For example, if the value of imports increased while exports remained unchanged, there would be a deterioration in the CAD. This would increase the supply of the $A as importers would sell more $A in order to buy foreign currency, leading to a depreciation of the dollar. As a result of this depreciation, a given level of financial inflows would be able to buy more $A, therefore the positive balance on the C&FA would increase in $A terms to match the bigger deficit on the CA.
Conversely, an improvement in the CAD results in an appreciation of the $A and a decrease in the surplus of the C&FA.
However, the most significant influence on the value of the ER is the financial markets’ perception of developments in the BOPS. If financial markets believe an increase in the CAD is not sustainable, they may be less willing to buy Australian assets (decreased demand for the $A) and thus cause a depreciation. This can cause great instability as market sentiment can change quickly.
