Topic 4 Economics

Macroeconomic Objectives

The Australian government pursues several economic objectives in managing the economy. It
designs policies that it hopes will allow the objectives to be achieved. Macroeconomic objectives are
those that relate to the economy as a whole, rather than to sectors. There are several objectives,
but the four major macroeconomic objectives are listed in the table below.

Achievement of these objectives has to be measurable so that economists, who advise the
government, know to what extent the objectives are being achieved. The government statistics body
publishes indicators to measure each one of these objectives. For example, in Australia it is the
Australian Bureau of Statistics (ABS) and in Malaysia it is the Department of Statistics of Malaysia.

The main indicators are shown in the table below:

Indicators of Macroeconomic Objectives

Variable Indicator/s Macroeconomic

Objective
Full Unemployment A low level of unemployment
Employment rate
Price Stability Consumer Price Index (CPI) A low and stable rate of inflation
(Inflation)
Economic Growth Gross Domestic Product A steady rate of increase of national
(GDP) output (GDP)
External i) Current Account Deficit as a A favourable balance of payment
Balance percentage of GDP position
ii) Foreign Debt as a
percentage of GDP
iii) Exchange rate

Full Employment

- The condition in which people who are able and willing to work are employed.
- Full employment does not mean 100% of the labour force is employed.
- There will still be a small percentage of unemployed labour since frictional unemployment
(One types of unemployment) exists.
- Frictional unemployment is the amount of unemployment that results from workers who are in
between jobs but are still in the labor force.

Indicator of unemployment

1. The Labour Force

- Refers to those who are employed (part-time & full-time) and those who are unemployed but
actively seeking work.
- The Australian labour force refers to all persons of working age (between 15 and 64 years
old) who are employed in full time or part time work, or are unemployed, but registered
as actively looking for work.
- Is everyone above 15 years of age included in the labour force?
- No, those above 15 years of age who are not in the labour force are:

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1. Students
2. Housewives
3. Pensioners
4. Disabled people
5. Discouraged workers.

Australia’s population is slightly above 20 million people. 16.6 million are civilians over the age of
15 years; of these, 10.3 million participate in the nation’s labour force.

Employed Unemployed
Working more than one hour per week in paid Actively looking for work. 0.5 million.
employment.10.3 million.

Source: ABS August (2006)

1. Total Australian = Employed (part time + full time) + Unemployed

Labour Force = 10.3 m + 0.5 m
= 10.8 m

2. The Labour = Is the percentage of those eligible to work: employed or actively seeking
Force employment.
Participation = Labour Force x 100
Rate (LFPR) Working Age Population
(%)
= 10.3 m employed + 0.5 m unemployed x 100
16.6 m civilians over 15 years old
= 65 %

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3. Unemployment = Unemployment occurs when someone is willing and able to work but
rate (%) does not have a paid job.
= The unemployment rate is the percentage of people in the labour force
who are unemployed.
= Number of Unemployed x 100
Labour Force
= 0.5 m unemployed x 100
10.8 labour force
= 4.6 %

Figure 1: Labour Force Participate Rate and Unemployment Rates

Source: ABS, 2020

Final Examination Tips:

1. Relationship = Positive/ Negative (inverse)
2. Trend = Increasing/ Decreasing

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Topic 4 Economics

Refers to the Figure 1;

- Unemployment usually falls when the labour force participate rate rises. (Negative
relationship)
- However, when the media reports an increase in the labour force participation after a
recession ends, some of those people who were not actively seeking employment will begin
to look for work. For example, students are more inclined to leave school, and mothers are
more likely to apply for jobs.
- Increasing labour force participation during an economic upturn can therefore, have a
confusing effect on the unemployment rate. (positive relationship)
- When economic activity starts to increase, the unemployment rate can actually increase, or
not decrease as fast as expected, as more people begin to actively seek work. This is
because the job seekers are initially unemployed.

Figure 2: Australia Unemployment Rate 2000-2019

GFC

Source: Marcotrends 2021

Trend in Australia Unemployment Rate

- In 2007-08 it had fallen to an historic low of 4.2%, after 17 years (from 1991 to 2008) of
consecutive economic growth.
- In 2008-09 the impact of the Global Financial Crisis (GFC) led to the unemployment rate
rising to 5.8% but a recovery in economic activity in 2010-11 helped to lower unemployment
to 5.2% by 2012.
- However, the unemployment in Australia rises around 6% in 2015, highest for 13 years. The
main reason was a 28,100 strong decline in full-time jobs, while there were estimated to be
15,900 more part-time workers than the previous month.
- According to the major international agencies including IMF, EC, and OECD, unemployment
rate is Australia reached 5.7% in 2016 and started to decrease in 2017 and 2018.
- EC and OECD predict further fall of the unemployment rate in Australia until 2020 while IMF
expects it to reach 4.8% in 2019 and then remain stable until 2024.
- However, unemployment rate increased to 6.2% in April 2020.
- The target rate unemployment rate is the natural rate of unemployment, believed to be
about 5%.

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Topic 4 Economics

• Labour force participation typically moves with the business cycle.

When businesses are hiring more workers and offering higher
wages, the incentives are greater to actively look for work.
• In contrast, when businesses are not hiring and offering smaller
wage increases, there is less of an incentive for people to look for
work.
• There are also structural influences affecting labour force
participation that are independent of the business cycle.
• Some examples of trends that have affected the participation rate
in the past include: more opportunities to work part time; an
increase in the number of females looking for work (increased
female participation); and people working for longer as they delay
their retirement.

What are the main causes/ types of unemployment?

• There are three main types of unemployment – cyclical, structural and frictional
unemployment. In practice, these cannot be measured directly, and they can often overlap,
but they provide a useful way of thinking about unemployment.

1. Frictional unemployment
- Frictional unemployment occurs when people move between jobs in the labour market, as
well as when people transition into and out of the labour force.
- Examples of frictional unemployment include:
a) young people leaving school/university to find jobs
b) people searching for better paid career jobs
c) women leaving and re-entering the workforce after rearing children
d) people leaving a failed business to join a new industry
- Movement of workers is necessary for a flexible labour market and helps achieve an efficient
allocation of labour across the economy.
- However, people may not find jobs immediately and need to invest time and effort in
searching for the right job. Businesses also spend time searching for suitable candidates to
fill job vacancies.
- As a result, people looking for jobs are not matched immediately with vacancies and may
experience a period of temporary unemployment.
- Frictional unemployment is likely to occur at all points of the business cycle and, like
structural unemployment, may not influence wages or inflation.
- Frictional unemployment is related to and compatible with the concept of full employment
because both suggest reasons why full employment is never reached. Frictional
unemployment is always present in an economy.
- This type of unemployment exists during full employment.

2. Cyclical or general unemployment

- Cyclical unemployment occurs with changes in economic activity over the business cycle.
Over time, the economy experiences many ups and downs. That's what we call cyclical
unemployment because it goes in business cycles.
- Cyclical unemployment occurs during recessions because, when demand for goods and
services in an economy falls, some companies respond by cutting production and laying off
workers rather than by reducing wages and prices. When this happens, there are more
workers in an economy than there are available jobs, and unemployment must result.
- As an economy recovers from a recession or depression, cyclical unemployment tends to
naturally disappear.

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- Refers to Figure 2 (page 4), cyclical unemployment rose in 2008-09 in Australia because of
the Global Financial Crisis (GFC) and the lower rate of growth. It is caused by a deficiency of
total spending. As the overall demand for goods and services decreases, employment falls
and unemployment rise.
- It is also called as deficient-demand unemployment. Cyclical unemployment is also known
as involuntary unemployment as workers are laid off as a result of a fall in the demand for
labour, not because they lose the incentive to work.
- Cyclical unemployment is caused by a contraction in economic activity or aggregate
demand.

3. Structural unemployment
- Structural unemployment occurs when there is a mismatch between the jobs that are
available and the people looking for work.
- This mismatch could be because jobseekers don’t have the skills required to do the available
jobs, or because the available jobs are a long way from the jobseekers.
- Occurs when certain industries decline/ technology changes because of long term changes
in market conditions.
- Another factors leading to the incidence of structural unemployment in Australia are the
various microeconomic reforms in industry (e.g. tariff cut in manufacturing and reforms
to Public Trading Enterprises) in the 1990s and 2000s, which have led to the restructuring of
workforces in industries affected by such reforms. For examples;
a) When a major industry such as steel, TCF (textile, clothing, and footwear) or PMV
(passenger motor vehicles) in a particular geographic region reduces its demand for
labour causing widespread unemployment.
• This is the case in manufacturing regions undergoing large scale structural
adjustment such as the Port Kembla, Wollongong, Newcastle, Whyalla and
Geelong industrial regions of Australia.

b) In the agricultural sector, many unskilled and inadequately educated workers are laid
off because of modern mechanization.
▪ A structural unemployed person faces difficulties in finding a new job without
undergoing training or having additional education.
- In contrast to cyclical unemployment, structural unemployment exists even when economic
conditions are good.
- In theory, this type of unemployment should not directly influence wages or inflation and is
best addressed through policies that focus on skills and the supply of labour.

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4. Seasonal unemployment
- Seasonal unemployment occurs at different points over the year because of seasonal
patterns that affect jobs.
- For examples:
a) Fishermen who are unable to catch fish in winter or in rainy weather.
b) Many people are employed at tourist spots during peak periods such as during
festive periods and are unemployed during off-peak periods.
c) Workers employed during farm harvest times or people working summer jobs such
as Christmas retailing
d) Winter jobs in the snowfields such as ski lift operators or instructors.
- The ABS publishes seasonally adjusted labour market statistics, which remove seasonal
patterns in the data.

