Economics notes

NOTE: these notes generally follow the syllabus however where applicable syllabus areas
or information is condensed or rearranged for succinctness

Source: Tim Riley Economics textbook, Australia In The Global Economy textbook

10.1 THE GLOBAL ECONOMY

FEATURES OF THE GLOBAL ECONOMY

Economic integration and International convergence

Globalisation refers to the increasing level of economic integration

between countries. Leading to the emergence of a global market place or
single world market.
Economic integration refers to when trade barriers are reduced or
removed between countries to facilitate growth in international trade and
investment.
Global economic integration has raised living standards by allowing
countries to focus on the export of G&S in which they have a comparative
advantage in exchange for G&S in which other countries have a
comparative advantage.
The integration of regional groupings of countries has resulted in large
amounts of inter-regional trade and intra-industry trade
More policy coordination groups e.g. G7, G8, G20, OECD
WTO is the first multilateral organisation with the authority to enforce
nationals governments compliance with rules on free and fair trade
o Leading to integration and standardisation of rules and norms to
operate in the global economy.
Trading bloc such as EU are only beneficial if they create rather than trade
from other regions
Main forms of economic integration:
o Free trade area: where a group of member countries abolish trade
restrictions between themselves
o Customs union: member countries not only abolish trade
restrictions but adopt common external restrictions
o Common market: a customs union that allows free mobility of
labour and capital within common market countries
o Monetary union: a common market with a single currency and a
single central bank
A majority of nations have adopted a market economic system or are in
transition from socialist to capitalist
Other forces promoting convergence of economic systems include:
o Spread of similar technology and economies of scale in production
o Growth of international trade and consumerism
 o Increased levels of migration and labour mobility
o Political cooperation between governments to embrace benefits of
globalisation

Contemporary Trading Blocs and Agreements and International

organisations

A trading bloc in a strict economic sense if when a group of countries join

together in a formal preferential economic relationship to the exclusion of
other economies.
Multilateral trade agreements are considered the most effective way of
achieving trade liberalisation on a global basis because they are non-
exclusive and create rather than divert trade.

Types of
International
Agreements

Regional: Bilateral:
Multilateral:
EU, APEC, ANZCERTA,
WTO
ASEAN, NAFTA Austraia-US FTA

EU (European Union), formed in 1959:

o A single European market with no trade barriers and free mobility of
G&S, people, labour and capital.
o Is a full monetary union with most states adopting: a single
currency, the euro, in replace of national currencies, a single
interest rate, and single foreign exchange and monetary policies
conducted by the European central bank.
o Main benefits of the EU monetary union: a reduction in transaction
costs by using a single currency, greater economic stability and
improved economic performance through coordinated monetary,
exchange rate and other economic and social policies.
o Recent sovereign debt crisis in southern Europe has revealed a
number of problems with the union: states that were granted
membership under the condition that certain economic
improvements were made (such as Greece) have not made those
improvements, and many EU policies are ignored such as the policy
that debt must not exceed 3 per cent of GDP (currently no EU
member has a debt to GDP ratio of less than 3 per cent)
NAFTA (North American Free Trade Agreement) signed in 1992:
o For the USA and Canada it increased their international
competiveness by allowing domestic companies to exploit lower
production costs in Mexico.
o For Mexico it gave greater access for it exports to the large and high
income markets of USA and Canada.
 o Opponents argue that NAFTA diverts trade, as firms would relocate
to the cheaper Mexico, rather than create trade. Also non member
country companies may relocate to Mexico to access US and
Canadian markets whilst avoiding those countries strict tariffs. In
response rules of origin were established which are used to
determine if goods are wholly produced in the North American
region.
APEC (Asia Pacific Economic Cooperation) formed in 1989:
o Multilateral regional trade forum which pursues common trade
policy issues and developed mechanisms for closer trade and
investment links in the Asia Pacific region
o Major achievements:
1994 Bogor Declaration with dismantling of trade barriers by
developed economies by 2010 and for developing economies
by 2020. Involved Individual Action Plans for trade
liberalisation and Collective Action Plans for the regional
facilitation of common standards, rules and procedures.
Establishment of electronic tariff database for the region
A review of regional customs procedures and a review of
existing market access arrangements in the region.
ASEAN (Association of South East Asian Nations) formed in 1967:
o Initiatives: fostering commerce and industry links between member
economies, consultation on banking and finance, and dialogues with
other regional groupings such as NAFTA and the EU
o 1992 agreement on the formation of the ASEAN Free Trade Area
which would allow greater regional specialisation and economies of
scale and attract more foreign investment into the region.
o In 2009 ASEAN, Australia and NZ signed the ASEAN-Australia-NZ
Free Trade Area (AANZFTA) agreement.
ANZCERTA (Australia New Zealand Closer Economic Relations Trade
Agreement) signed in 1965:
o In Response to Britain joining the EU ANZCERTA was signed with the
objectives to:
Strengthen the broader economic relationship between AUS
and NZ
Develop closer economic relations through mutual free trade
Eliminate barriers to trade with minimal level of disruption
Develop trade between AUS and NZ under conditions of fair
competition
o Agreement has led to free flow of labour and capital resources
between the two countries improving efficiency of resource
allocation.
WTO
o GATT was signed in 1947 and became WTO in 1995. Basic guiding
principle of GATT and WTO are:
Non discrimination, which means that trade concessions
granted to one member nation must be extended to all
member nations
 Trade liberalisation which involves the WTO working towards
the elimination of all tariff and non-tariff barriers through a
process of multilateral negotiations between member
countries
Stability of trading relations, where WTO mechanisms are set
up to discuss and solve trade disputes between countries
Transparency of trade agreements, where trade preferences
between countries are open to scrutiny and discussion in the
WTO forum
o Since 1947 there have been nine rounds of trade negotiations
mainly resulting in cuts to tariffs. The eighth round was held in
Uruguay and the ninth was principally held in Doha
o Uruguay round focused on areas were GATT rules did not previously
exist, such as:
Trade in agriculture
Trade in services
Trade related intellectual property rights
Trade related investment measures
o Major outcome of Uruguay round was agreement by EU and US to
cut agricultural subsidies
An average cut in all agricultural tariffs of 36 per cent
Domestic support measures to be cut by 20 per cent
Export subsidies to be cut by 36 per cent in budgetary terms.
o Doha round had intention of reducing protection and achieving free
and fair trade. Main agenda items:
Further reduction on agriculture subsidies, building on those
in Doha round
Trade concessions from developed countries to developing
countries to give them more manufacturing and agricultural
export market access
Measures to allow environmental and labour standards to be
imposed on trade related activities
o Doha round collapsed as EU, US and developing countries failed to
reach agreement on reform to agricultural trade.
IMF
o Established under Bretton Woods Agreement in 1944 with a role to
assist countries in the post World War Two period.
o IMF was established with pool of central bank reserves and national
currencies which could be made available to countries with short
term balance of payments issues.
o A new form of IMF reserve asset, Special Drawing Rights (SDR), was
introduced in the 1970s as many countries floated their exchange
rates. This allowed countries to obtain foreign exchange by drawing
on their own currency balances held by other IMF countries
o The IMFs five main responsibilities in the global economy are:
Promoting international monetary cooperation
Facilitating the expansion of international trade
Promoting exchange rate stability
 Supporting the multilateral payments system
Making resources available to members experiencing balance
of payments difficulties.
World Bank
o Also set up under the 1944 Bretton Woods Agreement
o It focus on long-term development projects in developing or
emerging economies. It attempts to influence the design of
macroeconomic and microeconomic policies in developing
countries.
o The world bank has a number of organisations that provide specific
assistance to lower income countries:
International Development Association provides soft loans
(loans at little or no interest).
International Finance Corporation role is to attract private
investment to the Banks projects
Multilateral Insurance Guarantee Agency provides risk
insurance to private investors investing in developing
economies.
o In recent years the World Banks major aim as set out in the
Millennium Development Goal to reduce the proportion of people
living of less than US$1 a day to 14.5 per cent of all people by 2015.
o At the end of 2008 the WB tripled its lending in response to the GFC
to US$35 Billion

World Economic Growth

IMF estimate for gross world product in 2008 was about US$69 trillion
Overall, globalisation era has only produced a small increase in the level of
economic growth globally
o Average world growth in output between 1997-2007 was 3.9 per
cent
High income and newly industrialised economies have mostly emerged as
winner in globalisation, with faster economic growth built on increased
trade and investment flows.
o The advanced industrialised economies accounted for 55.3 per cent
of world GDP in 2008 with 15.3 per cent of the worlds population in
2007.
o Developing economies accounted for 36.6 per cent of world GDP in
2008 yet had a majority 77.9 per cent of the worlds population in
2007.
Globalisation was expected to bring about greater similarities in growth
level of economies
o Wider gap in long-term growth rates between faster and slower
growing economies has emerged
o Sometimes referred to as convergence in economic growth rates

Trade

Rapid liberalisation of global trading environment

 o Through trade agreements and micro-economic reform (removing
protection)
o High growth in world trade and investment between 1970s and
1990s due to financial deregulation, globalisation, and
improvements in technology and communications
Trade has rapidly increased in response a range of major trading
agreements, as mentioned earlier (WTO, NAFTA, etc.)
Direction of trade flows has shifted
o High income countries accounted for 82 per cent of global
merchandise exports in 1995 and 71 per cent in 2007. Every other
region saw an increase in their share of world exports.
o East Asia and pacific region saw largest increase in global
merchandise exports rising from 7 per cent in 1995 to 13 per cent in
2007.
Compositional shifts in world trade
o Parts and components, services (financial, business, accounting,
insurance telecommunications, entertainment), ETMs, technology
goods
Trade between the three major economic groupings (Europe, North
America, and East Asia; known as the global trade and investment triad)
has become increasingly intra-regional overtime.
o East Asias intra-regional trade rose from around 35 per cent of
those total countries trade in 1980 to 55 per cent in 2004
o EUs intra-regional trade in 2004 was 65 per cent
o This trend has been accelerated by preferential liberalism
(liberalising trade, as described in the first dot point through trade
agreements etc., but with a preference for countries in that region)
MNCs/TNCs (multi/transnational corporations) have emerged as one of the
main drivers of global trade
o A global wed of production facilities has emerged to facilitate the
distribution and production of parts and components
o Since the 1990s the number of TNCs has grown from 37,000 to
79,000.
Changes in the international business cycle have magnified effect on the
level of world trade - greater volatility in trade
o In the downturns in the mid-1970s, early 1980s, in 2001 and in the
GFC growth in world trade has contracted faster than the
contraction in world economic output.
Statistics on global trade (NOTE: take your pick different statistics suit
different essays or essay questions better):
o Word exports of G&S has increased threefold since 1980s
o Average growth in world trade in 1990s was 6.6 per cent; in 2000s it
is 4.8 per cent
o Trade has been heavily geared towards highest income countries
Advanced industrialised economies as a group accounted for
65.1 per cent of world exports of G&S in 2008.
However Share of world trade by LDCs has increased from 23
per cent to 29
 o Trade in G&S has increased from US$8.7 trillion (38 per cent of
global output) in 1990 to $US31.2 trillion (63 per cent of global
output) in 2007
o World trade in G&S grew from 12 per cent of world GDP in the
1960s to 25 per cent of world GDP in the 2000s
Impacts in global trade flows:
o Shifts in trade affect the structure of an economy over time if an
economy is experiencing increased demand for particular exports,
resources in that economy will shift towards increasing the
production of that G or S.
o Example: global resources boom and demand for Australian mineral
has led to an expansion in mining investment and operations in
Australia and our economy is now dominated/driven by mineral
exports.

