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External Stability Notes

Topic: Australia and the world economy

AOS 3 Outcome 3
Relationship between trade and living standards including lower prices and greater consumer
choice, economies of scale, access to more resources for business and government
Trade Liberalization

 Cutting tariffs
 Reducing cash subsidies
 Abolishing import quotas
 Free trade agreements

Advantages Disadvantages
 International specialization  Mixed effect on income distribution (can
 Countries focus on producing goods with promote long term income inequality)
greatest comparative cost advantage  Mixed effects on economic stability
 Absolute cost advantage (cheapest and (prevent infant industries from
most efficient in world) developing)
 Comparative cost advantage- (area of  Can promote economic instability
production which is the lowest cost and  Weaken environment and living
has least opportunity cost) standards
 Economies of scale (fixed costs spread  Prevent development of infant industries
over large output)
 Lower prices, greater choice for
 Boosts GDO and incomes
 Greater efficiency
 Economies of scale
 Innovation
 Imports of new capital
 Creation of more jobs
 Greater access to resources
 Greater consumer choice
 Promotion of peace
 Enrichment of culture

Balance of payments and components

Balance of payments-statistical account of value of transactions Australia has with the rest of the
world, consisting of financial and current account.

Balance on Net goods Net services Net primary Net secondary

Current incomes incomes

Credits minus Debits-credits for Credits received Debits minus

debits for exports services exported from overseas credits for
e.g. commodities, e.g. education, and minus debits residents
wool, oats royalties, e.g. wages, e.g. gifts, taxes,
construction, interest dividends foreign food
insurance, profits donations

Balance on Capital and Financial account (CAFA)

Balance on capital-net capital transfers and net acquisition of non-produced and financial assets
Capital transfers(Largest)-flow of funds into Australia
Net acquisition-sale of copyrights, patents
Balance on financial-determines how Australia funds CAD.
Balance on financial account-foreign assets and liabilities
Direct Investment-purchase and expansion of Australian companies by foreign firms/individuals
Purchase of residential property
Net portfolio investment-difference in value of purchases of Australian shares minus value of
overseas shares purchased by Australian investors
Net reserve assets-government transactions involving dealings in reserves of foreign currencies
Net errors and omissions-inaccuracies in calculations and estimates

Causes of Australia’s current account deficit and components

Causes of Australia’s current account deficit-can create shortfalls and higher domestic prices for
goods and services
Strong domestic spending reduces potential of Australian exports increasing CAD
Can cause RBA to raise interest rates to control inflation-weaker domestic spending-shrinks’ CAD
AS side conditions
Lack of domestic spending-increases CAD
Higher production costs-increases CAD

Relationship between CAD and capital account

Australia’s BOP should equal zero. Capital and financial account should balance current account.
Current account deficits increase net foreign debt (NFD)
Ongoing current account deficits increase Australia’s net foreign liabilities
Current account deficit caused by national savings gap, large difference between household and
business savings and government investment needed to drive economic growth. As a result,
Australia has heavy income debits to pay in the form of interest on foreign loans increasing
Australia’s CAD.

Causes of Australia’s CAD including cyclical and structural factors

Cyclical Structural
Aggregate demand side factors Aggregate supply side factors
Changes economic activity overseas Lack of household savings
 Weaker economic activity  Large gap in national savings and
overseas-depress commodity prices and government investment needed for
TOT-lower export to import economic growth
Prices-Higher CAD  Increases NFD and NFL
 Increases long the structural CAD
 Better TOT-lower CAD Dependence on overseas borrowing
Changes in consumer and business confidence Weaker growth in productivity
and real disposable income  Labour productivity
 GDP per number of hour worked
 Lower consumer confidence will result in  Multifactor productivity
lower consumer spending  GDP divided by inputs of natural, capital
 More disposable income diverted to and labour resources
savings Changes in real unit labour costs (RULC’S)
 Greater consumer and business Natural disasters
confidence-lower CAD  Real wager costs per unit
Changes in interest rates  Determines structural CAD
 High min wage decreases national
 Higher interest rates restrict supply of productivity
credit in Australia Oil prices
 Reduces consumer spending and  Higher oil prices ($100 per barrel
business investment between 2008 and 2012) exerted
 Higher CAD upwards pressure on CAD and downward
Government defense spending and foreign aid pressure on exchange rate
Interest rates Demographic changes (changing population)
Current structural CAD 3% of GDP