Final Examination Questions:

1. Which type of unemployment that exists during full employment?

Frictional unemployment (1 marks)

2. Which type of unemployment is close to full employment?

Structural unemployment (1 marks)

3. Explain which type of unemployment is of greater concern by government?

Cyclical Unemployment. Since it affects nearly all industries at the same time, so it involves a
very large proportion of the labour force. (2 marks)

4. Which types of unemployment refers as a high unemployment?

Cyclical & Structural unemployment. (1 marks)

Even at the natural rate of unemployment (full employment), there will be some frictional,
structural and hardcore unemployment. There are two reasons for unemployment that do not fit the
official definition.

a) The Hidden or disguised unemployed

- Refers those people who would like to work but are not actively seeking employment.
- Hidden unemployment occurs when people are not counted as unemployed in the formal
ABS labour market statistics but would probably work if they had the chance.
- Their reasons will be quite varied.
- Examples:-
i. Married women with children, who would work if suitable jobs were available, and they
could find suitable child care facilities.
ii. Some people willing to work if the company provide transportation. Otherwise, they
don’t.
- However, most of them are discourage from seeking work, believing they will not be able to
find a job. If they were offered a job, they would accept it.
- This group is outside of the labour force and is not included in the unemployment statistics.

b) The Underemployment
- Underemployment refers to those who work for more than one hour per week.
- Underemployment occurs when people are employed but would like and are available to
work more hours.
- There are two categories of underemployed people defined by the ABS;

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i. part-time workers who would prefer to work additional hours.

ii. people who usually work full time but are currently working part-time hours.
- Underemployment rates are generally higher among groups that have a larger proportion of
people working part time, such as females, younger workers, and older workers.

Explain Why It is Difficult to Measure Unemployment Accurately?

1. The Hidden or disguised unemployed

- No measure of unemployment is completely accurate since there are some people out of
work but looking for a job who are not picked up by the official statistics.
- Official unemployment data misses out the “hidden unemployed” - an example are
discouraged workers who have been out of work for a long time and who have stopped
applying for jobs.

2. The Under-employment
- Another problem with the official unemployment rate is that it doesn’t consider the quality of
jobs that workers have. People are considered employed if they have part-time or temporary
jobs.
- In many countries data may ignore the extent of under-employment, for example people who
want full-time work but have to settle for a part-time job.
- Thus, if hidden unemployed and the underemployed were included in the unemployment
rate, the ‘real’ rate of unemployment would be double the official rate.

3. Time Lag
- Unemployment figures are published two or three weeks after the survey, so they are a little
out of date.
- A particular month’s rate is known in the second half of the following month.
- Unemployment rate figures therefore tell us the rate in the previous month, as October’s
figure is published in November, for example.

Recap;
• Full employment involves zero or very low unemployment. In practice there will always be
some frictional unemployment as people are looking for new jobs or leaving school.
• Economists in Australia suggest an unemployment rate of 5% is close to full employment.
However, it is difficult to determine precisely.
• Full employment implies the macro economy is operating at its full capacity and there is no
output gap or demand deficient unemployment.

Question:

1. Why the Economist targeting full employment?

• The main reason for targeting full employment is because, high unemployment has various
social and economic costs.
• Therefore, given the costs of unemployment, there are many social benefits to achieving full
employment.

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The Effects of Unemployment on Individual, Firm, Government and the Economy (Full
employment less than 5%)

1. On people (society):
a. Lower standard of living – The people who are unemployed will suffer a loss of income
and will either have to survive on private savings or on benefits. As a result, they will be able
to buy fewer goods and services and will see a fall in their standard of living.
b. Loss of skills – When someone becomes unemployed, they will stop working and will start
losing their skills and ability to work. The longer someone stays unemployed, the less
employable they will be to firms because firms will need to spend money on retraining them.
- Loss of confidence/depression – People who are unemployed will also suffer a loss of
confidence in their ability. Many people who become unemployed will also suffer stress
related illnesses and depression, increased drug and alcohol dependency, health problems
for the unemployed, higher suicide rates, and the breakdown of family relationships.

2. On firms:
a) Lower wage costs – Unemployment in an economy increases the supply of labour available
for firms to employ. This creates a downward pressure on wages as labour is less scarce
and more people are willing to get a job at a slightly lower wage. This will have a positive
effect on firms as their variable costs will fall.
b) Larger pool of labour – Unemployment creates a large pool of labour which gives firms
more choice of who to employ. This allows them to employ workers with higher skills and
more experience.
c) Less demand for goods and services – Unemployment in an economy means that a lot
more people will have less disposable income. Therefore, spending on most goods and
services will fall. As a result, firms will experience lower sales revenue and will likely see a
fall in profits.
d) Higher training costs – As we have seen, many firms will benefit from lower wage costs as
a result of unemployment. However, many firms may also have to spend more resources on
training new employees because they have been out of work for so long. Training new
employees uses up a firm’s time and resources and as a result most firms will see an
increase in employment costs.

3. On the government:
a) Fewer tax revenues – Because fewer people are working, there will be fewer people
earning enough income to pay tax. Firm no longer in the business leads to less company
tax. As a result, the government will receive less tax revenue less government revenue from
individuals and firms and this will have a large impact on the government’s finances.
b) Lower economic growth (GDP) – As fewer people have jobs, firms won’t be able to
produce as many goods and services. As a result, the output of goods and services in the
economy, GDP, will be lower. This also has an impact on government taxation and spending
and will negatively affect their finances.
c) Higher welfare costs – Unemployment in an economy means that fewer people will be
working and more people will be claiming unemployment benefits. More people claiming
benefits creates a drain on the government’s finances and means they have to spend more
on benefit payments and less on other areas of the economy – so there is an opportunity
cost.
d) Higher supply-side costs – With unemployment in an economy, more people won’t be
working. These people need to be taught skills in order for them to be employable by firms.
The government will have to spend more money on training the unemployed so that they
have the right skills to be employed in a modern economy. This is also a drain on
government finances and this money could also be spent elsewhere.
e) The social costs of unemployment - are difficult to quantify but have been linked to
undesirable social trends such as rising crime rates, increased drug and alcohol

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dependency, health problems for the unemployed, higher suicide rates, and the breakdown
of family relationships.
f) Government borrowing – Overall, this rises in government spending along with the fall in
tax revenue may result in a higher government borrowing requirement. (Foreign debt
increases)

4. On the economy:
a) Economic growth fall
- When people are unemployed in large numbers, it hurts the rest of the economy,
creating a cyclical problem. When people have less money to spend because of
unemployment, other companies suffer from less consumer demand.
- Then, when companies suffer because of lost business, they might in turn be forced to
make layoffs of their own, making the unemployment rate rise and overall spending drop
even more.
- The multiplier effect works in reverse, with demand, production and employment
continuing to fall, and unemployment spreading to other parts of the economy.
- Therefore, economic growth falls to lower levels.

b) Unemployment benefits increases

- Unemployment leads to higher payments from state and federal governments for
unemployment benefits. At the same time, those governments are no longer collecting
the same levels of income tax as before.
- Firm no longer in the business leads to less company tax.
- All this, forcing the government to borrow money for other country (which leads to foreign
debt increases) or cut back on other spending.

Evaluate the view full employment should be primary macro-objective.

The main macroeconomics objectives of the government will include low inflation, increasing the
sustainable growth rate, full employment, and balance of payments equilibrium.

What are the positive and negative effects of full employment?

Positive effects
1. Maximizing potential output in an economy, achieving productive efficiency and economic
growth
2. Reduces inequality and prevents relative poverty from those who are unemployed.
3. Full employment will improve business and consumer confidence which will encourage
higher growth in the long-term.
4. Unemployment is a big cause of poverty, stress, and social problems.
5. Full employment reduces government welfare spending and enables more income taxes –
improving budget position.

Negative effects
1. Full employment may cause labour shortages and wage inflation. This can lead to ordinary
inflation.
2. Attempting to achieve full employment could lead to a boom-and-bust economic cycle. If
growth is above the long run trend rate, the growth will be unsustainable.
3. Example: Britain’s period of full employment in the 1950s meant many companies struggled
to fill vacancies in unpopular jobs; this labour shortage was partly solved by encouraging
immigration.

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Evaluation

- Full employment does not necessarily have to be inflationary. If the growth is sustainable, we
could get close to full employment without inflationary pressures.
- It depends on the skills of the workforce. If there are big labour shortages in skilled labour, full
employment could lead to shortages of labour.

Price Stability
➢ Price stability or low inflation is a major objective of a government’s economic policy
because rising inflation reduces real incomes (purchasing power) and living standards.
➢ A slow rate of inflation is not harmful to the economy.

Inflation
➢ Inflation is a rise in the general level of prices of goods and services in an economy over a
period of time.
➢ Inflation is best defined as a sustained increase in the general price level leading to a fall
in the purchasing power or value of money.
➢ Inflation is also a situation where there is too much money chasing too few goods.

Deflation
➢ Deflation is a situation of a falling in the general level of prices.
➢ Price deflation is when the rate of inflation becomes negative.
➢ For example, the general price level is falling, and the value of money is increasing.

Stagflation
➢ Occurs when the overall price level rise rapidly (inflation) during the periods of recession or
high persistent unemployment.

Hyperinflation
➢ A very rapid rise in the price level (prices rise more than 50% a month).

Disinflation
➢ Is a slowing in the rate of price inflation.
➢ It is used to describe instances when the inflation rate has reduced marginally over the short
term.

What are the differences between deflation and disinflation?

Deflation Disinflation
- Is a decrease in general price levels of - Shows the rate of change of inflation over
throughout an economy. time.
- If there is a higher supply of goods and - The inflation rate is declining over time, but it
services but there is not enough money remains positive.
supply to combat this, deflation can occur. - For example, if the inflation rate in the
- For example, cellphones have United States was 5% in January but
significantly dropped in price since the decreases to 4% in March, it is said to be
1980s due to technological advances that experiencing disinflation in the first quarter of
have allowed supply to increase at a faster the year.
rate than the money supply or demand of
cellphones.

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Measurement of inflation
- Inflation is measured by Consumer Price Index (CPI).
- CPI is an index that measures changes in the average price of consumer goods and services.
- CPI is the most common and accurate measure of the rate of inflation.
- CPI is also called the cost-of-living index.
- CPI measures the rate of increase in price of a basket of commodities that represents average
consumption expenditure.
- It is published every quarter. The group of goods and services that make up the theoretical
basket, or regimen, is decided by surveying metropolitan wage-earning households.

- It is divided into 11 major groups or categories such as food, clothing and footwear, housing,
household equipment, transport, alcohol and tobacco, health, recreation, education,
communication, financial and insurance services.
- Table 1 shows changes in eight of these CPI categories of expenditure between 2005 – 2006
and 2007 – 2008.
- The CPI is a weighted average of price movements in eight Australia’s cities.
- ABS researchers record the price of each item at regular intervals and use these to calculate the
cost of the whole basket of goods.