Investment

Growth in FDI and portfolio investment is mainly due to easing of capital

controls between countries as financial deregulation spreads to global
financial markets.
Central banks also removed direct lending controls, allowing a greater role
for market forces to allocate financial and investment resources.
Also increased turnovers in world stock markets through new technologies
allowing greater access for individuals, companies and governments to
raise funds or engage in merger and acquisition activity.
International trade increasingly linked with investment as companies use
FDI to gain access to foreign markets
Since the 1980s portfolio investment has increased investment sevenfold
FDI flows were valued at around US$ 80 billion in 1980, US$201 billion in
1990, and peaked at US$1.8 trillion in 2007

Much of increased Investment flows has been directed to emerging
economies in need of large capital injections to assist industrialisation,
modernisation, urbanisation, and eco development
Major structural change in the direction of world FDI occurred between
1990 and 1997, with increasing shares of FDI going to emerging
economies in Asia
The supply of capital will continue to grow from pension and mutual funds
and MNCs
Australia has benefited largely from Chinese investment

NOTE: global investment falls under global finance (below). However they can
often be distinguished by describing the shorter term, speculative shifts of
money as finance and the longer term flows of money to buy or establish
businesses as investments. (This is not a strict definition)

Finance
 Integration of national financial systems to create a world financial market.
This has been the result of financial deregulation in most countries
Financial deregulation and floating exchange rates leading to increased
capital mobility
Controls on foreign exchange currency markets, flows of foreign capital,
banking interest rates and overseas investments in share markets were
lifted.
Collapse of communism and NIEs has increased demand for capital, as
transition countries have sought more integration with the global
economy.
Main types of global forex transactions are spot transactions, outright spot
transactions and swaps
Stats:
o Foreign exchange turnover increased dramatically - Forex turnovers
increased from $US 15 billion in 1970s to around $US 2 trillion in
2000s
o Financial flows have increased from US$ 2.3 trillion in 1990 to $US
31.9 trillion in 2000s
o Global capital market turnover grew from US$2.8 trillion in 1995 to
US$7.6 trillion in 2008
o Exchange derivatives where worth about US$ 1 trillion in 1988 and
reached about US$56 trillion in 2007.
The main institution participating in forex include MNCs, banks, super
funds, and central banks
95 per cent of forex turnovers are due to the actions of speculators
seeking short gains from currency movements.
Main participants in forex markets in 2007:
o Commercial and investments banks acting on behalf of clients. They
accounted for 43 per cent of total turnover in 2007
o Financial institution that buy and sell currencies on behalf of clients
to make a profit. Accounted for 40 per cent of total turnover
o Non-financial institutions such as government, MNCs, IMF, World
Bank. They accounted for 17 per cent of total turn over
Types of forex traders:
o Exporters want to be paid in their own currency, which mean
importers need to convert the currency they operate in to make the
payment for G&S
o Foreign investors who are purchasing assets such as property or
shares
o Speculators who make short-term currency trades
Impact of global financial flows:
o Changes in financial flows have an effect on confidence within a
country and in that economy.
o To an extent the value of the currency is seen as an indication of
overseas confidence in the economys future therefore when
money is flowing out of an economy and the exchange rate is falling
it can weaken confidence in the economy therefore slowing
domestic growth.
Technology Revolution and Electronic Commerce

The ICT revolution has led to new types of products and employment in
businesses servicing the global market through the internet.
o New products, services and processes increase the range of choice
for consumers while greater international competition leads to lower
prices
Firms can use IT systems to reduce costs and increase efficiency
o Ordering of stock and inputs can be done instantaneously, allowing
firms to respond to changes in demand quickly and to reduce the
wastage of resources
o Time savings through use of internet and electronic commerce allow
firms to reduce labour costs in marketing and final distribution
o The role of wholesaler or middlemen in the distribution chain is
reduced, reducing costs
Rapid technological change allows for faster rate of innovation
World Information Technology and Services Alliance estimates that the
global marketplace for information and communications technology will
reach US$4 trillion by 2011
In late 2008 worldwide internet usage surpassed 1 billion users

Labour

Labour markets have also liberalised, however tight restrictions remain

(due to border security and terrorism)
A vigorous international labour market has emerged due to labour
strategies in particular industries
International market for labour appears to be concentrated at top and
bottom ends:
o High skilled labour travels the global village to where the returns
are highest.
o Low-skilled labour is also in demand in advanced economies where
it may be difficult to attract significant people born locally to do
certain types of work.
Guest workers from mainly developing countries gain temporary
employment in developed economies or NIEs in response to labour
shortages in particular industries in those countries.
Workers frequently make a substantial contribution to the balance of
payments in their home countries by remitting savings from their salaries
o Workers remittances reached US$371 billion in 2007
A international labour organisation publication identified key issues in
international labour markets
o Workers from developing economies were often exploited
o Emerging black market in migrant workers being smuggled to work
in illegal industries
o Developed countries need, to increase labour supply due to ageing
population, often led to illegal migrant labour
Another problem is brain drain from developing economies
 o Highly skilled workers seek employment and higher incomes in
other rich industrial countries
o Reduced availability of highly skilled labour in those economies
Governments that have embraced a globalisation strategy have generally
pursued policies to raise labour productivity as a way of increasing
competiveness
o Example: successive Australian governments deregulated and
decentralised wage determination and instituted policies to increase
the flexibility of the labour market
Short-term structural unemployment as domestic economies open up to
international competition and jobs move offshore.

International Business Cycle

Greater synchronisation of short-term economic growth, reflecting the

increased importance of the international business cycle.
Globalisation and economic integration have meant that the economic
performance of individual economies is more closely linked to changes in
international business and commodity cycles.
Financial or global contagion can occur where a crisis in one financial
market or economy is spread to others, causing regional or global
instability
o Increased integration between countries and regions led to the
rapid spread of the GFC in 2007-08 causing a global recession.
Change in international business cycle will have varying effects on the
domestic economy cycle. The main transmissions for these changes are :
o Trade flows: boom or recession will directly affect demand for
imports from other economies
o Investment flows: one of the main causes of weak FDI inflows to
developing countries in the late 2000s was the weaker economic
performance in the US.
o TNCs: improved economic conditions in developed countries will
lead to increased investment in other economies as TNCs seek to
increase their productive capacity.
o Financial flows: a 2009 IMF paper, How Linkages Fuel the Fire,
showed that bank lending and financial flow linkages transmit
financial conditions from advanced to developing economies and
was the main reason the GFC spread so quickly from the US to other
economies
o Financial and market confidence: strong correlation of the
movements in share prices among the worlds major stock
exchanges.
o Global interest rate levels: supply of foreign credit for domestic
investment.
o International organisations: Research by the RBA has found that 63
per cent of changes in output levels in Australia can be explained by
changes in interest rates, growth levels and inflation in the G7.
 Therefore domestic Australian factors have less influence on
economic growth than international factors in any given year.
There are two types of external shocks that can be transmitted from the
global economy to a domestic economy:
o Real shocks: changes in variable such as world output, commodity
prices or technological change which can cause structural changes
to occur in the real economy. Negative and positive real shocks.
Positive real shock: the global resources boom in 2004-07
caused by strong demand for commodities from developing
economies, particularly China. It caused global output to
reach 5 per cent in this period above the 3.7 per cent trend
for the decade. It led to higher export incomes, higher rates
of capacity utilisation leading to increased investment in new
plants/projects and equipment, and falling unemployment.
o Financial or monetary shocks: changes in financial variables such as
changes in international share prices, global interest rates or
inflation rates.

FREE TRADE AND PROTECTION

The basis of free trade advantages and disadvantages

Free trade is imposing no artificial barriers to trade. The argument for free trade
is based on the economies concept of comparative advantage:

Comparative advantage nations should specialise in the areas of

production in which they have the lowest opportunity cost and trade
with other nations so as to maximise both nations standard of living.
Opportunity cost represents the alternate use of resources. That is, the
costs of satisfying one want over the costs of an alternate want.
Since countries have different factor endowments specialisation of
production will take place, and expected economic gains (such as cost
reductions through economies of scale) will result if countries engage in
free trade.
A reason for a country specialising in the production of goods in which it
has a comparative advantage is that it may be able to generate
economies of scale in production

Advantages of free trade Disadvantages of free trade

Increased specialisation - leads to
economies of scale, resulting in
greater levels of output and
employment
Greater range of output due to
specialisation, increasing quality
Newly established firms in infant
industries will find it difficult to
compete against established
foreign firms - Infant industries will
take longer to generate the
necessary economies of scale to
 and quantity of goods available to
consumers
Increased productivity of resources
- leading to greater allocative
efficiency
Increased competition between
firms - leading to lower consumer
prices and higher real incomes
Encourages innovation and spread
of new technology and production
processes
More efficient allocation resources
due to comparative adv.
Overall:
Higher national income and living
standards as a result of lower
prices, higher eco. growth,
increased production of G&S and
increased consumer choice
compete.
The most efficient and competitive
producers will attract resources
away from less efficient and less
competitive industries, causing
some regions to lose key industries
and experience unemployment.
Can lead to negative externalities
because some nations may
produce goods at a lower cost
because of weaker environmental
protections or exploitation of
labour in LDCs which reduce
compliance costs.
Inability of country to diversify their
economic base because they
specialise in production according
to comparative advantage.
Production surplus may be
dumped (sold at unrealistically low
prices that domestic business
cannot compete) which may hurt
efficient domestic industries.
Country pursuing free trade can
often experience sustained or
ongoing CAD. This can lead to a
shortfall in export income to
finance import income

Reasons for protection

Infant industries: these businesses usually start out on a small scale, with
costs that are relatively higher than those of more established firms because of
these firms larger scales of production which reduce costs. It is argued infant
industries need protection in short run to enable them to expand their scale and
reduce their costs of production so that they can compete with the rest of the
world. If this argument is valid protection should only be temporary, otherwise
there would be no real incentive for the industry to reach a level of efficiency
that would enable it to compete without protection.

Prevention of Dumping: is the practice of exporting goods to a country at a

price lower than their selling price in their country of origin. It may be used to
dispose of large production surpluses or to establish a market position in another
country. The only gain from dumping is a reduction in price for consumers, which
will be short-term as foreign producers put up prices once competition is
eliminated. Economists consider this the only valid argument for imposing
protection.
Protection of domestic employment: the argument is that if local producers
are protected from competition with cheaper foreign imports, the demand for
local goods will be greater and this will create more domestic employment.
However protection will tend to distort the allocation of resources away from
areas of more efficient production towards areas of less efficient production. In
the long term this lead to lower growth rates and higher unemployment

Defence and Self-sufficiency: major powers generally want to retain their own
defence industries so that they can be confident that in a time of war they would
still be able to produce defence equipment. A similar argument can be made for
self-sufficiency of food supplies.

