By Professor of Economics John Hicks in the Charles Sturt University School of Business.

There are many dynamic factors that affect the cost of overseas travel for Australians, not least being inflation, interest rates, currency investors and Australia’s distance from European and American tourism destinations.

Foreign currencies

Before travelling overseas, a person must first exchange their Australian dollars for the currency(ies) of the country(ies) to which they wish to travel.

Americans, for example, are generally not interested in providing Aussie tourists with the goods and services they seek (chocolate ice-cream sundae at Ghirardelli’s in San Francisco or entry into LA’s Disneyland) in return for Australia’s plastic money. They want ‘greenbacks’ – US dollars.

To acquire US dollars, the Aussie tourist must buy them.

They can do so at their bank in Australia or at any airport currency-exchange kiosk. Or, in this digital world, they can use their bank card where the conversion is done through the provider effectively selling you US dollars to complete the transaction.

How much can money buy?

The price at which you are able to buy US dollars is known as the exchange rate. At the time of writing , an Australian dollar (AUD) could buy you about 65 US cents or 0.65 US dollars (USD).

Back in February of 2023, that same Aussie dollar would have fetched over 71 US cents. In February of 2008, the AUD was doing much better and could buy nearly 95 US cents, although in September of 2001 it was doing much worse than now and could purchase only 49 US cents.

Like the price of all goods and services, the price of foreign currency will change as the conditions of supply and demand in the market change – and as the price changes the amount of fun we can have with our holiday savings will also change.

Overseas travel a costly exercise

A falling Australian dollar (against the US dollar) is unwelcome news for travellers to the US.

As the Australian dollar falls, the cost of everything tourists want to buy in the US rises; not because the US dollar price of these goods and services rises, but because the Australian dollar price of buying a US dollar increases and this raises the outlay we have to make in terms of Australian dollars for everything we want to buy in the US.

The fluctuations we observe in the exchange rate over time are inevitable as the Australian government, like most modern governments, has decided that the value of their currency will be freely determined by the market for foreign exchange, with only a modicum of intervention.

A case of supply and demand

Like any market, there is both a demand side and a supply side. The demand for Australian dollars in the foreign exchange market is determined by the desire of foreigners, such as US citizens, to buy Australian goods and services.

As the price of AUD falls in terms of USD, Americans will demand more AUD because they can essentially get more Australian goods and services for much less of their home currency.

On the flip side, Australians are discouraged from buying US goods, therefore reducing the amount of AUD supplied to the foreign exchange market.

When the demand inevitably exceeds supply from this, the price of the Australian dollar will be bid up establishing a new equilibrium exchange rate of the AUD against the USD.

The opposite outcome will occur when the demand for AUD declines and the supply increases.

How did we get here?

There are investors in both Australia and America who are looking for somewhere profitable to put their money. In June of last year, they could have purchased Australian long-term government bonds earning 3.77 per cent per annum or similar US government bonds earning 3.14 per cent.

While there are many other things that investors in each country would consider, the relatively higher yield on long-term government bonds in Australia would have been a factor in encouraging both Australian and US investors to place their funds in the Australian securities rather than their US equivalents.

As a result, a decision by both Australian and US investors to buy Australian bonds reduced the supply of AUD in the market for foreign funds and raised the demand for the Australian Dollar.

Together, these decisions supported the AUD:USD exchange rate.

Twelve months later however, the differential in yields on the government bonds in question had narrowed considerably.

Although you could earn 3.9 percent per annum on Australian bonds, you could get 3.75 on US bonds.

The resulting increase in supply of AUD to the foreign exchange market by Australian investors wanting to buy US bonds and the reduction in demand for AUD by American investors now preferring to buy US bonds rather than Australian bonds is likely to have been a factor in bringing the exchange rate between the AUD and USD down.

What does the future hold?

As always, it is uncertain. One feature that does stand out, however, is the greater apparent success of the US in bringing inflation down.

At the time of writing their inflation rate was well below ours, sitting at 2.97 per cent compared with 6.11 per cent. Twelve months ago, the US had an inflation rate of more than nine per cent which was well in excess of our 6.17 per cent.

This swing in the inflation differential will also be impacting on our exchange rate.

As the average price of goods and services in Australia increases relative to those in America, both Americans and Australians will be switching their purchases away from the Australian items towards goods and services produced in the US.

In the process, the supply of AUD to the foreign exchange market will increase and the demand for AUD will fall – again likely bringing the exchange rate down and disrupting our travel plans.

ENDS