Table 1: CPI by Group 2005 -2006 to 2007- 2008 (2005 = 100)

Year Food Clothing Housing Household Transport +6 All Groups
Equipment categories

2005- 162.4 109.2 129.3 122.2 155.5 132.0 151.7

2006

2006- 172.4 108.4 133.7 124.6 158.0 133.8 156.1

2007

2007- 177.8 109.3 140.6 123.4 165.2 135.7 161.4

2008

Source: ABS 2011

- The rate of increase in the price of the total basket is deemed to be the inflation rate of Australia.
- The rate of inflation can be calculated as follows: for any specific year (1996) subtracting the
previous years’ (1995) price index, dividing by the previous year’s index and multiplying by 100.

Rate of inflation = CPI current year – CPI pervious year x 100

CPI previous year

Example
The CPI was 156.9 in 1996 and 160.5 in 1997, so the rate of inflation for 1997 is:

Rate of inflation = 160.5 – 156.9 x 100

156.9
= 2.3%

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Figure 1 Australia Infation Rate from 2000 to 2019

1
3

Source: Marcotrends 2021

- Refer to Figure 1, price stability is not necessarily the same as zero inflation, but instead steady
levels of low-moderate inflation are often regarded as ideal.
- The Reserve Bank of Australia has set a target range of 2-3% per year as an acceptable,
average level of inflation over a complete business cycle.
- This is a rate of inflation sufficiently low that it does not materially distort economic decisions in
the community.
- This is Australia’s price stability objective.

Trend in Australia Inflation Rate

1. There was however an upsurge in inflation between 2006 and 2008 due to the resources
boom and increased wage pressures.
2. The higher inflation rate in 2008 changed with the impact of the GFC and recession in
2008-09. This led to lower global commodity prices such as oil and food, and declining
global inflation.
3. However, a strong economic recovery in 2009-2010 and the impact of floods and
Cyclone Yasi in late 2010 and early 2011 led to higher CPI inflation of 3.1% in 2011.
4. In 2020, inflation rate for Australia was 0.9 %. Though Australia inflation rate fluctuated
substantially in recent years, it tended to decrease through 2001 - 2020 period ending at 0.9
% in 2020.

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Limitations of the CPI as a measure of inflation in Australia

1. The survey includes only a sample of all goods and services consumed in the economy. So its
calculation is not perfectly accurate.

2. The published inflation rates will not accurately reflect the cost of living of each individual, as
individuals spend their money on different selections of goods and services. For example, a
smoker will be more affected by a price rise in cigarettes than a non-smoker.

3. The measure of price increase does not allow for quantity changes in products.

4. Time lag - The inflation rate is published six to eight weeks after the end of the period for which
it was calculated. This means that we know the rate for a particular quarter, say the June
quarter, halfway through the next quarter.

Causes or Types of inflation

The major causes of inflation are pressures that can come from both the demand and supply
sides of the economy.

1) Demand-pull inflation
• Demand-pull inflation occurs when price levels increase as a result of aggregate demand
(AD) increase.
• Why AD increases?

AD = C + I + G + X - M

where;
C = Consumption
I = Investment
G = Government spending
X = Exports
M = Imports

• Refer to the above diagram, when AD increases from AD to AD1, it results in an increase in
real GDP from Y to Y1, and an increase in the price level from P to P1. Price increases from P
to P1 refer as demand-pull inflation.

2) Cost-push inflation
• Cost-push inflation occurs when firms respond to rising cost of production, by increasing
prices to protect their profit margins.
• Why cost of production increases? – Refers to Trend Australia Inflation rate on page 13.

a) Wage inflation can contribute to cost-push inflation. This is usually caused by strong labor
unions. A company with the ability to create a monopoly can also create cost-push inflation.
That's because controls the supply of a good or service.
b) Natural disasters can temporarily create cost-push inflation by damaging production
facilities, such as Cyclone Yasi and flood.

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c) The depletion of natural resources will be a growing cause of cost-push inflation. For
example, overfishing reduces the supply of seafood, driving up prices.
d) Government regulation and taxation also reduce supplies. For example, subsidies of corn
ethanol production reduced the amount of corn available to feed people and animals. This
shortage created food price inflation in 2008.

• Refer to the diagram, an increase in the

cost of production can be represented by a SAS1 SAS
1
shift in the AS curve to the left.
• If firms see an increase in their costs, the
likely respond is a reduction in the real GDP
e1
from Y to Y1, as price rises from P to P1.
P1
• Price increases from P to P1 refer as cost- e
push inflation. P

AD

Y1 Y GDP

Recap;
• Price stability or low inflation is a major objective of a government’s economic policy
because rising inflation reduces real incomes (purchasing power) and living standards.
• The target range of 2-3% per year and this is Australia’s price stability objective.

What are some of the main consequences of inflation on Individual, Firm, Government and
Economy (Price stability more than 3%)

Beneficial effects of Inflation Harmful effects of Inflation

1. Income distribution
- Inflation makes some people poorer and some people richer.
- People who gain/ benefit from inflation are: - People who tend to lose from inflation are:
a) Businessmen who earn higher profits. a) People who keep savings to buy
b) Property owners such as real estate assets or property – now unable to
owners. buy due to higher prices.
c) Shareholders who receive higher b) People dependent on fixed incomes
dividends since companies’ profits are such as salaried workers and
higher. pensioners.

2. Borrowing and Lending

- Inflation favours borrowers (those who - But it disadvantages lenders, because the
borrowed at fixed interest rates) because repayments are of a lesser value than they
repayments are less of a burden as the were when the contract was drawn up.
value of money falls. - Inflation discourages savings because with
the price rising, consumer needs to spend
more income to buy goods and services.
- Therefore, it reduces the real value of
savings, kept in money form.
3. Firm 3. Firm
- Inflation may encourage firms to expand. A - Inflation imposes extra costs on firms.
low and stable level of demand-pull inflation - Menu costs – costs involved in having to
may make entrepreneurs optimistic about change prices as a result of inflation.

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Topic 4 Economics

future sales. - Shoe-leather costs – costs involved in

moving money around to gain high interest
rates.
4. Revenues of the government 4. Balance of trade (Economy)
- The revenues of the government increases, - During inflation, many countries face a
which is good as the budget balance of the deficit balance of trade since imports are
government improves. higher than exports.
- For example a company sells its products - For example, if Australia’s inflation rate is
and services at higher prices, which greater than other trading partners (assume
increases the total income of the company, exchange rates are the same), Australia’s
which in turn increases the gross (before exports become relatively more expensive
tax) profits of the company (provided that all and imports become cheaper than products
other factors influencing profits remain offered by local industry.
constant). - Spending switches away from Australian
- Greater before tax profits result in greater production, slowing economic growth and
taxes paid to the government. pushing up unemployment rate.

Evaluation questions:

1. What is better: inflation or deflation?

2. Inflation or Deflation: Which is the greater risk?
3. Why inflation is more preferable than deflation?
4. Why deflation is dangerous than inflation?
5. Deflation is always good for the economy.

Inflation Deflation
Benefits Costs Benefits Cost

1. Inflation can boost 1. Fall in value of 1. Rise in value of 1. Discourages both

economic growth money/ purchasing money/ purchasing investment and
(mild and moderate power ↓. power ↑. consumer spending.
inflation). Economic growth ↓.
2. Growing revenues 2. Fall in real wages – 2. Rise in real wages – 2. Reduced business
leads to higher gross salaries workers and salaries workers and revenues.
profits. pensioners. pensioners.
3. Low unemployment. 3. Menu costs and 3. Increases efficiency 3. Wages cutbacks and
shoe leather costs. and lower costs of layoffs –
(production cost ↑) production. unemployment ↑.
4. Debtors – repay 4. Loss of international 4. Improved of 4. Increase real value of
loans with money competitiveness international debt.
that is less valuable. (X↓). competitiveness (X↑).

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Topic 4 Economics

Economic Growth

- Economic growth is best defined as a long-term expansion of the productive potential of the
economy.
- Economic growth refers to the rate of increase in the total production of goods and
services within an economy.

Economic growth increases the productive capacity of an economy, thereby allowing more wants to
be satisfied. Sustained economic growth should lead to higher living standards and rising
employment. Short term growth is measured by the annual percentage change in real GDP.

Economic growth can only be realized over the years.

However, the economic growth of a nation does not move
constantly but will experience short-term ups and downs.
This is called the business cycle.

In a business cycle, economic growth is measured by the

aggregate output and the unemployment rate. There are
four phases in a business cycle: recession, recovery, boom
and contraction.

What determines the rate of economic growth?

Every country is different, each factor will vary in importance for a country at a given point in time.

Drivers/ Sources of growth

There are two sources of economic growth such as,

1. An increase in the economy’s resources, and
2. Improved methods of production that uses existing
resources more productively. (PPC shift outwards to
the right)

Here are some of the main determinants of economic

growth – they apply for both developing and developed
countries although the relative weighting that we might
attach to each will depend on the individual circumstances
facing each country or region.

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Topic 4 Economics

Figure 1 Key Drivers of Economic Growth

Sources of growth

1. Natural resources
- Natural resources such as land, mineral deposits, waterways, climates conditions and other
‘gift of nature’ provided an essential foundation for economic growth.
- Combined with the other resources of capital and labour, natural resources can be
developed and organized to increase the productive capacity of the nation.
- Australia’s abundance of natural resources has been a key contributor to its growth
performance.

2. The quality and size of the labour force

- A major determinant of economic growth is the quality and size of the labour force.
Consequently, education and vocational training are essential to the growth potential of the
Australian economy.
- The promotion of education and job training schemes increase the knowledge, skills and
flexibility of the workforce. This contributes to potentially higher of productivity and efficiency.
- Thus, education and training are fundamental in raising levels of economic growth.

3. Research, Innovation and Technological Development

- Research, innovation and technological development are essential to any economy wishing
to increase its long tern productive capacity.
- Improved technology lifts overall efficiency and raises the productive base of the economy.
In this way, technological development contributes substantially in increased economic
growth.

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Topic 4 Economics

- For example, direct foreign investment undertaken in Australia provides the benefits of
‘overseas’ technical expertise and development. That is, ‘imported’ overseas technology can
contribute substantially to increased economic growth within Australia.