Methods of protection and the eff ect of protectionist policies on

the domestic and global economy

Artificial barriers placed on imports

Tariffs: a tax on imported goods imposed for the purpose of protecting domestic
industries. The effects of a tariff are:

Stimulates domestic production and employment as domestic firms are

artificially more competitive than foreign firms.
Reallocation of resources towards less efficient industries
Consumers pay higher price and receive fewer G&S.
Raises revenue for government
Retaliation effect can be experienced in response to tariff other countries
may impose protection which may offset gains in employment and
production by reducing them in export competing industries.

Quotas: are restrictions on the amounts or values of various kinds of goods that
may be imported. The effects of a quota are largely the same as a tariff, except
there is no government revenue. However some revenue may be obtained
through selling import licenses.

Local content rules: these specify that goods must contain a minimum
percentage of locally made parts. In return for guaranteeing that a certain
percentage of good will be locally made, the imported components may not
attract a tariff.

Artificial competitive advantage for Exports

Subsidies: cash payments from government to business to encourage the

production of a good or service and influence the allocation of resources in an
economy. Subsidies are often granted to business to help them compete with
overseas produced G&S. Subsidies tend to reduce prices, thus lowering inflation
and benefiting consumers.

Export incentives: these are programs that give domestic assistance such as
grants, loans or technical advice (such as marketing or legal information), and
encourage business to penetrate global markets or expand their market share.
Effects of protectionist policies

Local industries and firm receiving protection gain in the short term because
they are able to raise prices, increase output and raise market share.

Major macroeconomic effects of protection on domestic economy are negative:

Resources are misallocated: resources are directed away from efficient and
competitive industries to industries that rely on protection
Inflation: distorting effects of tariffs on import prices, which can be pasted
into the domestic cost and price structure
Negative protection: efficient export industries are penalised by paying
higher prices for capital equipment, and because they cannot easily pass on
these cost in world markets, their competitiveness is reduced.
Economic growth: is retarded because capital and labour may not be used
intensively if output is geared towards small domestic markets where it if
difficult to reap economies of scale.
Export earnings: are lower because protect domestic industries tend not to
seek overseas market because the domestic industry lacks competitiveness.

Microeconomic effects:

Rent seeking: protected industries devote resources to the unproductive

activity of political lobbying for maintenance or increases in levels of
protection
Generally in Australia the management and labour forces in protected
industries used outdated work practices and had low levels of productivity
Non-exposure to international competition leads to minimal adoption of
innovation and the latest cost-saving technology

Statistics and facts:

Non tariff barriers in the EU, USA, S. Korea and Japan reduce Australias net
farm export income by depressing world agricultural prices.
US Department of Agriculture estimates that trade policies like those of the
EU, USA, S. Korea and Japan reduce agricultural prices by 12 per cent
OECD estimates that agricultural policies in OECD countries cost consumers
and taxpayers US$300b every year.

Australian policies regarding free trade and protection

Governments MAIN AIMS in reducing protection are to:

Force domestic industries to become internationally competitive by exposing
them to competition from imported goods
Encourage resources to move away from industries that cannot improve their
competitiveness to those that can focus on areas of the economy where
Australia has a comparative advantage
Allow Australia to benefit from greater integration with the global economy by
giving business and consumers access to G&S available in global markets at
lowest prices
 Promote structural change (microeconomic reform) in the economy with the
long term aim of encouraging efficient firms to produce what the global
economy demands

Process towards complete free trade:

1970s Whitlam govt. introduces 25 per cent across the board cut to
protection to stimulate greater industry efficiency and lower the price of
imported consumer, intermediate and capital goods.
1970s-80s protection increased in industries such as passenger motor
vehicles (PMV), textiles, clothing and footwear (TCF) and steel industries
which experienced intensified export competition.
1980s Hawke government implements policy of large scale dismantling of
industry protection with 1988 industry statement:
o This statement phased in cuts to protection over 4 years
o PMV, TCF and steel industry exempted from cuts. They were put on
separate industry plan allowing for much longer phase down of
protection period
1986 Australia joins Cairns Group of agriculture free trading countries
1989 Australia helped to form APEC forum in response to EU and NAFTA
1990s 1991 Industry Statement introduced to accelerate the pace of
reform. It announcing following measures:
o Reduction of majority of tariffs to 5 per cent by 1996
o Abolition of import quotas for PMV and a reduction in tariffs for PMV to
15 per cent by 2000
o Abolition of import quotas on TCF and reduction in maximum tariff to
25 per cent by 2000
o Exemption of sales taxes on export industries to improve their
internationally competiveness.
1994 Australia became member of WTO (was member of GATT in 1944)
1994 Australia signs Bogor Declaration committing APEC nations to
eliminate all trade barriers by 2020.
2000s Automotive Competiveness and Industry Investment Scheme
introduced by Howard in 2001 to provide transitional assistance to PMV.
Continued tariff reduction throughout 2000s
2007 Productivity Commission (PC) estimates tariff assistance to domestic
producers is valued at $9.2b
2010 Around half of imports are tariff free with the remainder subject to
tariff of 5 per cent or less. Only TCF had tariff above 5 per cent at 10 per cent
which also falls to 5 per cent in 2015.

1968- 1977- 1982- 1986- 1994- 2003- 2005 2007

69 78 83 87 95 04
36% 23% 25% 19% 9% 4.5% 3% 1.8%
Average tariff levels in AU, source: Productivity Commission

Implications of Australian policies for individuals fi rms and

governments
Individuals

As employees
o Increased structural unemployment as industry restructure to gain
efficiencies
o Increased use of capital equipment in favour of labour increased
unemployment
o Increased future employment opportunities as efficient domestic
industries expand into international markets.
o Higher wages Centre for International Economics (CIE) produced
modelling in 2009 that calculated real wages have increased by 2
per cent due to Australias trade liberalisation policy.
As consumers
o Decrease in prices of g&s due to increased competition
o Increase range of g&s available
o Improved living standards CIE modelling calculated the average
family income has increased by $3,900 per year

Firms

Short term
o Firms operating in marginal, import-competing industries may
shrink or cease operations as they not cannot compete in global
marketplace.
o Increased investment in order to implement necessary changes to
sustain profits/market share
o Increased payments for redundancy
o Increased need for workplaces training and capital expenditure to
accommodate changes in productivity
o Lower input costs as imported capital equipment may be cheaper.
The PC estimates that reduced tariffs will reduce input costs for
services by $4.8b; for mining by $298m; and for primary producers
by $56m
Long term
o Decrease in cost of production as methods become more efficient
and productivity increases therefore increased profits
o Increased potential market globally competitive

Government

Short term
o Increase welfare and industry payments increased structural
unemployment and transitional assistance to business
In 2004 the government announced $50m in labour market
assistance to workers made redundant by the closure of an
engine plant in South Australia
o Decrease in tax revenue due to decrease in tariffs
Long term
 o The benefits of reduced protection was estimated by the PC as a
gain of $4b to GDP through additional export income and higher
rates of economic growth
o Increased eco growth
o Increased access to overseas markets increase in trade
agreements as economy in competitive in global market.

Implications for Australia of protectionist policies of other

countries and organisations

Australian agricultural producers face significant barriers to trade:

The EU operates the Common Agricultural Policy which subsidies EU

farmers by 25 per cent. Farmers in US, Japan and S. Korea also receive
similar subsidies, putting Australian agricultural producers at a significant
disadvantage.
Australian Bureau of Agricultural and regional Economic estimates that a
reduction in global agricultural protection could boost Australian
agricultural exports by US$9b by 2020.

Australian firms exporting non-agricultural goods generally face fewer barriers to

trade.

The mining and resources sector is more likely to face export barriers from
the Australian government trying to secure energy supplies. If a foreign
government were to impose tariffs on Australian resource exports it would
raise costs for business and consumers but would not encourage resources
exploration.
Manufactured goods face few barriers to trade as most economies have
low tariffs or have bilateral of multilateral agreements with Australia.
Australia service industry encounter no artificial barriers to trade,
however, though they account for three quarters of GDP they account for
less than a quarter of exports. This is because services face a number of
barriers to trade including natural barriers such as geography, transport
costs, language and cultural differences, and local tastes and preferences.
The Australia Services Roundtable estimates that liberalisation of global
trade in services could increase exports by up to $5b a year for Australia.
Examples of service export barriers:

Service industry Potential trade barriers

Financial services Restrictions on foreign ownership of banks and other
financial institutions
Transport services Restrictions on airlines providing services in another country
Professional Licensing laws that only recognise own countries
services educational qualifications
Construction Government procurement rules that mandate use of local
services suppliers
Utility services Government monopoly provision of electricity, gas and
 water
Environment Government preference for local suppliers of waste or
services recycling
Media & Minimum local content requirements to preserve countrys
Entertainment culture

IMPACT OF GLOBALISATION ON THE STANDARD OF LIVING IN THE

GLOBAL ECONOMY

Variation in the standard of living in the global economy

Contrasts in level of development

Impact of globalisation

Fuck it, its not real economics

10.2 AUSTRALIAS PLACE IN THE

GLOBAL ECONOMY
AUSTRALIAS TRADE AND FINANCIAL FLOWS

Value, composition and direction of Australias trade and fi nancial

fl ows

The Australian economy ranks 14th in GDP size in the world

Large growth in services exports between 2002 to 2010 - A surplus
occurred in net services between 2002-07.
The value of exported services grew by 60 per cent between 2002 to 2009
while the value of import services grew 71 per cent in the same period.
Exports and imports in goods as a percentage of GDP rose from 12 per
cent in the mid-1980s to 23 per cent in the 2000s
Australia recorded a surplus in the G&S balance of $5 billion in 2008-09

The changing direction of trade

In 1950s Australian mainly traded with the US, UK and other European
Countries
In following decades Australias trade shifted towards Japan.
In the past two decades China, South Korea, and the ASEAN countries
have come to dominant out export markets.
Reasons for this:
 o The UK joined the EU in 1973 and was required to impose the same
barriers with Australia as with other countries and give preference
to trade with EU members.
o By the 1960s the Japanese economy was sustaining rapid economic
growth and its demand for product inputs such as minerals was
increasing rapidly
o During the 1980s Japanese growth rates began to slow down and
the direction of Australias trade shifted more towards other
economies in Asia
Asia accounted for 59 per cent of exports in 2008.
In 2007 China became Australias largest trading partner.
The EU (particularly Germany) and the US remain important but primarily
as a source for imports.

Changing composition of Australias trade

Primary industries has always been the main focus of Australias exports
as it is in commodity goods that Australia has the greatest comparative
advantage
The composition of Australias imports Since the 1980s:
o The share of capital goods has remained unchanged
o Part-finished intermediate g&s have declined
o Consumer goods have steadily increased
While imports have remained relatively unchanged Australias exports
have significantly changed
The agricultural sector has declined: large fluctuations in world prices and
trade protectionist policies have influenced export revenue making it
unattractive export to focus on. It also has little extra value added in
processing.
Minerals have rapidly increased: world economy and resources boom has
ensured demand however prices and volumes fluctuate significantly
Australia does not compete in the manufacturing sector, however sales of
sophisticated niche market manufactured goods picked up in the 1990s.

