Understanding the appreciation of the Australian dollar and its policy implications
A commonly used measure of the real effective exchange rate is the RBA's real TWI,
which uses the core consumer price index (CPI) measure of price levels (which
excludes food and energy).
There are also alternative weighting schemes. Movements in trade-weighted measures
such as the real TWI provide only a rough measure of changes in Australia's trade
competitiveness, since weights based on trade shares do not capture changes in prices
relative to countries that are competing suppliers to our exports in third countries
The economic role of the exchange rate
In an open economy, the exchange rate is a key economy-wide relative price that helps
to maintain equilibrium across both the financial and real sides of the economy. The
exchange rate — along with other variables such as interest rates, output and prices —
adjusts to simultaneously equate demand and supply in the foreign exchange market,
other financial markets, and goods and services markets.
Most importantly, movements in the nominal exchange rate play a critical role in
allowing the real economy to adjust to shocks while limiting the impacts on
macroeconomic stability. As the currency normally appreciates (depreciates) in
response to shocks that have a stimulatory (contractionary) impact on the economy,
the exchange rate functions as an automatic stabiliser that helps keep the economy
growing at a rate consistent with its non-inflationary level of capacity utilisation (full
For instance, a shock that boosts demand for Australian goods requires domestic
prices to rise relative to foreign prices (that is, a real exchange rate appreciation) unless
there is substantial spare capacity in the economy.
This brings demand and supply
into line by shifting spending from domestic to foreign goods and by promoting
increased supply of domestic goods. Similarly, a shock that reduces demand for
Australian goods will require a real depreciation.
Under a flexible exchange rate regime, where monetary policy targets low inflation,
these relative price movements occur mainly through the nominal exchange rate. This
is closely linked to the operation of monetary policy, as the exchange rate tends to
appreciate (depreciate) when domestic interest rates rise (fall) relative to foreign
interest rates. When the economy is strong (weak), monetary policy will be tighter
Unless otherwise stated, impacts on the exchange rate are discussed on the assumption that
other things are unchanged, including in the rest of the world. A shock with identical effects
on Australia and our trading partners would not affect the exchange rate. Hence, the
exchange rate only helps adjustment to shocks that are 'asymmetric'.