4. Capital accumulation
- Capital accumulation or investment is an important prerequisite for economic growth. Private
investment spending on plant, machinery and equipment ensures the future production of
goods and services.
- The greater the degree of capital accumulation, the greater the potential for increased
production. While one aspect of private investment spending involves the replacement of
machinery, it is the adoption of more efficient capital and the development of economies of
scale which make capital accumulation a key factor to increased productivity and growth.

5. Population growth
- Population growth, whether in the form of natural increase or immigration, can cause a
higher rate of economic growth.
- While population growth is important, increasing the quality, not just the quantity of
Australia’s population is a key factor in promoting economic growth.
- Selective immigration programmes, basing the ‘intake’ on skills and vocation, plus initiatives
education and training reforms have contributed significantly to improving Australia’s
potential for increased growth.

6. Political stability
- The political stability of the nation is a vital factor in determining economic growth and the
standard of living. Countries experiencing civil disturbances and political instability are
unable to effectively sustain efficient production.
- As a result, these countries are also disadvantaged through their inability to attract foreign
investment and export markets.
- Australia and other countries which are political stable and able to function effectively, are
more able to promote business confidence, both domestically and from overseas.

Gross Domestic Product (GDP) vs Gross National Product (GNP)

(National Product = National Income)

GDP GNP

- Refers to total market value of all the final - Refers to total market value of all final goods
goods and services produced within a and services produced by the residents of a
country in a given period of time. country during a given period of time.

In order to calculate GNP, we must add net factor income abroad to the GDP;

• Net factor income abroad is the different between the income received from abroad and the
income paid abroad.
- Only final goods and services are included in this measure. This means that production
intermediate goods and services are not counted.
- For example, a table is a final good because it is sold to end user. A screw or paint, bought
by a table manufacturer, is an intermediate good because it is used in producing a table.
- If table and screw/ paint were counted in GDP, the screw or paint would be accounted twice.

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Topic 4 Economics

In sum;
GDP
+ Factor income received from abroad Net factor income
- Factor income paid abroad from abroad
GNP

What goods and services are not parts of GDP?

• 8 things not counted in GDP [no production]

1. Secondhand sales 5. Non-market transactions

2. Public/Private transfer payments 6. Australian producing goods and services in
overseas
3. Purely financial transactions Underground Economy
7. Unreported legal business activity
4. Intermediate goods 8. Illegal business activity

1. Secondhand Sales [no production]

• Secondhand sales are excluded from GDP because they either no current production or
involve multiple accounting.
• For example, selling your car to friends, this transaction should be excluded in determining
this year’s GDP because it does not represent any current production.
• Similarly, if you purchased a brand-new car but resold it a week later to your neighbor, this
will also not be included in GDP.

2. Public/Private Transfer Payments

• Transfer payments is a one-way payment to a person for which no money, good, or service
is given or exchanged.
• Public transfer payments refer to social security payments (pension, unemployment benefit),
welfare payments, and veteran’s payments which government makes to households.
• Private transfer payments refer to transferring funds from one private individual to another
private individual.
• These payments for example, a university student’s monthly subsidy, an occasional gift from
a wealthy relative, scholarship, your parents giving you $250 cash for Chinese New Year/
Hari Raya or $1000 for making an “A” in SAM Economics.

3. Purely Financial Transactions

• Buying and selling of stocks (shares) and bonds are also excluded from GDP. There is no
current production. For example, if 100 shares of Dell stock are bought.
• Buying stock is not buying a product but buying ownership of the firm. Buying bonds is
making a loan.
• However, the services provided by the security broker are included in GDP.

4. Intermediate Goods
- Only final goods and services are included in the GDP. This means that production
intermediate goods and services are not counted.
- For example, a table is a final good because it is sold to end user. A screw or paint, bought
by a table manufacturer, is an intermediate good because it is used in producing a table.
- If table and screw/ paint were counted in GDP, the screw or paint would be accounted twice.

5. Non-market transactions
• Work in your own household or volunteer work in the community does not count because
there was no payment.

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Topic 4 Economics

• For examples, growing own vegetables, washing own car, homemakers’ services, parental
childcare, volunteer efforts.

6. Australian Producing Goods and Services in Overseas

• If Australian and Australia Companies produce goods and services in overseas, it does not
count in GDP, but would count in GNP.
• Remember, we are measuring production inside Australia.
• Imports represent production outside of Australia.

7. Unreported legal business activity

• Unreported “legal” business activity does not count.
• This is two-thirds of the “underground economy.”
• For examples:
o Surgeon does not report $500 of his $3,400 bill.
o Waitress does not report all tips she received.
o Dentist does not report $400 for teeth whitening.
o A worker who wants to retain unemployment benefits may obtain an ‘off-the-books’ or
‘cash-only’ job so there is no record of work activities.

8. Illegal business activity

• Illegal business activity also does not count because of unreported.
• Making up 1/3 of the “underground economy/ black market,”
• For examples, loan sharking, murder for hire, gambling, drugs, prostitution, and money
laundering.

Measuring GDP

There are THREE methods of measuring GDP

1. The Expenditure approach 2. The Income approach

- This method of calculating GDP involves - This measures the value of all the incomes
totaling the expenditure of the various earned in the economy.
agents on the economy on final output. - By adding employee compensation, rents,
- Components of expenditure approach; interest, proprietor’s income, and corporate
profits, we get GDP.
i) Personal consumption expenditures
(C) Example
ii) Gross Private Domestic Investment (I)
iii) Government Purchased (G) Employee compensation $ 4703
iv) Net Export (Export (X) – Import (M)) Rents 148
Interest 450
Thus, C + I + G + (X-M) = GDP Proprietor’s income 545
Corporate profit:
Example - Corporate income taxes 319
- Dividends 336
- Undistributed corporate profits 149
Personal consumption (C) $ 5480
Gross private domestic investment (I) 1238 GDP $ 6650
Government purchases (G) 1454
Net export (X-M) - 97

GDP 8084

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Topic 4 Economics

3. The production approach

- GDP is a production measure which calculates the value added by each stage of production
in the production of goods and services.
- Value added is the increase in the value of goods and services as a result of the production
process.
- The value added in final goods is included in GDP, and the values of intermediate goods are
excluded. Why?
o Because the value of final goods is already included in the value of all intermediate
goods involved in producing the final goods.

4. The Average
- The practical problems of collecting all the necessary information can produce inaccuracies
and so the three methods, outlined above, give slightly different figures.
- The average of the three answers is the best available measure of an economy’s production.

Nominal GDP versus Real GDP

Nominal GDP Real GDP

• Nominal GDP is the • Real GDP is the total market value of goods and services
total market value of produced, measured in constant prices.
goods and services
produced, measured Real GDP = Base year price index x Nominal GDP
in current prices. Current year price index

For example, if the current price index is 160 while base year price
index is 100 and the nominal GDP is $10,000 million, then the real
GDP is:
Real GDP = 100 x $ 10, 000 million
160
= $ 6,250 million

What is the different between Real GDP and Nominal GDP?

- The difference between the nominal GDP and real GDP is due to the inflation rate in market.

Per Capita Income (GDP per capita)

• Per Capita Income refers to GDP Per Capita = National Income
the average income per head Total Population
of population.
• Per capita income is used as For example, the national income of a country with a total
an index of change in the population on 20 m is $ 50 b. So, the per capita income is:
standard of living of a
country. GDP Per Capita = $ 50,000,000,000
20,000,000
= $ 2,500

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Topic 4 Economics

Measuring economic growth

• The economic growth rate of
a country can be measured Growth rate = Real GDP this year – Real GDP last year x 100
through gross domestic Real GDP last year
product (GDP) or gross
national product (GNP) For example, if the real GDP for year 2003 is $ 232,359 million
based on real income. and $ 248,954 million for year 2004. The growth rate from year
• The growth is the percentage 2003 to 2004 is:
change in the quantity of
goods and services produces Growth rate = $ 248,954 - $ 232,359 x 100
from one year to another. $ 232,359
= 7.14 %

Figure 1 Australia Annual Growth Rate from 2000 to 2019

2 4

6
1 3

Source: Marcotrends 2021

Trend in Australia Economic Growth

- The macroeconomic objective is to achieve a steady and continuous rate of economic growth.
- The target rate of growth is 3% to 4% per year, a rate that reduces unemployment or
maintains full employment, without accelerating inflation.
- Such a growth rate will gradually improve standard of living.

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Topic 4 Economics

Below are the significant events that contributed to Australia Economic Growth. Please
refers to Figure 1.
Item No. Events
1 In 2000-01 real GDP growth slowed to 2.1% because of slower US and slower global
growth. However, Australian growth recovered in 2001-02 to 3.9% as global growth
strengthened.
2 In 2002-03 real GDP growth was reduced to 3.2% because of slower world growth and the
impact of the drought on farm production and rural exports.
3 Higher domestic interest rates, the global credit crisis and the Global Financial Crisis
(GFC) and recession in late 2008 caused the economy to slow dramatically. Real GDP grew
by 1.4% in 2008-09 largely due to impact of the government’s use of fiscal and monetary
policies.
4 A global recovery after the GFC led to 2.6% growth in Australian real GDP in 2009-10.
5 The strong growth result was propelled by household spending, business investment and
construction related to the mining sector.
6 Australia's GDP growth slipped to 2.4 per cent over 2017. This is due to Household
consumption rebounded by higher discretionary spending in hotels, cafes and restaurants and
recreation and culture. The big drags on growth were net exports — particularly in rural goods
and tourism — while residential construction and a sharp fall in larger scale engineering and
construction took their toll.
Economic growth recorded at -2.44% in 2020. The outlook for the Australian economy in
2020–21 remains uncertain, with only moderate growth expected for output, household
consumption and domestic final demand, given their recent falls. Consumer inflation and
wage growth are likely to continue to be weak.

Limitation of GDP measurement. (Why GDP fails as a measure of well-being/ standard of

living)

- GDP is an indicator of economic activity that is measurable in money terms; it does not
measure welfare.
- Even though, GDP is a reasonably accurate and extremely useful measure of domestic
economic performance, but how far is it true?
- Does GDP measure living standard? NO

1. Non-market Transactions
- Certain production transactions do not take place in markets, thus, GDP as a measure of the
market value of output fails to include them.
o Non-market activities doesn’t measure some very useful output because it is unpaid
(homemakers’ services, parental child care, volunteer efforts, home improvement
projects, growing own vegetables).
- Such transactions are escaping from GDP account, causing GDP to be understated.