Trends in Australias financial flows

Year Total Foreign investment into Total Australian investment

Australia abroad
1980- $46.8 billion $13.4 billion
81
1995- $461.3 billion $185.9 billion
96
2008- $1735.1 billion $1009.2 billion
09

Financial flows grew most rapidly in the 1980s, when the Australian
dollar was floated and financial markets were opened up.
Level of portfolio investment in 1980s was lower than direct
investment. Portfolio is now higher than direct investment
 Australia has always been a net capital importer, with the level of
foreign investment in Australia consistently remaining close to twice
the level of Australian investment abroad.
Australian businesses have substantial overseas assets, and
Australia also has significant short-term overseas investments such
as shares.
Main sources of foreign investment into Australia are the USA,
Britain, Japan, Hong Kong, China, Singapore and New Zealand.

The balance of payments

Current account non reversible transactions

Goods
Services
Net primary income
Net secondary income

Capital and Financial account reversible transactions. Also financial

inflow has the immediate effect of increasing the supply of foreign exchange to
Australia while financial outflow reduces it

Capital account
o Capital transfers credit
o Capital transfers debits
o Net acquisition/disposal of non-produced, non-financial assets
Financial account
o Direct investment
o Portfolio investment
o Financial derivatives
o Other investment
o Reserve assets

The current account is calculated as:

net goods + net services
(the balance on goods and services)
+
Net income + net current transfers
The capital and financial account is calculated as:
Capital account + direct investment +portfolio investment
+
Other/financial investments + reserve assets
The balance of payments is calculated as:
Current account + capital and financial account
+
Net errors and omissions = 0

Links between key balance of payments categories

In theory the floating Australia dollar plays the key role of ensuring that there is a
balance in the balance of payments. Under a freely floating exchange rate,
equilibrium occurs where:

Supply of $A Demand for $A

The supply of $A is represented The demand for $A is
by: represented by:
-Payments for imports of goods -Receipts for exports of goods
and services (M) and services (X)
-Income/transfers overseas (Y -Income/transfers overseas (Y
debits) credits)
-capital and financial outflow (K -Capital and financial inflow (K
outflow) inflow)

Following with the idea that theoretically the floating Australia dollar ensures the
balance in the balance of payments, then for equilibrium in forex markets:

Supply of $A = Demand for $A

Which in turn implies:

M + Y debits + K outflow = X +Y credits +K inflow

Rearranging the equation:

M X + Y debits Y credits = K inflow K outflow

OR

Deficit on the current account = Surplus on the capital and financial account

Australias balance of payments performance

Australia has experienced persistently large current account deficits since

the mid 1980s:
o Net goods balance is usually in deficit
o Net services is usually in surplus
o Net incomes has always been in deficit since 1980
o Net current transfers regularly records very small deficits or very
small surpluses
In 2000-01 the CAD reached its lowest level in two decades at 2.4 per cent
CAD was 4.8 per cent of GDP in 1999-2000 compared 3.2 per cent of GDP
in 2008-09
CAD has averaged over 4 per cent of GDP, giving Australia one of the
highest CAD outcomes amongst advanced economies

Balan Net Net Balance on Capit Financi CAD as

Year: ce on incom current current al al % of
G&S e transfer account accou accoun GDP
s nt t
1980- -2.9 -2.4 -0.4 -5.8 0.2 4.7 -3.9
81
1990- -0.7 -17.2 0.5 -17.5 2.1 15.9 -4.3
91
2000- 1.8 -18.7 0.0 -16.9 1.1 16.3 -2.4
01
2008- 5.8 -43.6 -0.6 -38.4 2.3 37.2 -3.2
09

Australias current account deficit moves in cycles reflecting short and

longer term, domestic and external influences. Generally the deficit
increases when domestic growth is stronger than world growth:
o Balance of goods and services (BOGS) is influenced by short term
cyclical factors such as changes in global demand for
commodities, Australias terms of trade and the demand for imports
from Australian consumers and business
o High economic growth within Australia generally contributes to a
higher CAD. An economic downturn has the opposite effect as it did
in 2000-01, 2008-09 and in the early 1990s.
o The net incomes are more stable than the BOGS and remain high
regardless of cyclical swings in the CAD. This is because the main
factors that determine income credits and debits the size of
foreign liabilities, and the servicing costs associated with those
liabilities are structural factors that do not change substantially
from year to year.
Trends in 2000s:
o RBA raised interest rates in 2000 to reduce import spending. In
2001 stronger growth in exports cut the trade deficit and the CAD.
o Drought in 2002-03 reduced export income and a weak global
economic recovery softened demand for Australian exports. Import
spending also increased due to strong domestic growth.
o In 2003-04 the drought persisted while Australian economic growth
continued to exceed world growth reducing export income and
increasing import spending
o In 2004-05 a global recovery in growth and softening drought
conditions led to a rise in exports, but imports also rose due to
strong domestic growth.
o In 2005-06 the global resources boom boosted exports.
o In 2006-07 the CAD rose due to higher net income deficit as
investors sought a return on investment from the mining boom.
o 2007-08 the G&S deficit rose due to stronger import spending
o 2008-09 saw an improvement in the CAD due to the effects of the
GFC.

Foreign liabilities and the balance of payments

Net foreign liabilities reflect Australias total financial obligations to foreigners,

minus the total financial obligations of foreigners to Australia. There are two
components:
 Net foreign debt: total stocks of loans owed by Australians to foreigners,
minus the total stock of loans owed by foreigners to Australians.
+
Net foreign equity: is the total value of assets in Australia such as land,
shares and companies in foreign ownership, minus the total value of
assets overseas that are owned by Australians

Overseas investment in Australian equity does not add directly to Australias

foreign debt. However, we do have to send overseas some returns on equity
investments, such as profits on companies or rent on land.

On the other hand borrowing does add directly to Australias foreign debt. Initial
borrowed sum eventually has to be repaid and the debt must be serviced
(regular interest payments = debt servicing)

Australias net foreign debt to GDP ratio has grown dramatically during the
period of globalisation

Issues in the balance of payments

The main issues associated with the trends in the balance of payments:

The terms of trade:

Terms of trade measures the relative movements in the prices of an

economys imports and exports over a period of time.
Essentially it measures how much export income can be used to buy
imports.
Export income is increased by increasing the quantity of G&S sold or by
increasing the price of G&S sold.
Therefore the terms of trade has a very significant impact on Australias
balance of payments:
o If the terms of trade deteriorates as it did between 1989 and 1994 it
means that the same volume of exports can buy less imports. This
would then lead to a larger deficit in the G&S balance and therefore
an increase in CAD.
o The prices of primary exports on global markets tend to change
rapidly. Therefore Australia can experience large shifts in its terms
of trade. One of the benefits of diversifying Australias export base
is that it will create a more stable terms of trade, reflecting the fact
that prices of manufacturing and service exports tend to be more
stable...

The structure of Australias export base (Australias narrow export

base)

Almost 60 per cent of Australias export earnings come from Australias

mineral and agricultural commodity exports. In comparison to other
advanced economies this indicates an unusually heavy reliance on the
exports of primary industries
 In the long term Australias narrow export base contributes to the volatility
in the CAD because Australia is exposed to large fluctuations in the
commodity prices from year to year.
Concerns over reliance on primary industry exports have lessened in
recent years as Australia has benefited from the medium-term trend
increase in resource prices that was only partly reversed during the GFC.

International competiveness

Australias competiveness depends on cost issues (price) and non-cost

issues (quality)
Cost competiveness is influenced by labour costs and productivity levels,
infrastructure costs, the cost of basic services such as electricity and
water, access to raw resources, transport costs, the tax system, and the
value of the currency.
Benchmarked against productivity of the average American employee, the
productivity of the average Australian employee went from 79 per cent of
the American equivalent in 1990 to 86 per cent in 1999, before dropping
to 83 per cent in 2008.
Non-cost issues include quality of G&S produced, reliability of supply, the
effectiveness of marketing efforts, and the quality of customer service.

Structural change

In order to diversify Australias narrow export base and improve

international competitiveness Australian governments must implemented
a range of micro-economic reforms. Reforms attempt to address structural
factors that affect international competiveness such as inflation,
productivity levels, wages growth, and the improved efficiency of the
public sector.
If Australia has an inflation rate higher than countries it competes with,
Australia exporters are put at a competitive disadvantage, because
their costs of production are increased. This was problem throughout
the 1980s, but since the 1990s Australia has maintained relatively low
inflation.
For Australia to develop a high-value-added export sector it needs
education for a highly skilled workforce, investment into research and
development, and adequate tax and other incentives for venture
capital. These three factors have been highlighted repeatedly as
critical factors in research on export success in advanced economies
To compete internationally Australian firms must sustain productivity
growth.
Competitive labour costs are important for business as labour is the
largest component of business costs.
To improve international competiveness Australia needs to embrace
the changing role of government, emphasising a smaller and more
efficient public sector. There is a view amongst international investors
that greater competiveness will be achieved in countries with a smaller
 public sector, lower taxes and in particular with minimal levels of
government ownership of business.
As a result of the sustained increases in resource prices, the Australian
economy has undergone structural change since the early 2000s towards
emphasis on resources industries.

Cost of servicing foreign liabilities

Major effects of ongoing CAD is that is must be financed by a surplus in

the capital and financial account through debt and equity borrowings
(foreign liabilities)
A higher level of foreign liabilities then contributes to an outflow of funds
in net incomes due to interest costs on foreign debt and returning profits
on foreign investment.
If the foreign liabilities rise, the deficit on the net income component of
the current account will grow. The main issue in the balance of payments
has nearly always been the net incomes deficit from 1999 to 2009 the
net income deficit accounted for 50 per cent or more of the CAD
One of the best economic measures of a countrys capacity to service its
foreign debt is the debt servicing ratio, which measures the proportion
of export revenues used to make repayments on foreign debt.
When interest rates overseas are low, as they were during the past
decade, the servicing costs of foreign debt are lower.
Exchange rates also affect the size of the net income. Investors demand a
set percentage return on investment, therefore if the exchange rate is low
it costs more Australian dollars to meet that set return on investment than
if the exchange rate was high.
o More recently, more loans have been taken out in Australian dollar
terms, and favourable exchange rate movements and lower global
interest rates have reduced the proportionate size of foreign liabilities
and their servicing costs.

National savings

Australia has one of the lowest levels of household savings in the

developed world.
Over time, a lower national savings rate contributes to a higher level of
foreign liabilities, because Australia has to rely more on the savings of
foreigners to fund local investment.
Government can address the savings problem by implementing policies to
increase the level of personal savings (such as compulsory
superannuation), and through measures to eliminate the budget deficit
and move the public sector into surplus, so not to crowd out (crowding
out effect) the domestic credit market.

