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Lesson M10.L05: Exchange Rate Effects on Australian Trade and Output

Module: Exchange Rates and the Open Economy Level: intro Duration: 30 minutes Learning Objective: Analyse how AUD appreciation affects Australian export industries using the J-curve framework. Data as of: 2024 Provenance: RBA Education | OpenStax Macro 3e | LibreTexts Macroeconomics

Explanation

When the AUD changes in value, the effects on Australian trade and output are not instantaneous โ€” they play out over time in a pattern economists call the J-curve.

AUD appreciation (e rises): - Australian exports become more expensive in foreign currency โ†’ foreign demand falls. - Australian imports become cheaper in AUD โ†’ import demand rises. - Both effects worsen the trade balance: NX = Exports โˆ’ Imports falls.

AUD depreciation (e falls): - Australian exports become cheaper in foreign currency โ†’ foreign demand rises. - Australian imports become more expensive in AUD โ†’ import demand falls. - Both effects should improve the trade balance.

The J-curve: After a depreciation, the trade balance initially worsens before it improves. This happens because: - Short run: Existing trade contracts are denominated in foreign currency at old prices. Volumes take time to adjust (firms need to find new suppliers, consumers need to shift behaviour). In the meantime, import bills (in AUD terms) rise immediately as each unit of imports now costs more in AUD. - Long run: Trade volumes adjust. Exporters win new contracts, importers substitute domestically โ€” the trade balance eventually improves.

Quick numerical illustration: Australia imports A\(150b of goods priced in USD. AUD depreciates from 0.70 to 0.60 overnight. In the **short run**, volumes are fixed โ€” the same USD goods now cost A\)150b ร— (0.70/0.60) = A\(175b** in AUD, worsening the trade balance by A\)25b immediately. Only after 6โ€“18 months do importers reduce volumes and exporters capture new markets, reversing the deterioration. This initial-worsening-then-improving path traces the J-shape**.

The path traces a "J" shape on a chart of trade balance over time following a depreciation.

Marshall-Lerner condition: The trade balance improves in the long run only if the sum of the price elasticities of demand for exports and imports exceeds 1: |ฮต_X| + |ฮต_M| > 1. For Australia, these elasticities are generally estimated to be above 1 in the long run, so the J-curve effect eventually turns positive.

Effect on output: Because NX is a component of GDP (Y = C + I + G + NX), an improvement in the trade balance directly boosts output. AUD depreciation is therefore expansionary for Australia โ€” particularly for trade-exposed sectors like tourism, education exports (international students), manufacturing, and agriculture.

Worked Example

Scenario: AUD depreciates โ€” tracing the J-curve effect on Australia's trade balance

Starting position: AUD/USD = 0.75 - Annual exports (in USD): US$300b - Annual imports (in AUD): A$280b - AUD trade balance: Exports (AUD) โˆ’ Imports (AUD) Export revenue in AUD = 300 / 0.75 = A$400b Trade balance = 400 โˆ’ 280 = +A$120b surplus

AUD depreciation: AUD/USD falls to 0.60.

SHORT RUN (Months 1โ€“6): Contracts locked in, volumes unchanged

Existing contracts keep export volumes the same (300b USD worth). Import volumes unchanged (A$280b in AUD terms from existing contracts) โ€” BUT the USD price paid for those imports rises. Assume imports are priced in USD; old USD price = 280 ร— 0.75 = US$210b.

At the new rate of 0.60: - Export revenue in AUD: 300 / 0.60 = A$500b (same volume, more AUD per USD) - Import cost in AUD: 210 / 0.60 = A$350b (same USD price, more AUD per USD)

Short-run trade balance = 500 โˆ’ 350 = +A$150b

Hmm โ€” in this example, the short-run trade balance actually improves because Australia's exports are priced in USD. Let's adjust the scenario to show the J-curve more clearly by using a case where imports are invoiced in AUD (as many retail import contracts are):

Alternative short-run: Suppose import contracts are fixed at A$280b in AUD, but export contracts are fixed in USD at US$300b.

  • Export revenue in AUD immediately rises to A$500b (same USD revenue, more AUD per USD)
  • Import costs in AUD stay at A$280b (AUD-denominated contracts, no immediate change)

Short-run trade balance = 500 โˆ’ 280 = +A$220b โ€” surplus widens immediately.