2. GDP and the Environment / Quality of life

- Another limitation of GDP is its failure to take into account environment issues such as
polluted air and water, congestion, noise (transport), oil spills, increased incidence of cancer,
destruction of habitat for wildlife will influence living standards negatively, but this effect is
not yet measured in the GDP statistics.
- Therefore, under the production, when a manufacturer pollutes a river and government
spends to clean it up, the cleaning expense is added to the GDP while the pollution
subtracted.

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Topic 4 Economics

3. The underground Economy (Shadow Economy)

- Economists agree there is a large underground sector in out of economy.
- Official GDP estimates may not take into account the black market, where the money spent
is not registered resulting in inaccurate or abnormally low GDP figures (unreported legal
business activity).
- For examples:
o A bell captain at a hotel or waiter at restaurants may underreport tips from
customers.
o A worker who wants to retain unemployment benefits may obtain an ‘off-the-books’ or
‘cash-only’ job so there is no record of work activities.
- The size of the black/informal economy differs between countries – particularly bigger in
LEDC’s, with poor tax collection services.
- Some participants in this sector engage in illegal business activities such as gambling,
loansharking, prostitution, and the narcotic trade.

4. Problem of false information

- This problem arises in developed as well as developing countries. People do not disclose
their income or underestimate their income to avoid paying higher taxes.
- This will affect the calculation of the GDP.

5. Inaccuracies
- As noted above, the data that are used to calculate the various measures of GDP come from
a vastly wide range of sources.
- Figures tend to become more accurate after a lag time as they are revised when additional
data are included.
- Statisticians in national statistics agencies make every effort to ensure their data is as
reliable as possible, and in the more developed countries, they can be assumed to be fairly
reliable.

Effects of Economic Growth

Sustained economic growth is a major objective of government policy not least because of the
benefits that flow from a growing economy.

Conflicts between Macro Objectives

Situation Economic Full Price

Growth Employment Stability

Bad (X achieve) (X achieve) (Achieve)

(Recession) Real GDP Unemployment Inflation rate low
low rate high

Good (Achieve) (Achieve) (X achieve)

(Peak) Real GDP Unemployment Inflation rate
high rate low high

Effects on Economic Growth

- Economic growth is defined as the sustained increase in real GDP or GNP per capita over time.
Economic growth is desirable for an economy as it increase it real national income and
standards of living for its people in general.
- Although, it is desirable, economic growth does have its benefits and costs.

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Topic 4 Economics

Benefits for individuals

1. Higher average incomes

- This enables consumers to have greater purchasing power, enjoy more goods and services
and enjoy better standards of living. Economic growth during the Twentieth Century was a
major factor in reducing absolute levels of poverty and enabling a rise in life expectancy.

2. Employment effects
- Economic growth stimulates higher employment, can lead to new entrants to the workforce
(through a higher participate rate).
- Higher economic growth will lead to an increase in demand for labour as firms will be
producing more. Therefore, unemployment will fall.
- The Australian economy has been growing since the late 1990s and we have seen a large
fall in unemployment and a rise in the number of people employed.

Benefits for the economy

1. Lower unemployment/ Full employment

- With higher output and positive economic growth, firms tend to employ more workers
creating more employment.
- High economic growth will help the economy achieve full employment. The labour force is
usually expanding. An increase in national output will lead to an increase in jobs.
- Therefore, high economic growth will ensure that sufficient new jobs are created for the new
entrants in the labour force which will help the economy achieve full employment.

2. Lower government borrowing

- Economic growth creates higher tax revenues, and there is less needed to spend money on
benefits such as unemployment benefit.
- Therefore, economic growth helps to reduce government borrowing.
- Economic growth also plays a role in reducing debt to GDP ratios.

3. External balance (Current Account Deficit)

- Long term economic growth can improve external balance. Economic growth resulting from
higher productivity and efficiency in export and import replacement industries will improve
Australia’s competitiveness on international markets.
- This will enhance our ability to increase exports and compete more effectively with imports.
- The subsequent improvement in Australia’s balance on merchandise trade will assist in
reducing Australia’s current account deficit (CAD) and strengthen the value of the $A.

4. Improved public services

– With increased tax revenues the government can spend more on public services, such as
health and education.
– Improved health care can improve quality of life through treating diseases and increasing life
expectancy. Increased educational standards can give the population a greater diversity of
skills and literacy. This enables greater opportunity and freedom.
– The revenue also uses to fund the social security and welfare system for the provision of
income support to the aged, sick, disadvantaged and unemployed.

5. Investment
- Economic growth encourages firms to invest, to meet future demand. Higher investment
increases the scope for future economic growth.
- High economic growth also leads to increased profitability for firms, enabling more spending
on research and development. Also, sustained economic growth increases confidence and
encourages firms to take risks and innovate.

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Topic 4 Economics

Costs of economic growth for individuals

1. Create wants
- As more and more wants are satisfied by economic growth and its increase in the standard
of living, more wants are created.
- Humans in general simply lift their level of wants as their wealth and income increase. New
wants become less and less necessary to survival and even comfort.
- For example, i-pad pro and i-phone X is a recent want.

2. Materialism and consumerism

- Economic growth may generate demands which may make people feel less contented. An
increase in national output will lead to an increase in the amount of goods and services
available for consumption.
- However, when people have more to consume, they may want to attain a higher level of
consumption. Therefore, if economic growth makes people more materialistic, it may make
them feel less contented.
- Economic growth can often lead to an emphasis on materialism and consumerism in society.
- Some loss of tradition cultural and family values is an inevitable outcome, but economic
growth should not be pursued at the expense of a decline in traditional cultural or family
values.

Costs for the economy

A
1. Inflation risks
- Fast-growing demand can lead to demand-pull
and cost-push inflation as resources become
scarce in relation to the increased demand for
goods and services.
A. Demand-pull inflation is defined as an increase
in the rate of inflation caused by the Aggregate
Demand (AD) curve.
B. Cost-push inflation develops because the
higher costs of production factors decrease in
aggregate supply (AS) (the amount of total B
production) in the economy.

- Economic growth might therefore conflict with the

objective of price stability.

2. Environmental concerns
- Growth cannot be separated from its environmental impact. A problem experienced by both
advanced and developing countries in pursuing high rates of economic growth is the
damage caused to the natural environment through pollution, deforestation, the destruction
of rain forests, and land degradation.
- More natural resources are needed to sustain higher rates of economic growth, and this may
lead to the depletion of non-renewable and renewable resources, pollution of the
atmosphere, and a consequent decline in environmental quality in a country.

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Topic 4 Economics

3. External balance (Current Account Deficit)

- Increased economic growth tends to cause an increase in spending on imports, therefore,
causing a deterioration on the current account and the level of foreign debt to finance the
deficit.

4. Structural unemployment
- High economic growth may lead to high structural unemployment due to rapid technological
advancement.
- However, rapid technological advancement will cause skills and knowledge to become
obsolete at a fast pace which will lead to high structural unemployment.

5. Inequality
- Higher rates of economic growth have often resulted in increased inequality because growth
can benefit a small section of society more than others.
- For example, those with assets and wealth will see a proportionally bigger rise in the market
value of rents and their wealth. Those unskilled without wealth may benefit much less from
growth.

Conclusion/ Evaluation:

- Economic growth is important for every country to cope with the developing world. But as
much as benefits we receive from this growth there are the costs and circumstances which
cannot be ignored.

External Balance
- External balance is the balance between money inflows to Australia and money outflows.

- External balance has THREE main dimensions:

1. Ensuring that current account in the balance of payments is in equilibrium.
2. Ensuring that the levels of net foreign liabilities and net external debt are sustainable as
a percentage of GDP.
3. Maintaining stability of the exchange rate in currency markets.

- A key goal of the Australian government’s macroeconomic policy is to achieve the objective of
external balance or external stability. External stability is achieved when export income is
sufficient to finance import expenditure.

- The Australian Government’s main economic focus in recent years has been on reducing the
size of the Current Account Deficit (CAD) and the Foreign Debt, and as a result to stabilize the
value of the Australian dollar. All three factors play an important part in creating external
stability.

The CAD and Balance of Payments in Australia

- It is important to look at the level and trends in Australia’s current account to understand the
sustainability of Australia’s external stability. The CAD is part of Australia’s Balance of Payments
(BOP).
- The Balance of Payments is a record of all financial transactions for a period of one year,
between Australia and the rest of the world. Figure 1 shows the composition of the Balance of
Payments.

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Topic 4 Economics

Figure 1: The Composition of the Balance of Payments

THE BALANCE
OF PAYMENTS

CURRENT ACCOUNT CAPITAL AND

FIN. ACCOUNT

• @ Trade Balance CAPITAL • Assets – E.g. Land,

GOODS real estate, building,
• Tangible – E.g. Car ACCOUNT
apartments, factories

• Intangible – E.g. FINANCIAL

SERVICES • E.g. Bank deposits,
Education ACCOUNT loans, shares, bonds,
foreign currencies
• E.g. Interest, rent, NET
dividend, profit
INCOME

• E.g. Aid, pension, CURRENT

gift, monies of
TRANSFERS
migrants

- The Balance of Payments is made up of the Current Account, which in Australia’s case is
generally a deficit, and the Capital and Financial Account, which has to be a surplus in order to
finance and balance the Current Account.

BOP = Current Account Deficit + Capital & Financial Account Surplus = 0

The Balance of Payment

- The BOP account records both debits and credits. A debit is any transaction that supplies the
country’s currency in the foreign exchange market. A credit is any transaction that creates
demand for the country’s currency in the foreign exchange market.
- A debit in indicated by a minus (-) sign because of the outflow of money and a credit is indicated
by a plus (+) sign due to inflow of money.

1. Current Account
- The first section of the BOP is the current account. The current account contains receipts and
payments on goods and services. The current account has four components (see Table 1 on
page 32). The major items in current account are the following:

a) Merchandise trade balance

- Merchandise trade balance is the difference between exports and import of physical goods.
- Merchandise trade is also referred to as visible goods.
- The formula for Merchandise trade balance is as follows:

Merchandise trade balance = Value of - Value of

merchandise exports merchandise imports

- If the value of a country’s merchandise exports are greater than the merchandise imports, it
is said that a trade surplus has occurred (exports > imports).
- If the value of a country’s merchandise exports are less than the merchandise imports, it is
said that a trade deficit has occurred (exports < imports).