The consequences of a high CAD

Economists differ over the extent to which we should be concerned about

Australias CAD and foreign liabilities. Some economists argue that any external
imbalances are simply the result of normal market transactions in a globalised
economy, and that the CAD and foreign liabilities are beneficial because
borrowing from overseas can increase investment and help the economy grow
faster. There are however clear risks to a sustained high CAD:

Growth of foreign liabilities. This will mean that lenders may become
reluctant to lend to or invest in Australia and decisions affecting the
Australian economy will increasingly be made by international business
Increased servicing costs associated with foreign liabilities. This can
contribute to the problem of the debt trap, in which Australia is borrowing
money simply to service its existing foreign liabilities.
Increased volatility for exchange rates high CAD may undermine
confidence of investors in the economy reducing demand for Australias
currency. This can cause a depreciation in the $A and worsen the CAD
problem in the short term as cost of imports increase.
Constraint on future economic growth in the longer term, the CAD acts
as a speed limit on economic growth. Higher levels on economic growth
generally involve increased imports and deterioration in the CAD.
Economies with a CAD problem are therefore forced to limit growth to the
level at which the CAD is sustainable. This is known as the balance of
payments constraint.
More contractionary economic policy if they find it necessary to
reduce a high CAD in the short term, governments will use tighter
macroeconomic policies and an acceleration of microeconomic reform
leading to short term unemployment and a slowdown in economic growth.
Sudden loss of international investor confidence leadings to
economic crisis. Countries with a high CAD are more vulnerable to shifts
in investor sentiment, and investor confidence can change suddenly. As
investors withdraw money from an economy, it can often have a dramatic
effect, sometimes triggering a major crisis.

EXCHANGE RATES

Measurement of Relative Exchange Rates

To other individual currencies

Measures 1 unit of $A relative to 1 unit of a foreign currency, usually that

of a major trading partner.

Trade Weighted Index

TWI is a measure of the value of the $A against a basket of foreign

currencies of major trading partners. These currencies are weighted
according to their significance to Australias trade flows.

Fixed exchange rate systems

Fixed exchange rate either through foreign reserves of currency and/or gold or
officially value the exchange rate

Governments can attempt to maintain a fixed exchange rate by either

buying or selling foreign currency in exchange for $A.
Alternately a government would devalue the $A when it officially
lowered the exchange rate and revalued the $A when it increased the
exchange rate

Managed flexible peg This system operated in Australia between 1976 and
1983.

Under this system the RBA would peg the value of the $A at 9am each
day and that price would operate throughout that day.
This system provides more flexibility than the fully fixed rate, but it can
still prevent the rate from drifting away from that which would exist
under pure market forces.

Australias fl oating exchange rate system

The Australian dollar ($A) was floated in 1983. Under a floating system, the
exchange rate is determined by the free play of market forces and not
government intervention.

Demands for $A will be affected by:

Size of financial flows into Australia from foreign investors
o The level of Australian interest rates relative to overseas rates
relatively higher Australian interest rates makes Australia a more
attractive location for foreign savings.
o Investment opportunities in Australia will also strongly influence
demand for $A
Expectations of future appreciation of the $A
Demand for Australia for Australian exports
o Changes in commodity priced and in the terms of trade have tended to
have an immediate effect on the dollar. A rise in commodity prices and
an improvement in the terms of trade are generally associated with an
increase in Australian exports.
o Demand for Australia exports will be influenced by the degree of
international competiveness of domestic exporters and Australias
inflation rate relative to overseas countries.
o Changes in global economic conditions will also influence the overseas
demand for exports
o Tastes and preferences of overseas consumers will affect demand for
Australians exports

Supply of $A is represented by all those people that wish to sell $A:

The level of financial flows out of Australia by Australian investors
o Level of Australian interest rates relative to overseas rates
 o Availability of investment opportunities overseas
Speculators in the foreign exchange market who expect the value of the
$A to go down
Domestic demand for imports
o Level of domestic income when the domestic economy is growing
output, employment and incomes are rising and the demand for
imports will also rise.
o Domestic inflation and the rate and the competitiveness of
domestic firms that compete with imports will also influence import
levels
o Tastes and preference of domestic consumers

Main factors causing an appreciation or depreciation of the Australian

dollar

Appreciation
Increase in Australian interest rates
or decrease in overseas rates
Improved investment opportunities
or deterioration in foreign
investment opportunities
Rise in commodity prices
Improvement in Australias
international competiveness
Lower inflation in Australia
Increased demand for Australias
exported G&S
Expectations of a currency
appreciation
Depreciation
Decrease in Australian interest
rates or increase in overseas rates
Deterioration in Australian
investment opportunities or
improvement in foreign
investment opportunities
Fall in commodity prices
Deterioration in Australias
international competiveness
Higher inflation in Australia
Increased demand from
Australians for imported G&S
Expectation of currency
depreciation

Reserve Bank intervention in the foreign exchange market

When the RBA feels that a large short term change in the exchange rate will be
harmful to the domestic economy (due to one of three reasons: exchange rate
deviation from long-run equilibrium, excessive speculation in forex markets,
excessive depreciation or appreciation), it may decide to step into the foreign
exchange market.

Dirtying the float (direct intervention) by selling $A the RBA may prevent a
rapid appreciation. RBA may also buy $A (by selling its foreign currency
reserves in exchange for $A only) to prevent a rapid depreciation

Cash rate (indirect intervention) if the RBA wants to curb a rapid

depreciation, it may increase the demand for $A by raising interest rates. To
decrease demand for $A it may lower the cash rate.
There is a third type of intervention which is performed by the government and
not the RBA. It is where the government changes its stance of macroeconomic
policy to increase or decrease domestic growth.

It should be noted that direct intervention by the RBA in the forex market may
have implications for domestic liquidity and the stance of monetary policy. If the
RBA sells foreign currency it takes Australian dollars out of domestic circulation
thereby restricting liquidity and pressuring the RBA to ease liquidity through use
of monetary policy.

To offset this, the RBAs intervention may be sterilised: this is where the
RBA offsets its transactions by buying or selling the equivalent amount of
government securities in the domestic financial market, leaving the
monetary responsibilities of the RBA unchanged.

The eff ects of a change in the exchange rate

An appreciation

Negative effects Positive effects

Australias exports become more Australian consumers enjoy
expensive on world markets and therefore increased purchasing
more difficult to sell, leading to a decrease power they can buy more
in export income and a deterioration in overseas produced goods
Australias CAD with the same quantity of
Imports will be less expensive, $A
encouraging import spending and Appreciation decreases the
worsening Australias CAD interest servicing costs on
Higher import spending and reduced Australias foreign debt
export income will reduce economic Reduce the $A value of
growth foreign debt that has been
Foreign investors will find it more borrowed in foreign
expensive to invest in Australia generally currency a phenomenon
leading to lower financial inflows known as the valuation
$A value of foreign income earned on effect.
Australias investments abroad and would Inflationary pressures in
cause a deterioration in the net income Australia will be reduced as
component of the CAD imports become cheaper.
The value of Foreign assets in Australian Reduces pressure on RBA
dollar terms will decrease known as the to raise rate.
valuation effect

A depreciation

Negative effects Positive effects

Australian consumers Australias exports become cheaper on world
suffer reduced markets and therefore easier to sell, leading to
purchasing power an increase in export income and an
 Increased interest
servicing cost on
Australias foreign debt
Raises the $A level of
foreign debt that has
been borrowed due to
valuation effect
Inflationary pressures in
Australia will increase
as imports are now
more expensive.
Increases pressure on
RBA to raise rates.
improvement in Australias CAD.
Imports will be more expensive discouraging
import spending and potentially improving
Australias CAD. Domestic production of
import substitutes should also rise
Lower import spending and greater export
revenue will increase Australias growth rate
Depreciation will also increase the value of
Foreign assets in Australian dollar terms, due
to valuation effect
Foreign investors will find it less expensive to
invest Australia.

Recent Movements in the Australian dollar

2000s saw one of the most volatile period in the $A since it was floated.

In just over 18 months the $A surged from US80 cents to almost achieve
parity in mid-2008 before losing almost a third of its value dropping to
US63 cents in early 2009.
The dollar surged to a 25 year high of 74 on the TWI in 2008 before falling
back to around 63 in 2009.
In late 2010 the $A achieved parity with the US briefly and continues to
hover around US97-100 cents

Year $US TWI

1990-91 0.79 58.91
1995-96 0.76 54.83
2000-01 0.54 50.33
2003-04 0.71 61.49
2006-07 0.79 64.82
Year-average exchange rate movements

10.3 ECONOMIC ISSUES

ECONOMIC GROWTH

Economic growth improves livelihoods, allows individuals to increase

consumption, creates job opportunities, and raises household and government
incomes. Higher household incomes directly reduce poverty and help people
afford the basic necessities of life. Growth also increases government revenues
that can be invested into schools, roads, and hospitals (Source: AusAID)

Economic growth is the increase in the volume of G&S that an economy produces
over time. It is measured by the percentage increase in the value of G&S
produced in an economy over a period of time. The ABS uses three separate
sources of data to calculate GDP:

The quarterly rate of economic growth: the percentage increase in GDP

from one quarter of a year to the next quarter of that year.
Year-on-year growth: the percentage increase in GDP from a quarter of a
year to the same quarter of the previous year.
Annual economic growth rate: percentage increase in GDP since the last
financial year.

Components of aggregate demand

Aggregate demand: refers to the total demand for G&S within the economy.

Aggregate supply: refers to the total productive capacity of an economy, i.e. the
potential output when all factors of production are fully employed.

AD = C + I+G + (X-M) Y=C+S+T

Where: Where:
AD = aggregate demand Y = aggregate supply or national
C = consumer spending by income
households C = consumer spending by households
I = investment spending by S = savings by households
business T = taxation by the government
G = government spending
X = export revenue
M = spending on imports

The economy is in equilibrium, that is, will tend to be stable, when the level of
aggregate demand and aggregate supply are equal:

Equilibrium occurs when:

Aggregate supply = Aggregate demand
Y = AD

Substituting for Aggregate demand and supply gives:

C+S+T = C+I+G+(X-M)

By rearranging the equation we get the leakages and injection in the

circular flow of income:
S+T+M = I+G+X
Leakages = Injections

By analysing the influences on leakages and injections we can see what

factors will cause the economy to expand or contract over time:

S - Influences on consumption (whether to spend or save):

Influences on consumption and saving

 o People and economies with higher incomes tend to consume more.
o Average propensity to consume: the proportion of total income
spent on consumption
o Consumption function: C = Co + cY: total consumption
expenditure = autonomous consumption + that income spent and
not saved (determined by the MPC).
Consumer expectations
The level of interest rates
The distribution of income
Stat: Household consumption represented 56 per cent of expenditure on
GDP in 2007-08

I Influences on investment

The cost of capital equipment

o Changes in interest rates: cost of borrowing to purchase capital
equipment.
o Government policies: changes in government policies relating to
investment allowances and tax concessions on capital goods
o Price or productivity of labour: labour is a substitute for capital
Business expectations
o Expected demand for their products
o General economic outlook
o New resources and/or increase in technology
o Inflation: leads to uncertainty on future prices and future costs
Private investment by firms accounted for 24.4 per cent of GDP in 2007-08

T&G Influences on government spending and taxation

One of main goals of government is to maintain a strong and stable rate of

economic growth.
Government spending usually makes up between one-fifth and one-
quarter of aggregate supply or income. It accounted for 22.2 per cent of
GDP in 2007-08

X&M Influences on exports and imports

Overseas and domestic income

International competitiveness of Australian exports
Overseas and domestic consumer tastes and preferences
Exchange rates: e.g. when exchange rates are weaker domestic industries
are more competitive and their products have greater appeal to foreign
consumers.
If export revenue was equal to import spending, net exports would add no
value to GDP. Because of Australias trade deficit net exports detracted 3.1
per cent from GDP

Multiplier process
 The MPS causes the amount of income generated by each successive
wave of spending to decrease
The sum of each successive wave of income generated will add up to the
total amount by which national income increases
The final increase in national income if equal to the initial increase in
aggregate demand multiplied by the multiplier.

