The exchange rate is the value of the Australian dollar against another currency (e.g. compared to the $US) or a basket of currencies of our major trading partners (e.g. the Trade Weighted Index). If the value of the exchange rate increases, it is likely to have a negative effect on economic growth for three main reasons:
This demand side impact is mitigated somewhat by the supply side impact that stems from lower costs for imported capital equipment that decreases prices and costs of production, thereby lifting AD and real GDP. Overall, however, the demand side impact on economic growth outweighs the supply side impact such that a higher AUD provides a constraint to growth.
With respect to low inflation, both the demand and supply side impacts have reinforcing effects when the dollar rises. The higher AUD reduces demand inflationary pressure even though the lower demand is for goods and services sold to overseas residents. This is largely because Australian exporters also typically produce for the local market. When they experience a decrease in demand, they reduce prices for Australian consumers of the same product. For example, tourism providers that lose custom from foreign tourists are more likely to reduce prices in order to attract local tourists. Further, the lower incomes resulting from lower export demand has flow on disinflationary effects. In addition, the higher AUD causes the costs of production for Australian producers to fall on average as the costs of imported capital equipment and intermediate goods (e.g. imported inputs) are now lower.
The lower economic growth should reduce the demand for labour and employment and increase the unemployment rate, thereby making it more difficult to achieve full employment. With less employment it is expected that the outcome for equity in the distribution of income would deteriorate given that there should be greater reliance on welfare.
With respect to the impact on external stability, with a deterioration in net exports, the higher AUD is expected to cause the Balance on Goods and Services to become less favourable and the CAD should rise. However, to the extent that any foreign debt is denominated in foreign currency (e.g. USD), the net primary income section of the current account should improve as Australian borrowers will pay less to service their foreign debt. In reality, borrowers protect against 'currency risk' via complicated hedging arrangements and we should expect the CAD to rise when the AUD increases.