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Topic 4 Economics

- In Table 1, the merchandise trade balance is ($782,740) million where there is merchandise
trade deficit.

b) Service balance
- Services balance is the difference of receipts and payments from services.
- Services balance is also referred to as invisible goods. Services such as tourism, education,
insurance, transport, shipping, finance etc.
- For example, tourists to Australia and overseas students studying in Australia are included
under these services.
- In Table 1, the services account is surplus of $66,010 million which indicates there is been
more services exports than services imports.

c) Net income
- Net income refers to the difference between income receipts and payment of country.
- Net income (i.e. rent, interest, profit and dividend) refers to income received from Australian
owned assets overseas minus the payment of income for foreign owned assets in Australia.
- In Table 1, shows a surplus value of $11,294 million which is the income inflow to Australia.

d) Net current/ unrequited transfers

- Net currents transfer includes gifts, pension, monies of migrants, military aid and financial
aid by the government, private individuals and organization to foreign countries and also the
inflows from other countries into Australia.
- For example, the Australian government and private individuals provided financial aid to
Tsunami victims in Acheh and at the same time, Malaysia provided aid to Australia.

Refer to Table 1 again, in sum;

Current Account Balance shows Deficit (791,508) values
= Goods + Services + Net Income + Current Transfers
= (782,740) + 66010 + 11,000 + (86072)
= (791,508)

Since, current account balance shows deficit values, Thus, we call this as–

Current Account Deficit (CAD)

Question: How is the Current Account Deficit being paid for?

The CAD is paid for by the Capital and Financial Account Surplus.

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Topic 4 Economics

Figure 2 Australia Current Account Balance from 2009 to 2020

Source: Knoema, 2021

2. Capital and Financial Accounts

a) Capital Accounts
- The second section of the BOP is the capital account, which records the payment flows on
purchases of foreign assets by Australian or Australian assets by foreigners.
- Assets in this case include anything that can be owned and that has value, such as land,
real estate, companies, building, apartments etc.
- For examples, the Australian Submarine Corporation situated at Outer Harbour in South
Australia, was funded by a group of European firms.
- HBP Billiton’s investment in Papua New Guinea to mine copper.

b) Financial Account
- It records foreign investment in Australia and Australian investment abroad. The components
of financial account are:

Direct investment : Refers to international investment that reflects the objective of

(Capital Account) obtaining a lasting interest by a resident in one economy, in an
enterprise in another economy.
Portfolio : Stocks and shares, options, rights, treasury bills, government
investment bonds and notes.
Other investment : Includes trade credits, loans, currency and bank deposits.
Financial : Includes currency swaps, options and other derivatives
derivatives products.
Reserve assets : Refers to foreign financial assets available to and controlled by
the monetary authorities (RBA) for financing payments and
foreign exchange dealings.

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Topic 4 Economics

In Table 1, the sum of the capital and financial accounts is referred to as the balance on
capital and financial account.
- It is showing a surplus value of $791,508 million.
- Again, Refers to Table 1, item 23 =

BOP = Current Account Deficit + Capital & Financial Account Surplus = 0

= (791,508) + 791,508 =0

Net errors and omissions

What is the function of Net errors and omissions?

- Net errors and omissions include statistical errors and adjustments in calculations by the
ABS, and allow,
a surplus balance on the capital and financial account to EXACTLY offset the deficit
on the current account, OR
a deficit balance on the capital and financial account to EXACTLY offset the surplus
on the current account
- So, when the two account balances are added together, the total is ZERO under a floating
exchange rate.
- Thus, refer to Table 1, the BOP (the current account, capital account and net errors and
omissions) must together equal to ZERO.

What happen if Current Account and Capital & Financial Account not balance?

Table below is the extraction from Table 2 (page 34)

2007 ($ m) 2008 ($ m)

Current account balance -58,360 -68,246

Balance on capital account and financial account

59,106 67,307

Net Errors and Omissions -746 939

How is the Current Account Deficit being paid for?

- Since Australia runs a large CAD, it must be financed by an equivalent surplus in the capital
and financial account.
- Conversely, countries such as Japan, German, and China which tend to record current
account surpluses, offset these with capital and financial account deficits, so that their BOP
sum to zero.
- Typically, deficit countries like Australia, Malaysia and the USA borrow from surplus
countries to finance their deficits.

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Topic 4 Economics

Table 1: Balance of Payments for Australia in the Year 2004 (in $ million)
Line 2004 ($ m)
Current Account
1 Exports of goods 894,631
2 Imports of goods 1,677,371
3 Balance of merchandise/ goods trade (Lines 1+2) (782,740)

4 Exports of services 380,614

5 Imports or services 314,604
6 Balance of trade in services (Lines 4+5) 66,010

7 Balance on goods and services (Lines 3+6) (716,730)

8 Income receipts 474,647

9 Income payments 463,353
10 Net income receipts (Lines 8+9) 11,294

11 Current/ Unrequited transfers -86,072

12 Current account balance (Lines 3+6+10+11) (791,508)

Capital Account
13 Foreign purchases of assets in the Australia 745,344
14 Australia purchases of assets abroad 431,152
15 Balance of capital account (Lines 13+14) 314,192

Financial Account
16 Net direct investment -45,755
17 Portfolio investment 520,000
18 Other investment 33,999
19 Reserve assets -15,666
20 Financial derivates -15,262
21 Balance on financial account (Lines 16+…+20) 477,316

22 Balance on capital account and financial account (Lines 15+21)

791,508

23 Net Errors and Omissions 0

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Topic 4 Economics

Table 2: Balance of Payments for Australia for 2007-08 (in $ million)

2007 ($ m) 2008 ($ m)
Current Account
Balance of merchandise/ goods trade -13,992 -20,787
Balance of trade in services 1,831 2,879
Net income receipts -45,903 -50,197
Current/ Unrequited transfers -296 -141

Current account balance -58,360 -68,246

Capital Account
Balance of capital account 2,381 2,256

Financial Account
Balance on financial account 56,725 65,051

Balance on capital account and financial account

59,106 67,307

Net Errors and Omissions -746 939

Why Capital and Financial Account (Foreign Investment) is important?

Foreign investment is essential to Australia’s prosperity. It has helped build Australia’s economy and
will continue to enhance the wellbeing of Australians by supporting financial growth.

What Does Capital Flows Mean?

The movement of money for the purpose of investment, trade or business production.

Impacts of capital flows

- Australia has long attracted foreign investment. Foreigners seek to invest in Australia because
of our fast growing, well-educated population, rich natural resource base, and a stable cultural,
legal and macroeconomic environment. Thus, the Government encourages foreign
investment.
- Interest rates are also kept a little higher than those in the USA and other countries who
compete for international capital.
- Therefore, in the case of Australia, there is a far greater inflow of capital than outflow.
- Australia has always been an importer of capital, from the beginning of its history and right
through its economic development.

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Topic 4 Economics

Figure 3 Total Foreign Investment Stock in Australia from 1999 to 2019

Source: https://www.austrade.gov.au/news/economic-analysis/global-ties-encourage-vital-foreign-
investment

1. Foreign Investment
- Foreign investment is very valuable to an economy. It develops resources and facilities
production that would otherwise not occur. Fuelled by capital, domestic firms can expand
and export.
- The amount of national saving is insufficient to finance total investment spending. In other
words, there is a gap between the funds available in Australia financial institutions and the
fund needed for investment, and this gap is filled by foreign investment.
- Foreign investment is needed in large and risky projects such as mining and particularly
mining exploration, and mining is Australia’s biggest export industry.
- Foreign funded economic development creates employment, income and production.
- There are TWO types of foreign investment:

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Topic 4 Economics

a) Direct investment b) Portfolio investment

- Direct investment refers to investment in an - Portfolio investment refers to overseas purchases

enterprise or asset where the foreign investor has of ‘paper assets’ in Australia.
control or a significant degree of influence over - Types of portfolio investment is purchase of
management. securities, debentures, and shares in existing
- Generally, investment is considered to be ‘direct’ Australian companies, fixed deposits within
when an investor has 10% or more of the voting Australian financial institutions and the purchase of
power in the company. government and semi-government securities (bond)
- Direct investment consists of; by private foreign investors.
Overseas ‘parent’ companies setting up - More technically, portfolio investment involves the
subsidiary companies within Australia. purchase of shares in existing companies.
Foreign takeovers of established Australian - In this instance, portfolio investment involves some
companies. degree of foreign ownership with foreign earnings
Overseas companies setting up new dependent on the profitability of the company
companies within Australia. involved.
The reinvestment of earnings, for example - For example, a Singapore purchase of Qantas
the reinvestment of profits of companies shares.
within Australia where such companies are
foreign owned.
- For examples,
a. General Motors – Holden in Australia is a
subsidiary of General Motors, the
enormous United States Company.
b. Campbell’s Soups, a United States firm,
bought enough shares in Arnott’s Biscuits,
an Australian firm, to establish control. A
new company, Campbell’s Soups
Australia, now operates Arnott’s Biscuits.

Figure 4 Portfolio Investment Dominates, at December 2018

Source: https://www.pc.gov.au/research/completed/foreign-investment/foreign-investment.pdf

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Topic 4 Economics

Which types of foreign investment that government preferred most?

- Direct investment.
- Direct investment represents a longer-term commitment to production in Australia than
portfolio investment.
- Portfolio investment tends to fluctuate more than direct investment.

2. Income transfers
- Capital transactions (direct or portfolio investment) create a flow of income transfers in future
years, mainly in the form of interest and dividends.
- Income transfers occur in both directions, some flowing home to foreign investors and some
flowing into the domestic economy. As such, both exert powerful influences on the domestic
economy.

a) Income repatriation
- Income repatriation refers to sending income ‘home’ to the original investors.
- The form of outflows is determined by the form of resources that generates the income.
- This summarized in the table below:

Form of resource provided Form of income paid

1. Loan Interest
2. Shares in Australia firms Dividend
3. Ownership of Australia firms Profit
4. Labour Salary
5. Ownership of Australia property Rent

- Note that while interest on the loan is a form of income payment, a loan repayment is
a capital transfer.
- The distinction is important is reading the BOP.
- Income transfers, including interest payments, are reported on the current account,
whereas loan repayments are reported on the capital and financial accounts.