Eff ects of Economic Growth

Higher economic growth can lead to a number of favourable outcomes in an

economy:

Living standards: real wages can rise and household enjoy a higher
disposable income and therefore higher material living standards
Levels of savings: the private and public sector can increase saving
through increased incomes. This can lead to an increase in the household
savings ratio, with households able to reduce debt and save for
retirement. Business also has greater capacity to utilise savings to
invest and expand as profits are higher. Government has increased
revenue through higher taxation and less spending on welfare as more
individuals are employed. This revenue is usually saved in high growth
scenarios to stabilise growth.
Productivity and technological progress: producers are able to reduce
production costs and innovated in keeping pace with rising demand for
G&S. Also increased profits giver business greater freedom to invest in
research and development.
Employment: creates jobs and countries with higher levels of economic
growth tend to create more highly paid and highly skilled jobs.
External stability: economic growth leads to higher output some of
which may be exported to other countries.

Higher economic growth can also cause a number of problems:

Inflation: higher economic growth results demand-pull inflation as

consumers demand more, and also cost-push inflation as prices go up and
wage claims rise in level with inflation
Income distribution: sometimes the benefits of economic growth flow
mainly to a particular group such as shareholders of executives, rather
than flowing more broadly.
External stability: increased consumer and business spending often
results in higher level of imports
Environmental impact: if growth is pursued with little or no regard for
the environment, it can result in pollution and depletion of non-renewable
resources.

Recent Economic Growth Trends

Year Growth % GDP ($b) Year Growth % GDP ($b)

1990-91 -0.6 577 2002-03 3.2 878.3
 1993-94 4.1 623.2 2005-06 3.0 967.5
1996-97 3.9 704.4 2007-08 3.7 1037
1999- 4.0 804.4 2008-09 1.0 1095.4
2000

In the early 1990s Australia experienced a recession

Between 1991 and 2008 Australia experienced it longest period of
sustained growth ever averaging 3.6 per cent per annum.
Australia experienced a quarter of marginal negative economic growth in
2009 but managed to retain an annualised growth rate of 1 per cent.

Australias robust economic performance reflects a combination of domestic and

external factors:

Global economic conditions: apart from a major slowdown in world

activity around the 2000s, from the 1990s to 2008 global economic
conditions favoured Australia with low inflation, lower interest rates, lower
unemployment rates and greater macroeconomic stability.
Resources boom coupled with emergence of China: Australias
growth through the 2000s has been underpinned by Chinese demand for
commodities. Chinas continued economic growth despite the 2008-09
downturns tremendously assisted Australia in avoiding a recession. The
development of the resources boom is described below:
o Rapid growth in emerging economies largely driven by China and
India has sharply increased demand for natural resources.
o At the same time major commodity exporters have been slow to
increase supply of resources, reflecting a long period of relatively
low investment in mining.
o This combination of rising demand and limited supply has pushed
up commodity prices at the same time that export volumes have
increased.
o The Australia treasury estimated that the terms of trade boom as a
result of this has increased national income by 13 per cent between
2002 and 2008. Treasury also estimates that GDP has been boosted
by $260b since 2003 through terms of trade increases alone.
o Directly, the resources boom has increased employment, resulted in
higher incomes for mining industry employees and businesses and
for investors in shares.
o Indirectly, the boom has increased government revenue from
company tax allowing Government to reduce personal income tax
across the economy.
Fiscal policy: fiscal policy has been accurately and successfully used to
make economic growth sustainable and to boost aggregate demand
during periods of low growth. In particular the Australian government
announced stimulus adding up to $77b to boost the economy during the
GFC.
Low domestic inflation: The RBA has continuously taken quick action to
prevent inflation above its target band, sustaining economic growth,
 providing a lower base to act from during the GFC and encouraging
business investment.
Productivity growth and long-term benefits of microeconomic
reform: productivity growth reached 2.6 per cent per year in the 1990s
dur to microeconomic reforms in the previous decades. Though this fell
back in the 2000s the take of new technologies has continued well into the
2000s.

Treasury has described the three Ps productivity, participation and population

as the major future challenges in achieving the highest rate of economic growth.
In 2002 released the Intergenerational Report which treasury would continue to
release every 5 years. It noted the future challenges for Australia growth
prospects, the main one being the ageing population and declining participation
rate.

The 2007 intergenerational report estimates that living standards will improve by
1.6 per cent in the next four decades, down from 2.1 per cent in the previous
three decades. It estimates average growth of real GDP to fall from 3 per cent in
the 2000s to 2.3 per cent by 2020 and to 2 per cent by 2040.

UNEMPLOYMENT

Measuring the Level of Unemployment

Labour force (also known as the workforce): consists of all employed and
unemployed persons in the country at any given time. The ABS uses the
following definition to determine those persons who are counted as part of the
Australian labour force or workforce:

Persons aged 15 years and over who are engaged in at least one hour of
paid work a week. It also includes those on paid leave, those stood down
without pay for less than four weeks, those on strike, etc.
Self employed persons working in family business or their own business.
Unemployed persons available for work and seeking work.

Labour force participation rate: refers to the percentage of the population

aged 15 or over, in the labour force, that are either employed or unemployed.
The average participation rate in 2008-09 was 65 per cent. The participation rate
is determined by four specific factors:

The size of the population

The level of net migration adds to skills base and size of labour force
The age distribution of the population the more people in the 15 years to
64 years age group the larger the pool of potential workers
The participation rate of the working age population an economy might
have a large working age population but a very small labour force if the
majority of the population isnt working
Unemployment: refers to a situation where individuals want to work but are
unable to find a job, and as a result labour resources in an economy are not
utilised. To be classified as unemployed a person must satisfy a number of
criteria:

Regularly checking advertisements from different sources for available

jobs.
Being willing to respond to job advertisements, apply for jobs with
employees and attend interviews
Register with an employment agency linked to job services Australia.

Natural rate of unemployment

Natural rate of unemployment: refers to the level of unemployment at which

there is no cyclical unemployment.

The natural rate of unemployment in effect represents the supply

constraint of an economy. This is because once the natural rate of
unemployment is reached, any stimulus to aggregate demand will not lead
to permanent reduction in unemployment.
This is why the natural rate of unemployment is referred to as the Non-
Accelerating Inflation Rate of Unemployment (NAIRU) stimulus to
aggregate demand will not reduce unemployment, but it will cause
inflation.
A lower NAIRUA increases an economies capacity to grow without fuelling
inflation.
The only way to further reduce unemployment once the NAIRU is reached
is through education and training programs.
Treasury calculated that the NAIRU for Australia in 2009 was 5.0 per cent,
however Australias rate of unemployment has fallen below this in the
2000s (it reached 3.9 per cent in 2008) while inflation was adequately
managed, suggesting the NAIRU is lower than 5.0 per cent.

The Main Types of Unemployment

Structural unemployment results from a mismatch of labour skills and

qualifications of employees with the available employment opportunities.

Cyclical unemployment occurs because of a downfall in the level of economic

activity, and falls during times of strong economic performance

Frictional unemployment is caused by people moving between jobs or

experiencing changing economic circumstances

Seasonal unemployment occurs at predictable and regular times throughout

the year because of the seasonal nature of some kinds of work

Regional unemployment occurs when one or two major industries in a

particular region reduce their demand for labour causing widespread
unemployment.
Hidden unemployment refers to those people who can be considered
unemployed but do not fit the official definition of unemployment. They are also
known as discouraged job-seekers because they believe they cannot find a job
and therefore do not seek employment.

Underemployment refers to those who work for less than full time hours per
week but would like to work longer.

Long term unemployment those people that have been out of work for 12
months or longer

The Causes of Unemployment

Level of Economic Growth

Derived demand demand for labour is derived from the demand for G&S
which labour helps produce. Therefore a downturn will increase the level of
unemployment and an upturn will decrease it.
Constraints on economic growth if there are continued constraints on
economic growth the economy will struggle to create enough jobs to
reduce unemployment

Government Policy

Stance of macroeconomic policy:

1992- Expansionary policy, with large deficits and low interest rates,
94 saw unemployment fall from 11 per cent to 8.5 per cent
1996- A shift towards tighter monetary policy and fiscal consolidation
97 contributed to slower growth and a slight increase in
unemployment to 9 per cent
1997- Interest rates reductions helped accelerate growth,
99 encouraging spending, business investment and job creation
1999- The cycle of interest rate increases in this year slowed down
01 growth in 2000 and 2001 and resulted in an increase in
unemployment
2003- The mildly expansionary stance of monetary policy supported
04 growth and led to a fall in unemployment levels
2005- Mildly expansionary fiscal policy alongside a major resources
08 boom helped sustain further reductions in unemployment to
around 4 per cent
2008- A shift to highly expansionary macroeconomic policy helped
09 abate a sudden spike in unemployment caused by the GFC

Inadequate levels of training, education and investment a mismatch of

skills to growth industries which are demanding employment prevents
unemployment from falling. Furthermore unskilled labour is less likely to
be employed in a highly skilled digital advanced economy.

Rising Participation Rates

 An increase in the labour force participation rate will tend to cause in
increase in unemployment in the short term.

Structural Change

Microeconomic reform will open industries to increased competition

potentially causing some businesses to cease operation or move offshore,
making much of their current workforce redundant.
Productivity higher productivity will tend to increase unemployment in
the short term, but increase employment in the long term as the economy
is internationally competitive and grows at a faster rate. Lower
productivity will decrease unemployment in the short term, but increase
unemployment in the long term as the economy grows slower and firms
may replace workers with more productive capital.
Technological change new and improved production methods often result
in the substitution of capital for labour.

Inflexibility in the Labour Market and Labour costs

Regulation too many regulations surrounding employment may

discourage employers from hiring new employees
Minimum wage rates high minimum wages rates make it less attractive
for employers to hire less skilled workers
Wage expectations an important factor that can cause unemployment is
the role of wage expectations in pushing up the price of labour relative to
capital. For example if employees expect a rise in the minimum wage it
may become cheaper to substitute labour for capital. The role of wage
expectations is linked to:
Rapid increase in labour costs this can be caused by a shortage of skilled
labour, excessive wage demands or industrial action.

The Impacts of Unemployment

Economic costs

Opportunity cost
o Unemployment means an economys resources are not being used
to its full capacity. Therefore unemployment is the opportunity cost
of lost output and income
Lower standard of living
o With high unemployment the production of both consumer and
capital goods is lower leading to a reduced rate of economic growth
and therefore living standards.
Decline in labour market skills for long term unemployed
o Known as hysteresis: this is the process whereby unemployment in
the current period results in the persistence of unemployment in
future periods as unemployed people can lose their skills, job
contacts and motivation to work.
Costs to the government
 o Falling incomes associated with unemployment generate less tax
revenue
o Government is forced to pay out more transfer payments as well as
funding training and labour market programs.
Lower wage growth
o Higher levels of unemployment mean there is an excess supply of
labour forcing down wages of restricting wage growth.