 Imports of defence equipment  Aging population, decreasing
contribute to CAD participation rate in lab our market
 Cuts in foreign aid reduce CAD-reduces  Reduces competitiveness of exports
secondary income debits  Immigration supply side factor-wage
Natural disasters-reduces access to resources costs lower and reduces bottlenecks

Relationship between current account and capital and financial account

Overall balance of payments should equal zero
Current account deficit should be offset by the capital and financial account surplus
Total value of credits for exports exceeds net debits for capital investments
Deficit in current account increases NFD and NFL
Composition and cause of NFD and NFE
Net foreign debt (NFD)-liabilities (overseas debt)-investments (overseas assets)
Composition of NFD
Public sector borrowing (official debt)

 Overseas borrowing to finance budget deficits e.g. (GFC 2008-2010)

Private sector (non-official borrowing)

 Overseas borrowing by companies needing to raise capital needed for expansions and
 Overseas borrowing by Australian banks
 Debt burden increases when Australian dollar appreciates\
 National credit ratings may downgrade

Causes of net foreign debt

 Lack of domestic savings-savings investments gap

 Budget deficits (2008-2016)-expansionary budgets
 Opportunities for foreign investors-adds to external liabilities-vast natural resources
 Sound economic political and social climate-promotes foreign investment in Australian
assets and residential property
 Lower AUD – (2013-2016)-makes purchase of Australian assets more attractive to foreign
investments-adds to external liabilities
 Financial sector deregulation and globalisation-increased capital inflow and foreign
ownership of Australian assets

Effects of NFD

Advantages Disadvantages
Finance for expansion-compensate for Economic hardship
deficiency in national savings Burden of debt payment
Access to foreign credit  Debt burden may become heavy when
Australian dollar falls in value from
country from which debt originates
Adds to CAD
 Deficit in net primary incomes
 Weakens currency
 Reduces purchasing power

Net foreign equity (NFE)-net value of assets owned by foreign investors in Australia

NFE and NFD-capital inflow to Australia

Terms of trade: factors which may influence the terms of trade

Terms of trade-ratio for the average price of Australian exports on international market

 Favourable-export prices rise

 Less favourable-export prices fall against import prices
Terms of trade is regarded as an aggregate demand factor in influencing spending levels
Less favourable terms of trade during (2013-2016)-decrease in AD and fall in economic activity
Measurement of terms of trade

Factors which influence Australia’s terms of trade

Changes in global conditions of demand

Fall in TOT

 Weaker economic activity in key trading partners e.g. China

 Weak consumer and business confidence
Increase in TOT

 Growth in consumer and household disposable income

 Stronger economic activity overseas in China
 Faster population growth
Changes in global conditions of supply

More favourable TOT

 Higher supply of goods and services will lower overall price levels for Australian exports
 Resource depletion or exhaustion
 Low productivity growth
 Natural disasters in Australia/Overseas

Less favourable TOT

 Discoveries of new natural resources

 New technology
 Climate
Effect of movements in terms of trade on balance on current account, domestic macroeconomic
goals and living standards
Effects of TOT

 fall in TOT-rise in CAD-deficit in net goods and services account

 rise in TOT-lower CAD-surplus in BOP and current account
Australian exchange rate

 fall in TOT-low demand for Australian exports decreases demand for AUD
 rise in TOT-pushes up value of AUD. Higher demand for Australian and export prices
increases demand for AUD
AD and domestic economic activity

 fall in TOT-reduces AD-weaker economic activity, lower export prices

 rise in TOT-increases AD and economic growth
Factors influencing values of exchange rate: Relative interest rates, demand for exports and
Imports, Capital flows, terms of trade and relative living standards

Measures of Australia’s exchange rate
Individual exchange rates-against the individual currencies of each country
Trade weighted index (TWI)-average exchange rate for a basket of foreign currencies
Value of AUD is determined by supply and demand in the foreign exchange market
Value of AUD will appreciate or depreciate according to supply and demand factors in the foreign
exchange market