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Topic 4 Economics

Source: https://www.pc.gov.au/research/completed/foreign-investment/foreign-investment.pdf

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Topic 4 Economics

Indicators of External Balance (External Stability)

1. Current account deficit (CAD) as a percentage of GDP
2. Net foreign debt (FD)/ External debt as a percentage of GDP
3. Exchange Rate

The Australian Government’s main economic focus in recent years has been on reducing the size of
the Current Account Deficit (CAD) and the Foreign Debt, and as a result to stabilize the value of the
Australian dollar. All three factors play an important part in creating external stability.

It is important to remember that any analysis of the CAD situation should recognize there is nothing
inherently wrong with borrowing overseas: the issue is whether the borrowings are put to productive
use and whether governments can readily adapt policies to handle major changes in economic
conditions.

If investors lose confidence in an economy’s capacity to sustain existing trends, they become
reluctant to hold Australian currency. That may cause an exchange-rate crisis and lead to
government action to impose harsh restrictions on spending and credit, ending, inevitably, in a
recession, as was seen in the Asian Financial Crisis in the late 1990s.

1) Current account deficit as a percentage of GDP

- A current account deficit (CAD) occurs when total payments for imports, services, income
and unrequited transfers EXCEED total receipts for exports, services, income and
unrequited transfers.

- A current account deficit (CAD) occurs when total imports debits exceed total export
credits.

- The CAD percentage as a GDP is a key measure of how sustainable the current account
deficit is over time. Since CAD has averaged - 4.5% of Australia’s GDP since the 1980s,
and economic growth has average 3% per annum, the CAD is considered to be
unsustainable if it exceeds the growth rate if the economy.
- The formula to measure CAD Percentage of GDP is as follow:

CAD Percentage of GDP = Current Account Deficit x 100

GDP

• Australia recorded a Current Account deficit of 3.10 percent of the country's Gross Domestic
Product in 2017. Current Account to GDP in Australia averaged -3.24 percent from 1959
until 2017, reaching an all-time high of 2.30 percent in 1961 and a record low of -7.30
percent in 2004.

Questions:

1. What is the target for CAD?

- In practice, then, the external balance objective is a current account deficit that is consistent
with continuing growth in GDP. In other words, the external balance objective is a stable
CAD as percentage of GDP, staying around 3%.
- Australia always has a CAD, and so by definition it always has an external imbalance. The
Australian government seems to target 3% for this indicator. Over the 10 years since the
recession of 1990-1991, the CAD has averaged 4.2% of GDP, indicating that the target has
not always been achieved.

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Topic 4 Economics

2. Which components in Current Account that contributed for Australia’s CAD?

• Net Income deficit and
• Merchandise/ Goods balance deficit.

Figure 5 Australia Current Account to GDP from 2010 to 2020

Source: Trading Economic, 2021

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Topic 4 Economics

The Causes of the Current Account Deficit (CAD)

The growth in the size of the CAD in both nominal dollar terms and as a percentage of GDP can be
attributed to a number of factors operating in the 1980s, 1990s, and 2000s:

No. Causes Current

Account
Components
1. The growth in foreign borrowings (both private and public) during the Net Income
1980s. Foreign debt replaced equity investment as the main source of
foreign capital in the 1980s, raising the size of the net income deficit
through higher interest payments overseas. However, in the 1990s there
was a switch away from a reliance on foreign debt to foreign equity
borrowings as a source of foreign capital
2. High inflation and declining international competitiveness in the 1980s Goods
reduced Australia’s export earnings relative to import expenditure,
worsening the goods balance in the current account.
3. The lowering of protective barriers (e.g tariffs and quotas) in the 1980s and Goods
1990s, coupled with the growth of domestic demand, led to increased
import volumes and import penetration in the domestic Australia economy.
4. The deteriorating state of the global economy. Widespread recession in the Goods
Asian region reduced Australia’s commodity and service exports in 1997-
98, and led to a large increase in the goods deficit, increasing the of the
CAD as a percentage of GDP. The US and global slowdowns between
2001 and 2003 also led to a rise in the goods deficit to -$46.8 billion in
2003-04
5. The depreciation of the Australian dollar (particularly against the USD) Net Income
between 2000 and 2002 led to increased debt servicing costs, since about
40% of Australia’s net foreign debt is denominated in foreign currency
loans (e.g USD and Yen), increasing the risk exposure of Australian
borrowers and foreign lenders to a depreciation in the exchange rate.
6. The impact of the drought in 2002-03 reduced farm exports, as did the Goods
slowdown in world economic growth. However, the global resources boom
in 2004-08 led to higher mineral exports, helping to halt the rise in the
deficit.

Australia – First current account surplus in 44 years

• Australia has recently recorded a current account surplus for the first time since 1975 thanks
to higher volumes of Australian resources exports and higher prices.
• Australia's current account swung into surplus in the past two years, reaching 2.5 percent of
GDP in 2020 and 0.6 percent in 2019 from a persistent deficit since the 1970s, supported
by strong commodity prices, reduced tourism imports, and declining income
payments.
• Australian exports have increased sharply since 2016 as Chinese authorities ramped up
stimulus in response to a slowing economy and trade tensions with the United States. Much
of this stimulus has been directed at the construction sector, which uses vast quantities of
Australian iron ore and coking coal. This increase in export volumes has coincided with a
rise in world prices for key Australian exports, partly due to supply disruptions in Brazil.
• A big economic story of 2019 – the collapse of global bond yields – has also been a positive
for the current account. Recent months have seen relatively sharp falls in long-term
government borrowing costs as well as short-term interest rates in Australia.
• For a nation that holds $1 trillion worth of net foreign debt, lower financing costs will be a
significant positive for the net income deficit – moderating the income payments Australians
make to foreigners more than the payments foreigners make to Australians. As a rough

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Topic 4 Economics

guide, national income increases by approximately $10 billion a year for every year-long
percentage point decrease in interest rates.
• Conditions are set to be supportive for the current account in 2019-20. Continued stimulus to
the Chinese economy will underpin Australia’s trade balance, while lower interest rates are
helping to narrow the net income deficit. And although some of the improvement in export
earnings will be lost by way of higher profits and dividends paid to foreign owners of
Australian companies, the moderation of Australian interest rates relative to those overseas
will help to contain the net income deficit. As commodity prices moderate, the expectation is
that the current account balance will move back towards its long-run average (deficit).

2) Foreign Debt/ External Debt

• Represent the amount a country (public and private sector) owes to other countries.

• Foreign debt is a subset of the financial obligations that make up Australia’s foreign
investment position. It is distinguished from other forms of foreign investment capital inflow
such as equity investment (foreign ownership) by the obligation to pay interest and/or repay
capital.

• Foreign debt is not to be confused with national debt, which is the total government debt.
National debt comprises government borrowings from overseas residents and government
borrowings from Australian residents and thus excludes overseas borrowings by the private
sector.

• The debt may be comprised of fees for goods and services or outstanding credit due to a
negative balance of trade. Total foreign debt can be a combination of short-term and long-
term liabilities.

• The foreign debt grows in every period in which new borrowing exceed repayments of old
debts. Economists use foreign debt as an indicator of external balance, studying not so
much the size of the debt, but its proportion to GDP, and the uses to which borrowed
funds are put.

Figure 6 Net Foreign Debt from 2007 to 2017

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Topic 4 Economics

• To track the economy’s performance, foreign debt is calculated as a percentage of GDP and
known Net Foreign Debt (NFD). This makes sense because, as inflation and economic
growth continually expand GDP, so borrowings and foreign debt also grow.

• Net Foreign Debt (NFD) is the amount of the gross debt, minus money loaned from
Australian residents to non-residents and assets held in reserve by the national Reserve
Bank (e.g., gold). If you borrow more than you are owed, this creates a net debt: Australia
borrows more than it is owed, thus creating the net foreign debt.

The formula to measure NFD Percentage of GDP is as follow:

NFD Percentage of GDP = Net Foreign Debt x 100

GDP

• Table 3 shows that NFD remained in the range of 40% to 50% of GDP for most of the period
2001-02 to 2013-14 but showed an upward trend in that period.

Table 3 Australia’s Net Foreign Debt as a Percentage of GDP and Interest on Foreign Debt
from 2001-02 to 2013-14

Year Net Foreign Debt Percentage of GDP Interest on Net Foreign

($m) (%) Debt ($m)

2001-2002 321,861 42.0 14,090

2002-2003 353,728 43.5 12,014
2003-2004 384,347 44.0 12,775
2004-2005 427,725 45.7 16,874
2005-2006 494,866 49.0 18,822
2006-2007 539,760 49.3 25,884
2007-2008 600,441 50.8 28,659
2008-2009 624,274 49.3 29,959
2009-2010 684,349 52.1 26,560
2010-2011 674,991 47.7 26,501
2011-2012 694,656 50.2 25,220
2012-2013 754,546 52.3 20,274
2013-2014 786,766 54.6 23,307
Source: ABS, (2014)

Interest liability on net foreign debt

• Refer to Table 3 above, in 2013–14 a total of $23 billion was paid in net interest overseas.
The net interest paid adds directly to the current account deficit.

• As with foreign debt, it is useful to obtain a measure of the relative size of interest on foreign
debt.

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Topic 4 Economics

The Causes of the Net Foreign Debt (NFD)

Factors contributing to the growth in the net foreign debt in the 1980s, 1990s and 2000s included:

No. Causes/ Factors

1. Persistent and increasing CAD throughout the 1980s, 1990s, and the 2000s, which required
financing through higher levels of overseas debt and equity borrowings.
2. The declining in domestic saving, both private and public, in the 1980s led to increased
reliance on foreign saving (mainly through overseas debt borrowing) to finance the NFD.
3. Federal budget deficits in the 1980s and early 1990s and other sources of public sector
borrowing, led to the public sector accounting for 40% of the total NFD.
4. The long-term depreciation of the Australian dollar against OECD currencies has increased
the size of the NFD, since 40% of the NFD is denominated in foreign currencies.