Social costs

Increased inequality
o Unemployment tends to occurs among lower income earners in the
economy, leading to loss of income which means this group earns
even less.
Other social costs:
o Severe financial hardship and poverty
o Increased levels of dept
o Increased levels of crime
o Bunch of other unimportant non-economic stuff
Particular unemployment issues unemployment by group and hidden
unemployment
o Youth - Persons aged 15-19 experience levels of unemployment up
to three times the rate of the general population. There is also a
pattern where youth unemployment increases about twice as much
as the increase in general unemployment, as observed during the
GFC.
o Indigenous Australians a PC study in 2007 found that the
unemployment among Indigenous Australians was 13 per cent
compared to 4 per cent for non-indigenous people. Also:
Indigenous Australians have a much lower participation rate
Research shows that Indigenous workers are three to four
more times likely to be discouraged job seekers compared to
non-indigenous workers (Hunter and Gray 2009)
o Women job loss during recessions have a disproportionate effect
on hidden unemployment; research by The Australian Institute
suggests women are more likely to exit the labour market and take
up domestic work immediately following job loss rather than follow
the unemployment path during recessions.
o Age related unemployment many older Australians fall into hidden
unemployment as the leave the workforce because of few job
opportunity and fewer opportunities to re-skill.
The take up of Pensions conceal older workers who would
otherwise be classified as unemployed (OBrien 2001).
Currently 400,000 people aged over fifty but younger than
the retirement age receive the disability support pension.
o People born outside of Australia unemployment rates are slightly
higher for people born outside of Australia, which might be caused
by language and cultural barriers. Also, Australian firms may not
 recognise overseas qualifications leading to systemic
underemployment of highly skilled people born outside of Australia.

Policies to reduce unemployment

Australia needs economic growth rates of around 3.5 per cent or higher to
reduce unemployment. The relationship between economic growth and
unemployment is explained by Okuns Law to reduce unemployment the annual
rate of economic growth must exceed the sum of percentage growth in
productivity plus an increase in the size of labour force in any one year.

Government can use policies to increase economic growth to reduce

unemployment in this way, or it can specifically target problems that cause
unemployment in the first instance:

Macroeconomic policies

Fiscal and monetary policy is very efficient in reducing cyclical

unemployment.
o Nation Building Economic Stimulus Plan funded labour intensive
infrastructure projects for reducing cyclical unemployment during
the GFC
Experience in economies such as Australia over the past few decades
have shown that monetary and fiscal policies are relatively ineffective in
reducing structural unemployment.

Government policy

The government can utilise regulation outside of microeconomic reform:

decreasing or increasing the number of work visas offered to overseas
workers, and increasing or decreasing the immigration rate and skilled
migration quota.
The government can utilise fiscal policy specifically targeted at
unemployment:
o Job Services Australia established in 2009, which replaced the Job
Network reduces frictional unemployment be improving the flow of
information between job seekers and potential employers. Also
reduces structural unemployment by assessing the skills of job
seekers and recommending training or education.
o The 2009-10 Jobs and Training Compact
o The Education Investment Fund and the Education Revolution

Microeconomic reform

Labour market reforms designed to make labour markets more flexible,

encourage competitive work practices and higher levels of labour
productivity.
o Decentralised wage determination linking wage rises to gains in
productivity
 Tax and welfare reforms strengthen incentives and obligation of welfare
recipient to work
o The Work for the Dole programme (1997)

Recent unemployment trends and an analysis.

The unemployment rate peaked in 1992-93 at 10.7 per cent largely due
to a severe Australian and global recession combined with structural
change caused by the microeconomic reforms of the previous decade.
Following the early 1990s there has been a steady decrease in the
unemployment rate largely due to sustainable economic growth rate
which averaged 3 per cent per annum over the mid 1990s late 2000s
period.
o In early 2008 unemployment reached a 34 year low of 3.9 per cent.
o Unemployment was lowest in Western Australia and Queensland
which most benefited from the commodities boom.
ADVANCED ECONOMIC ANALYSIS: Economists suggest that the average
unemployment rate of between 4-5 per cent during Australias 17 years of
consecutive economic growth hides the real story in the Australian labour
market:
o The ABS calculates the number of underemployed people as the
labour force utilisation rate. If this rate is added to the
unemployment rate we arrive at a figure of 13.8 per cent of the
labour force in 2010. It is difficult to measure hidden unemployment
but conservative estimates put total figure of official unemployed,
underemployed and hidden unemployed at around 15 per cent of
the labour force in 2010. Though the year 2010 is coming out of a
small downturn this would still suggest that they real level of
unemployment during the 17 years of consecutive growth was
significantly higher than official estimates.
The GFC caused unemployment to rise however unemployment only rose
to a peak of 5.8 per cent in 2009, much lower than forecast and much
lower than the OECD average of 8.8 per cent.
o A corresponding spike in underemployment emerged, suggesting
the reason for this relatively low unemployment rate was a
reduction in hours rather than jobs by employers. The ABS
estimates the underemployment increased by nearly 50 per cent
since mid-2008 to over 900,000 people by early 2010
o Youth unemployment rose from 8.1 per cent in early 2008 to 12.2
per cent in min-2009
o Unemployment during the GFC was spread disproportionally by
region areas in the north shore had unemployment rates of less
than 3 per cent in 2008 while areas in western Sydney had
unemployment rates well above 10 per cent.
o The ABS calculated that the number of discouraged job-seekers
grew by nearly 40,000 in 2008.
INFLATION

Measuring Infl ation

Inflation is the sustained increase in the general price level over time. In
Australia the most widely used measure of inflation is the Consumer Price Index
(CPI) calculated by the ABS. The RBA also calculated the underlying inflation rate
as it is seen as a more accurate measure as it is not affected by one-off volatile
price movements.

CPI or the headline inflation rate summarises the movement in the price
of a basket of G&S weighted according to their significance for the
average Australian household.
The underlying inflation rate is the average of these two inflationary
calculations added together:
o Trimmed mean inflation is determined by calculating the average
rate after excluding the top 15 per cent of items with the largest
price increases and the bottom 15 per cent of items with the
smallest price increases.
o Weighted median takes the middle/median inflation rate of the list
of every item on the CPI.

Main Causes of Infl ation

Demand-pull inflation occurs when aggregate demand or spending is growing

while the economy is nearing its supply capacity, so that higher demand leads to
higher prices rather than more output.

It can occur through excessive growth in any component of aggregate

demand, such as an increase in consumption spending, an increase in
business investment spending or an increase in net government
expenditure.
Another major source of demand-push inflation is an excessive increase in
the money supply, where an increased volume of chases the same amount
of G&S.

Cost-push inflation occurs when there is an increase in production costs that

producers pass on in the form of higher prices.

Common causes of cost-push inflation are a rise in government charges

and taxes or across the board wages increases that do not reflect
productivity growth.
Import inflation is a particular kind if cost-push inflation: imported inflation
is transferred to Australia through an international transactions, e.g. a rise
in the price of imported goods or a depreciation of the $A.

Inflationary expectations this can occur regardless of a real change in the level
inflation, but often is the cause of a real change in the level of inflation:
 If the price of G&S is expected to increase in the future consumers may
attempt to purchase products before such increases. This caused an
increase in consumption as future consumption is added to current
consumption, causing demand-pull inflation
If employees expect inflation to increase, they will take this into account
when negotiating their wage increases. In this way employees will seek
higher wages to offset the expected increase in prices, causing cost-push
inflation as firms accommodate increased wage costs by waging prices.
This is often referred to as the wage-price spiral.

Eff ects of Infl ation

Economic growth: inflation is the main constraint on economic growth as

policies to reduce inflation retard economic growth.
Wages (effects consumers and workers): higher cost of living and a fall in
real wages unless wage growth is the same as inflation growth. Leads to a
reduction in living standards for consumers and wager-earners
Unemployment (effects producers, government, and workers): higher
levels of inflation will usually result in more contractionary fiscal and
monetary policy resulting in slower economic growth and higher
unemployment. Business may also choose to reduce their labour force to
decrease cost pressures. This is known as stagflation where the rate of
inflation and the rate of unemployment rise simultaneously.
International Competiveness (effects exporters): as supply costs
increases Australian exporters will either have to let profit margins fall due
to a lower price-cost differential or increase prices on international
markets making their product less price competitive. Consumers will also
be more likely to switch to cheaper imported substitutes than buy
domestic G&S.
Government: the cost of providing G&S will rise and welfare payments
due to increased unemployed may rise causing an expansion in
government expenditure. However, taxation will also rise as taxpayers are
forced to pay more tax on consumer goods and wage earners are pushed
into higher wage brackets.
Investment: high inflation distorts the incentive to invest as it makes
producers uncertain about future profits and encourages short term
speculative investments.
Saving: Savers will find the real value of their savings will decline if
nominal interest rates do not keep up pace with inflation.

Policies to Reduce Infl ation

Monetary policy

Fiscal policy

Micro-economic policy

Recent Trends
 Inflation averaged 6-10 per cent since the mid-1970s to early 1990.
Inflation has stayed well below 3 per cent in both underlying and CPI terms
for most of the 1990s and 2000s.
o Adoption by the RBA of inflationary band targeting in 1993 for the
conduct of monetary policy.
o Structural changes during the 1980s and 1990s to increase
competition in product and factor markets.
o Adoption of a national competition policy in 1995 put downward
pressure on price levels in factor markets.
o Linking wage growth to productivity increases.
o The impact of technological change and globalisation helped reduce
production costs and increase competitive pressure to contain price
growth.
In 2006-2008 there was an upswing in inflation to around 4.5 per cent in
CPI and underlying terms. This reflects:
o Resources boom and associated increased wage rise claims.
o Economy nearing full capacity i.e. demand was exceeding supply.
With the onset of the GFC inflation dropped with CPI rising 1.5 per cent in
2008-09. This reflects:
o Demand pressures easing globally and domestically due to slower
economic activity
o Australian economy was operating with spare capacity i.e. supply
exceeded demand.
o Lower world commodity prices, lower housing costs and slower
growth in labour costs.

EXTERNAL STABILITY

The debt-trap cycle:

increase in
foreign
liabilities
increase in
foreign borrinings income outflows
or foreing to foreign
investment investors
required to fund
CAD
worsening of net
increase in income
CAD component of
current account

DISTRIBUTION OF INCOME AND WEALTH

ENVIRONMENTAL MANAGEMENT

Australias Key Environmental Statistics

Forest Area (thousand sq. Km, 2005) 1,637
Freshwater resources (per capita cubic metres, 23,412
2007)
Threatened animals and plants (no. of species, 623
2008)
Fossil fuels (% total of energy use, 2006) 94.7
Carbon dioxide emissions (per capita metric 18.1
tonne, 2005)

Ecologically Sustainable Development

Ecological sustainable development: involves conserving and enhancing

the communitys resources so that ecological processes and quality of life
are maintained. The keys principles are:
o Integrating economic and environmental goals in policies and
activities
o Ensuring the environmental assets are appropriately valued
o Ensuring fairness in the shifting of costs and assets within and
between generations
o Managing environmental risks with caution
o Taking into account the global effects of environmental issues
Australias National strategy on Ecological Sustainable Development
(NSED) was first developed in 1992 with three core objectives:
o Enhance Individual and community well-being and welfare
o Provide for equity within and between generations
o Protect biological diversity and maintain essential ecological
processes

Market Failure: private benefi ts and social costs

Market failure: occurs when the price mechanism takes account of private
benefits and costs of production to consumers and producers, bit it fails to take
into account indirect costs such as damage to the environment.