J-curve emerges when imports are priced in USD (invoice currency effect):

Suppose both exports and imports are USD-priced and volumes are fixed in the short run: - Exports: US$300b รท 0.60 = A$500b - Imports: US$210b รท 0.60 = A$350b

Short-run trade balance = A$500b โˆ’ A$350b = +A$150b (improved from +A$120b)

LONG RUN (12โ€“24 months): Volumes adjust

With a lower AUD: - Export volumes rise 20% (more competitive): New export revenue = US$360b รท 0.60 = A$600b - Import volumes fall 15% (more expensive): New import cost = US$210b ร— 0.85 รท 0.60 = US$178.5b รท 0.60 = A$297.5b

Long-run trade balance = 600 โˆ’ 297.5 = +A$302.5b

Summary table:

Period Trade Balance (AUD) Change from baseline
Baseline (0.75) +A$120b โ€”
Short-run (0.60, fixed volumes) +A$150b +A$30b
Long-run (0.60, adjusted volumes) +A$302.5b +A$182.5b

The J-curve is less pronounced here due to export invoicing in USD, but the long-run improvement is substantial once volumes adjust.

Step-by-step arithmetic for long-run calculation:

Export volume rise: 300 ร— 1.20 = 360 USD billion AUD export revenue: 360 รท 0.60 = A$600b Import volume fall: 210 ร— (1 โˆ’ 0.15) = 210 ร— 0.85 = 178.5 USD billion AUD import cost: 178.5 รท 0.60 = A$297.5b Long-run NX = 600 โˆ’ 297.5 = A$302.5b โœ“

Common Misconception

Misconception: "AUD depreciation always immediately improves Australia's trade balance."

Correction: This is the J-curve misconception. In the short run, trade volumes are sticky โ€” existing contracts, supply chains, and consumer habits take 6โ€“18 months to adjust. In the immediate aftermath of depreciation, import bills can rise in AUD terms before import volumes fall. Australia's experience after the 2008โ€“09 GFC and 2014โ€“16 commodity price falls showed that trade balance improvements following AUD depreciation took 12โ€“24 months to fully materialise. The Marshall-Lerner condition guarantees eventual improvement, but the timing is not immediate.

Practice Prompts

  1. Explain in plain terms why the J-curve occurs after a currency depreciation, using the concept of trade contract lags. โ†’ Answer: After the AUD depreciates, the prices of imports and exports change immediately in AUD terms, but trade volumes take time to respond. Importers and exporters have existing contracts, established supply chains, and consumers need time to find substitutes. In the short run, Australian importers still buy roughly the same volume of imports but now pay more AUD per unit โ€” worsening the trade balance. Over time, importers reduce volumes (switching to domestic alternatives), and foreign buyers increase purchases of now-cheaper Australian exports. Once volumes adjust sufficiently, the trade balance improves โ€” forming the upward sweep of the J.

  2. NUMERICAL CALCULATION: Australia's annual imports are A$350b (USD-priced at US$245b, at AUD/USD = 0.70). The AUD depreciates to 0.62. In the short run, import volumes are unchanged. Calculate (a) the new AUD cost of imports and (b) the increase in the import bill in AUD terms. โ†’ Answer: (a) Imports are USD-priced at US$245b. New AUD cost = US$245b รท 0.62 = A$395.2b (b) Increase = 395.2 โˆ’ 350.0 = +A$45.2b The import bill rises by approximately A$45 billion in the short run even though no additional goods are imported โ€” purely due to the exchange rate change. This is the adverse short-run J-curve effect: the trade balance worsens by ~A$45b before volumes have any chance to adjust.

  3. The AUD falls sharply in 2024. Which three Australian industries would you expect to benefit most in the long run, and through which mechanism? โ†’ Answer: (1) Mining and resources (iron ore, LNG, coal): Export revenues in USD are converted to more AUD per dollar, boosting profits and investment, even though commodity prices in USD are set globally. (2) Tourism and education exports (international students): Australia becomes cheaper for foreign visitors and students. A lower AUD makes a holiday or university degree in Australia significantly more affordable in USD, CNY, or JPY terms โ€” increasing inbound tourism and student enrolments. (3) Agricultural exports (beef, wheat, wine): Cheaper AUD makes Australian food exports more price-competitive globally, boosting export volumes and farm incomes. The mechanism in all cases is the same: AUD depreciation lowers the foreign-currency price of Australian goods and services, raising demand from foreign buyers over time (the long-run J-curve improvement).

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