Table 4 Australia’s Net Foreign Debt as a Percentage of GDP and CAD % of GDP from 2001-
02 to 2013-14

Year CAD % of GDP NFD % of GDP

2001-2002 2.1 42.0

2002-2003 3.7 43.5
2003-2004 5.4 44.0
2004-2005 6.5 45.7
2005-2006 5.8 49.0
2006-2007 6.1 49.3
2007-2008 6.7 50.8
2008-2009 3.4 49.3
2009-2010 5.0 52.1
2010-2011 3.0 47.7
2011-2012 3.2 50.2
2012-2013 3.6 52.3
2013-2014 3.8 54.6

What is the relationship between the CAD and Foreign Debt?

- Positive relationship
- There are two basic connections between the CAD and the Foreign Debt.
- Each year there is a CAD, this will increase the amount of borrowing needed to pay for it.
- This increases the Foreign Debt. As the Foreign Debt increases, this increases the interest bill
on the debt.
- This increases the income deficit in the CAD. This increases the CAD, and the cycle continues.

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Topic 4 Economics

3. Exchange Rate

The third indicator of external balance is the exchange rate. A stable exchange rate indicates to
investors around the world that the domestic economy is healthy, and that domestic production and
currency are worthwhile investment. Too much fluctuation in the exchange rate causes uncertainly
and dampens foreign investment and international trade.

The exchange rate is the price of one currency expressed in terms of another currency

How does a change in the exchange rate influence the economy?

• Changes in the exchange rate can have powerful effects on the macro-economy affecting
variables such as the demand for exports and imports; real GDP growth, inflation,
business profits and jobs.

Floating exchange rates

- Also known as free/ fluctuating/ Exchange
rate
flexible exchange rate.
- Under a floating system, a currency S (Supply of $A)
can rise or fall due to changes in
demand or supply of currencies on e
0.60
the foreign exchange market.
- Australian exchange rates, or value
of the Australian Dollar, has been D (Demand for $A)
free-floating since December 1983. 0
Q1 Quantity of $A
- That is, the value of the Australian
Dollar now depends on the supply
and the demand for Australian dollars
on international currency markets.

Supply of the AUD Demand of the AUD

- The supply of the AUD on foreign currency - The demand of the AUD on foreign currency
markets comprises the flow of funds out of markets comprises the flow of funds into
Australia for various payment in Australia for various payment in
components of current account and capital components of current account and capital
& financial accounts. & financial accounts.
- This is because we are required to convert - This is because oversea buyers are
Australian Dollar to foreign currency. required to convert their foreign currency to
Australian Dollar.

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Topic 4 Economics

Figure 7 Australian Dollar against Foreign Currencies from 1995 to 2014

An increase in the value of the exchange

rate in comparison to other currencies.

Demand Inflation,
Factors
A B
Employment,
Appreciation/ Economic
Causes Depreciation Effects Growth, Balance
Supply of Payments
Factors

A decrease in the value of the exchange

rate in comparison to other currencies.

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Topic 4 Economics

A. What causes the fluctuation in currency value?

Demand Factors
Increases in demand of AUD - Appreciation Decreases in demand - Depreciation

Why demand ↑? Why demand ↓?

1. Changes in the exports of the country: An 1. Exports ↓.
increase in exports of a country will lead to an
increase in demand for the currency. (Exports ↑)
2. Changes in Interest rate: Higher interest rate will 2. Lower interest rate.
attract more foreign investors to invest in the
country.
3. Investment opportunities: Increase foreign direct 3. Decrease foreign direct investment.
investment into a country.
4. Speculative sentiments: Whenever a currency is 4. Whenever a currency is going weak.
going strong, people will invest more in an
expectation to gain from it.
5. Global trading patterns: If strong global presence 5. Weak global presence in trade
in trade (Exports ↑). (Exports ↓).
6. Inflation Rate Differences: Suppose the price 6. Inflation in Australia – Exports ↓.
level decreases in Australia, while the price levels
of its trading partners remain relatively stable. (X ↑).

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Topic 4 Economics

Supply Factors
Increases in supply of AUD - Depreciation Decreases in supply of AUD -
Appreciation

Why supply ↑? Why supply ↓?

1. Changes in the imports of the country: If import 1. Imports ↓.
increases will lead to an increase in supply of the
domestic currency (Imports ↑).
2. Domestic income relative to incomes broad: If 2. Domestic income fall.
domestic income rise, more spending on imports.
3. Changes in Interest rate: A lower interest rate 3. Higher interest rate.
tends to decrease foreign investment in the
country, so more of the domestic currency will be
sold.
4. Government influence: In order to stop the wild
fluctuations and negative impacts of rapidly rising
or falling Australian dollars, the Reserve Bank can
intervene by buying and selling Australian dollars.
a) To arrest a dramatic upswing, it will increase
supply by selling AUD to the market.
b) Buying AUD from the market (Under demand
factors).

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Topic 4 Economics

B. The effects of exchange rate changes on economy (4 macroeconomics objectives)

Appreciation Depreciation
1. Employment • Unemployment may increase as a result of • Unemployment may
appreciation because this would increase the decrease…
relative price for exports and therefore reduce
the demand for exports.
• In turn, exporters’ profits would deteriorate, and
the export industry may shrink.

2. Economic • As a result of falling exports and higher • Lead to high rates of

growth unemployment, appreciation is likely to lead to economic growth in
lower rates of economic growth in the long the long run.
run.

3. Inflation • If the currency appreciates and this results in • Price increase leads to
unemployment, then consumption would likely demand pull inflation.
decrease.
• This may then lead to a reduction in demand
pull inflation.
• In addition, if the economy relies on
intermediate goods, like oil, then the higher
exchange rate could help to lower cost push
inflation.

4. Balance of • The current account balance tends to • The current account

payments worsen when the currency appreciates balance tends to
because exports become more expensive in improve…
comparison to imports.
• Therefore, the demand for exports usually falls,
whilst the demand for cheaper imports
increases.

Australia not only involves itself with international transactions with the USA but with a multitude of
other nations. In each case, the value of the AUD, relative to the currency of each of these other
countries, is determined by the supply of and demand for the AUD (or Australia’s supply of and
demand for that particular country’s currency)

Exchange rates vary from day to day because of the dynamic demand and supply conditions of
currencies on international markets. Assessment of the strength or weakness of the AUD is
generally made on the basis of movements in the value of AUD against the US dollar (USD).
Consequently, the AUD could depreciate against USD, but appreciate against other major
currencies.

The more accurate measure of the exchange rate is the Trade Weighted Index (TWI), which shows
the overall performance of AUD against the currencies of Australia’s major trading nations.
Australia’s TWI is based on 24 currencies, which together cover 90% of total trade. The TWI will
therefore give a measure of whether the Australian dollar is rising or falling on average against the
currencies of Australia's trading partners.

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Topic 4 Economics

Figure 11 Australia’s TWI from 1984 to 2014

External Imbalance

• External imbalance occurs when an economy’s receipts and payments are not equal. Debtor
countries like Australia and the US experience external imbalance as result of persistent
CAD, the excess of current outflows over current inflows. A constant of foreign capital is
needed to finance monthly CAD.

• In looking at the causes of external imbalance, however, it is best to study the underlying
causes of CAD, as it is these that create the need for capital inflow. We will examine the
main components of the current account – trade in goods, trade in services, and income
transfers and factors affecting these money inflows.

• Current transfers’ component will be ignored because it is very small and is fairly evenly
balanced between inflows and outflows.

Causes of External Imbalance

1. Trade in goods
• Australia’s trade balance in goods has been in deficits on all rare occasions over the last 40
years. This means that, as a nation, we spend more than we earn in trade.
• Most of overseas sales for Australia come from minerals, education, tourism services.
However, the bulk of Australia’s export is still primary products (agricultural goods) such as
wheat and wool, and minerals such as coal and iron ore. On the other hand, the bulk of
imports is manufacturing goods.

2. Exchange rate
- High exchange rates also contribute to trade deficits, making exports more expensive for
foreigners, and imports become cheaper for Australia.
- This reduces demand for exports and increases demand for imports.

3. Income transfers
- This section of the current account is the biggest contributor to the CAD. High levels of
foreign investment throughout Australia’s history have maintained high level of income
transfers overseas.

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Topic 4 Economics

- The mining and finance sectors have a very high level of foreign ownership, and so most of
the profit generated in these industries flows overseas.
- In addition, a traditionally low level of domestic saving means we have to borrow extensively
overseas to finance large and risky investment projects.

4. High growth
- In times of rapid growth in Australia, demand for imports increases, increasing the trade
deficit. This will occur during the boom phase of business cycle.
- From the end of the 1991-92 recession, Australia experienced a long boom, averaging 3% to
4% growth for over a decade.
- In such times, domestic firms can have difficulty supplying demand and imports are sought
instead. This effect adds to the normal rise in import spending that accompanies a rise in
total expenditure, as import spending is usually about 20% of GDP.

5. Commodity prices
- Fluctuations in commodity prices also cause export earnings to fluctuate, so that the trade
deficit worsens in periods of low commodity prices.
- For example, when price of wheat fall, wheat farmers earn less income for their exports.
Thus, a general fall in commodity prices pushes down exports earnings and contributes to
outflows and hence to imbalance.

Effects of External Imbalance

1. National income/ GDP

- External imbalance can occur when Australia firms become less competitive with foreign
firms.
- Australians then buy more imports, and fewer Australian made goods and services. Thus,
import spending rises. When Australian exporters lose competitiveness, export revenue
decreases. The result of a fall in competitiveness is a bigger proportion of GDP flowing
overseas.
- Domestic jobs may be lost and businesses close. Income transfers are always in deficit, and
this is another cause of a net flow on income overseas, rather than to Australian households.

2. Foreign debt
- Foreign debt continually increases due to CAD.

3. Credit rating
- Australia’s credit rating is reduced by substantial and persistent increase in the CAD.
- Australia is usually seen as a very low credit risk, maintaining a top level international credit
rating.
- In the early 1990s, after lavish overseas spending in the late 1980s, Australia’s credit rating
slipped for several years, but has since been restored to AAA.

4. Investor confidence
- Foreign investors may become concerned about a country’s external imbalance. They may
regard the country as a risky place to invest if an economic or political crisis occurs.
- In such circumstances, investors would impose increased charges on loans, to cover their
perceived risk. Funds may also become more difficult to rise abroad.

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Topic 4 Economics

Summary of External Imbalance

52