The price mechanism ignores costs benefits associated with production in two
main ways:

The costs of additional production do not take account of any additional

social or environmental costs
The price mechanism does not take account of future demand for G&S
that may not be satisfied or how the economys ability to grow in the
future may be affected because a resource has been used up or
destroyed.

Tragedy of commons: refers to a situation where the failure of the market to

assign costs to individuals leads to damaging overuse of resources such as the
natural environment.

Public and Private Goods

Public goods: non-excludable and non-rival

Private goods: excludable and rival

Free riders: refers to groups or individuals who benefit from a good or service
without contributing to the cost of supplying the G&S as a consequence, the
good or service is likely to be under-supplied in relation to total demand.

Major Environmental Issues

Preserving natural environments

Preservation of natural environments may include:

Restrictions on developments in environmental sensitive areas, such as

mining in national parks
Controls over emissions of waste products
Requiring new plantation in areas where logging has occurred
Controls over emissions of waste products
Actively protecting the natural environment from threats such as non-
native plants and animals

Government often face significant problems in trying to preserve the natural

environment:

Short term: intervention is likely to result in a reduction in economy

growth and an intervention in the price mechanism may cause higher
prices or reduce supply
Industries will face higher costs if they have to comply with rigorous
environmental standards. In a highly competitive global market place our
environmental standards make us less competitive.
Cost of repairing damage to the environment is often borne by taxpayers.

Controlling pollution

Pollution occurs when the natural environment is degraded in some way,

such as by harmful chemical substances, noise, or untreated rubbish.
Pollution is often observed far away from its original source making it
problems for the global economy and global institutions.
One of the best known problems pollution causes is climate change.
o The Intergovernmental Panel on Climate Change (IPCC) estimates
that emissions as a result of human activity have increased by
about 70 per cent between 1970 and 2004.
o Several economists have linked the growth in emissions to
increasing per capita incomes, and growth in the worlds population
over time.
o In the long run the IPCC estimates the increased emissions to lead
to average global temperatures rising by between 1.1 and 6.4
degrees.
o This would threaten economic growth as agricultural activity and
human health are put at risk from:
 An increase in sea levels of between 18 and 59 cm coastal
flooding that may affect 20 million people and place an
additional 30 million at risk of hunger
More intense droughts and floods
Extreme and unpredictable weather conditions
Skin cancer rates increasing by as much as 140 per cent
Number of environmental refugees increasing by up to 200
million
o The most comprehensive report on the effects of unmanaged
climate change on the Australian economy (Garnaut Report) found
that:
GDP could be reduced by 4.8 per cent by 2100, consumption
by 5.4 per cent and real wages by 7.8 per cent
Permanent environmental damage such as bleaching of the
Great Barrier Reef and the loss of up to 80 per cent of Kakadu
wetlands.
Increased incidence of heat related health conditions in
Australia, such as malaria and skin cancer
Increased frequency of droughts in southern parts of
Australia, decreasing agricultural production
Climate change also provides a case study of how policy can be used to
address environmental issues:
o 1997 Kyoto protocol which requires industrialised countries to
reduce greenhouse gas emissions by 5 per cent on 1990 levels by
2012. Australia ratified this agreement in 2007.
o When the Kyoto protocol expires in 2012 it is expected to be
replaced by a new international agreement in 2013 negotiated
through UN Framework Convention on Climate Change.
o Australia has also expressed interest (as have other countries
already done) in putting a cap on the level of emissions that can be
produced in any year.
The proposed Carbon Pollution Reduction Scheme would
include 6 greenhouse gases, 1000 large firms with mandatory
obligations and covered three-quarters of total emissions

Externalities

Negative externality: is an unintended negative outcome of an economic

activity whose cost is not reflected in the operation of the price
mechanism
Positive externality: is an unintended positive outcome of an economic
activity whose value is not reflected in the operation of the price
mechanism

The depletion of natural resource

Renewable resource: renewable resources can natural regenerate of

replace themselves in a short period of time. The resources can, however,
be depleted to point where they become non-renewable e.g. fishing is
 renewable however overfishing causes the resource to be depleted faster
than fish can reproduce, reducing fishing stocks.
Non-renewable resources: are those natural resources that are limited in
supply because they can only be replenished over a long period of time or
cannot be replenished

THE OBJECTIVE OF ECONOMIC POLICY

FISCAL POLICY

Fiscal policy refers to the use of the Commonwealth Governments Budget to

affect:

o Economic activity (economic growth, employment, inflation),

resource allocation, income distribution

Budget is the annual statement by Government of its income and

expenditure:

o Direct tax, indirect tax, other revenue

o Expenditure: social welfare, health, education

Budget outcomes:
o Deficit
o Surplus
o Balance
Changes in budget outcomes:
o Discretionary (influence structural)
o Non-discretionary (causes by cyclical activity)
o Also automatic stabilisers: policy instrument that
counterbalances economic activity
Unemployment benefits
Progressive income tax system

Impact on economic activity:

o Contractionary: multiplied decrease in consumption and
investment that dampens AD
o Expansionary: multiplied increase in consumption and
investment that stimulates AD
o Neutral: no overall effect
o Keynesian principles vindicated by recent use of budget to
stimulate economy out of recession
o Evidence BY IMF research papers that contractionary fiscal policy
that reduces debt can in medium-long term increase economic
growth because of the reversal of the crowding out effect.
Impact on resource use:
o Directly affect resource use such through government spending
on particular area of economy
 o Indirectly affects resource use through tax or spending decisions
that make it more or less attractive for resources to be used in a
certain way e.g. Taxes on tobacco
o Also through provision of public goods
Impact on income distribution
o Taxation and transfer payments
o Effects on inequalities
Impact on savings and CAD: public sector deficit and crowding out
effect making the pool of domestic funds smaller.

Methods of financing deficit: borrowing from private sector, overseas, selling

assets, or RBA (monetary financing)

Using budget surplus: pay of public debt or placing money in specially

established government-owned investment fund (future fund, Building
Australia fund, education endowment fund)

Current/recent stance:

o Cyclical factors: 2009-10 budget deficit of $56bn, forecast

taxation to decline by up to $210bn by 2012-13
o Structural factors: stimulus; $10.4bn economic security strategy,
$42bn national building and jobs plan

MONETARY POLICY

Influence cost and availability of money and credit in economy.

Objectives: maintain low inflation (inflation band targeting formalised by

statement of conduct on monetary policy in 1996 however original wording of
RBA Charter has not changed meaning the RBA must still pursue the
following goals), reducing levels of unemployment, and sustained level of
economic growth

Domestic markets operations are the main instrument of RBA that influence
interest rates in economy

Cash rate is set by forces of demand and supply in the short term
money market (market for short-term loans between financial
institution)
RBA influences this through DMO
o Banks are required to hold a certain proportion of funds in
exchange settlement (ES) accounts, which the banks hold
with the RBA
o Supply of funds in ES accounts is affected by day-to-day
banking transaction between banks and through taxation and
transfers as the RBA is the bank to the government
 o RBA exercise direct control of supply of funds through the
forced buying and selling of CGS to financial institutes. These
may be outright or may take the form of repurchase
agreements
o This buying and selling of CGS increases or decreases supply
of funds in ES accounts thus decreasing or increasing cash
rate

Impact of cash/interest rate through 6 channels of transmission mechanism:

Investment, savings, and consumption decisions are made on rate

of interest
Alters cash flow between borrowers and lenders: high interest rate
decreases cash flow as more cash has to paid to servicing debt
Cost of credit
Affect on asset prices: may alter distribution of wealth. By
discouraging spending leading to less demand and fall in asset price
Exchange rate: high interest rate encourage capital inflow
Inflationary expectations

MICROECONOMIC POLICY

Microeconomic policy overall aim: encourage efficient operation of markets

o Allocative efficiency: economies ability to shift resources to where

they are used most efficiently
o Technical efficiency: ability of economy to achieve maximum level of
output per given level of input
o Dynamic efficiency and innovation: economies ability to shift
resources between industries in response to changing patterns in
economy.

Microeconomic theory states the product and factor markets will work more
efficiently if there is more competition between private business and the market
forces operate without government interference. Hence micro-reform focuses on
removing distortions

Main reforms
o Deregulation: removal of simplification of rules that constrain
efficient market operation
Financial sector: 3 steps; floating of Australia dollar, removal
of RBAs direct monetary controls over banks, and removal of
barriers to foreign banks entering Australia
Telecommunications: dominated by Telstra, but was opened
up to Optus and Vodafone in the early 1990s. Full
competition in 1997. In 2009 the government announced it
would undertake reforms to remove the virtual monopoly
 Telstra has including separating Telstra into its wholesale and
retail business
o Reforms to public trading enterprises:
Corporatisation of PTEs: aims to encourage PTEs to operate
independently from government as if it were a private
business. Involves eliminating political and bureaucratic
supervision.
Privatisation of PTEs: completely government free
o National competition policy reforms:
National Competition Policy agreement in 1995 between
states to engage in micro-reform
As part of reforms Australian Competition and Consumer
Watchdog was set up
National regime to regulate costs of access to infrastructure
o Also tax reform, labour market policy, and reducing protection
o Overall impact of micro-reform:
Benefits: greater efficiency and productivity growth, new
business and job opportunities, higher economic growth and
living standards, lower inflation
Costs: short term unemployment, closure of inefficient
industries, greater work intensity, higher inequality

EFFECTIVENESS AND LIMITATIONS OF ECONOMY POLICY

Limitations on policy implementation

Time lags:

Significant time lags can exist in implementing economic policy and

waiting for those changes to have an impact on the economy.

Policy Implementation time lag Impact time lag

Fiscal Medium term major changes Short term (a few months)
to the budget occur on an
annual basis and need to go
through a complex process of
budget committee meetings
and department scrutiny.
However, the government can
announce major fiscal policy
changes between budgets
Monetary Short term the board of the Medium term (6-18 months)
RBA meets to discuss changing
the cash rate every month and
announce any change to
financial markets at 2.30pm on
the same day. However the RBA
governor does have the
discretion to changes interest
rates if conditions change
 significantly during the period
of time between RBA meetings
Microecono Long term (a few years) Long term (up to 20 years)
mic reform microeconomic reform often
involves extensive planning,
detail and consultation. It often
occurs in response to or after a
major government study has
been commissioned. They can
also take a lot of time to
implement if it is necessary to
secure the support of the state
governments.

Political constraints:

The three year political cycle is often regarded as a constraint on long-

term economic policy decision making typically government undertake
long term reforms in the first year of tenure and around halfway through
their three year term the begin preparing for the next election, reluctant to
make policy that could be perceived as unpopular
The issue of unpopular policies often leads governments to delegate
unpopular decisions to government organisations. For example if the
government was in control of interest rates rather than the independent
RBA they would be under political pressure to keep interest low.
System of federalism can also act as a constraint as responsibility is
shared across jurisdictions making national coordination difficult. The
Council of Australian Governments (COAG) was created in the 1990s to
facilitate agreements between the commonwealth government and the
states on policy issues such as microeconomic reform.

Theories that explain the limitations of macroeconomic policies:

Crowding out effect

Twin deficits hypothesis
Quantity theory of money