises in terms of another priced currency. An appreciation of the currency can occur when demand increases and/or a decrease in supply has occurred as shown in the above image.
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Factors affecting an Appreciation of the Currency
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Increase in Demand:
An appreciation of the currency can occur if demand increases, as shown in the left model showing a shift to the right of the demand curve from D1 to D2. As a result, the price of AUD to USD has appreciated from P1 to P2 and quantity of Australian dollars on the currency markets has increased from Q1 to Q2. An increase in demand occurs from an increase credit transactions of the balance of payments, which can include:
An increase in exports
An increase in income credits
An increase in foreign investment
An increase in demand is one the prominent reasons to why the Australian dollar appreciated sharply during the mining investment boom to $1.10 USD. Large increases in foreign investment and exports saw an increase in demand and hence, causing the currency to appreciate.
Decrease in Supply:
An appreciation of the currency can occur if supply decreases, as shown in the right model showing a shift to the left of the supply curve from S1 to S2. As a result, the price of the AUD to the USD has appreciated from P1 to P2 and the quantity of Australian dollars on the currency markets has decreased from Q1 to Q2. A decrease in supply occurs from a decrease in debit transactions of the balance of payments, which can include:
A decrease in imports
A decrease in income debits
A decrease in Australian investment abroad
Effects of an Appreciation
An appreciation of the currency will reflect lower net exports as exports become more expensive for overseas buyers, positioning them as internationally uncompetitive while imports will become cheaper and more competitive with goods and services. Aggregate supply may increase as cheaper imports means that cost of inputs such as oil or cheaper and that businesses can purchase more imported capital which will improve aggregate supply in the long run.
Depreciation of the Currency
A depreciation is where the price of one currency falls in terms of the price of another country's currency. A depreciation can occur when there's a fall in demand and/or an increase in the supply of a currency as show in the image above.
Factors Affecting a Depreciation of the Currency
Decrease in Demand
A decrease in demand from D1 to D2 will depreciate the currency from P1 to P2 and also cause the quantity of Australian dollars in the currency market to fall from Q1 to Q2. A decrease in demand is caused by a decrease in credit transactions of the balance of payments, which can include:
Decrease in exports
Decrease in income credits
Decrease in foreign investment Increase in Supply An increase in supply from S1 to S2 will depreciate the currency from P1 to P2 and also cause the quantity of Australian dollars in the currency to increase from Q1 to Q2.
Increase in Supply
An increase in supply is caused by an increase in debit transactions of the balance of payments, which can include:
An increase in imports
An increase in income debits
An increase in Australian investment abroad
Effects of a Depreciation
A depreciation will increase net exports as exports will become cheaper for overseas buyers, making them more internationally competitive while imports become more expensive and less competitive with domestic goods and services.