Factors influencing supply of AUD

 Consumer and business confidence

 Tax rates/disposable income
 Inflation
 Budget receipts, government spending outlays
 Household savings ratio
 Speculation
Factors affecting demand for AUD

 Overseas economic activity
 Consumer and business confidence in key trading partners
 Speculation
 Interest rate gap between nations
Effect of exchange rate movements on current account balance, domestic macroeconomic goals
and living standards
Domestic macroeconomic goals

 Inflation (1-2%)
 Full employment (<5% of labour force)
 Strong and sustainable economic growth (2-3%/annum)

 Demand pull inflation-higher cost of living-lower material livings standards

Low UAD stimulates exports-high demand pull inflation
Higher AUD-lower demand pull inflation

 Cost push inflation

Lower-lower costs of production
High AUD-higher costs of production for firms which import capital
Economic growth

 Affects net export spending-AD and cyclical level of economic activity

 Weaker AUD-boost investments
 Weaker AUD good for exporting companies
 Stronger AUD good for importing companies

 Weaker AUD-higher AD-higher economic growth-reduces long term cyclical unemployment

through new jobs and overseas demand
 Weaker AUD-lowers production costs and costs of imported capital allowing businesses to
become more productive and expand production capacity-in turn, demand for labour will
increase and cyclical unemployment will decrease
Current account deficit

Value of exports

 Fall in the value of AD-exports (commodities, iron ore, education) are less expensive-cad
 Rise in value of AUD-increases CAD-exports become more expensive overseas

Value of primary income credits and debits-affects capital inflow/outflow to Australia

 Fall in value of AUD makes purchase of Australian assets less attractive

 Stronger AUD-higher inflow of capital to Australia
 Reduction in CAD, discourages primary income debits
Factors which may influence Australia’s international combativeness: productivity, production,
costs, availability of natural resources, exchange rates, and relative rates of inflation and effect of
these factors on domestic macroeconomic goals and living standards

International competitiveness
 Competitive selling price for exports
 Non price factors
Better quality
Needs of consumers
Customer service

Factors which influence International competitiveness

Production costs
 wages, labour costs,
 costs of finance
 Raw materials and equipment
Amount of output produced from input of resources (natural, labor, capital)
Multifactor productivity-amount of output produced unit of input of natural resources (Natural,
Capital, Labour)
Changes in effective can be explained by
 Cyclical nature of productivity
 Technological change
 Unpaid overtime
Labour productivity- GDP per total hours worked

Effect of trade liberalization on Australia’s international combativeness, domestic
macroeconomic (low inflation (2-3%)), full employment <5% cyclical, sustainable economic
growth 2-3%) goals and living standards (material/non material).
Availability of natural resources
 Greater access to natural resources will reduce costs of production and lower prices of exports
Exchange rate
 Lowe exchange rate-lower export prices, increased intentional competitiveness
 Higher AUD-higher export prices, decreases international competitiveness
Relative rates of inflation
 Increases domestic and intentional consumer spending through lower prices
 Increases international competivivens, icnreases efficency

Corporate tax rates

 Increase/decrease costs of production and operation
Government subsidies

Trade liberalisation

 Cutting tariffs
 Removal of quotas
 Abolishing import quotas
 Increasing number of FTA’s
 Scaling back protectionist policies

Tariff cuts

 Force countries to sepcialize in areas of production where there is comparative cost


Effects of trade liberalistion on domestic macroeconomic goals
Lowers inflation

 Caused resources to be used in the most productive area possible

 Firms forced to specialize in production of goods with comparative and absolute cost
 Economies of scale (fixed costs over large volume)-decreases average cost per unit
 Imported capital-increases efficiency and productivity
Economic growth

 Increase economic growth

 Increasing local competition
 Firms are forced to restructure to become more efficient
 Access to international markets-higher GDP


 Firms increase demand for labor when exposed to international markets, leading to lower
cyclical unemployment through the creation of new jobs
 Business expansion
 Reduces structural unemployment-increases profitability

Living standards

Advantages Disadvantages
Material livings standards Higher structural unemployment
Faster economic growth Prevention of development of infant industries
Lowe inflation-low consumer prices Environmental damage-non material living
non material living standards Exposure to economic instability
 Greater consumer choice
 Cultural enrichment
 peace