Economics - Topic 2 Syllabus Notes PDF

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10.2 HSC Topic Two – Australia’s Place in the Global Economy 25% of indicative time The focus of this topic is an examination of Australia’s place in the global economy and the effect of changes in the global economy on Australia.

Outcomes A student: H1 demonstrates understanding of economic terms, concepts and relationships H2 analyses the economic role of individuals, firms, institutions and governments H4 analyses the impact of global markets on the Australian and global economies H5 discusses policy options for dealing with problems and issues in contemporary and hypothetical contexts H7 evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments H8 applies appropriate terminology, concepts and theories in contemporary and hypothetical economic contexts H9 selects and organises information from a variety of sources for relevance and reliability H10 communicates economic information, ideas and issues in appropriate forms H11 applies mathematical concepts in economic contexts H12 works independently and in groups to achieve appropriate goals in set timelines.

Content Students learn to: Examine economic issues • assess the impact of recent changes in the global economy on Australia’s trade and financial flows • examine the effects of changes in trade and financial flows on Australia’s economic performance • analyse the effects of changes in the value of the Australian dollar on the Australian economy • discuss the impact of free trade and protection policies on the quality of life in Australia • propose likely changes to the structure of industry within Australia as a result of current trends in the global economy

Apply economic skills • calculate the main components of Australia’s balance of payments • analyse the relationship between the balance of the capital and financial account and the net income balance  explain the relationship between the current account balance and the balance of the capital and financial account  use supply and demand diagrams to explain how the value of a currency is determined under different exchange rate systems  analyse the impact of changes in the components of the balance of payments on the value of the Australian dollar

Students learn about:

Overall Trends in BOP

Australia’s trade and financial flows Value, composition and direction of Australia’s trade and financial flows • trends in Australia’s trade pattern Composition -

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Direction -China has become Australia’s dominant trading partner

trends in financial flows – debt and equity

Value

Australia’s Balance of Payments • structure – Current Account, debits and credits – Capital and Financial Account

BOP (Balance of Payments – includes both the current account and the Capital and Financial Account )

CURRENT ACCOUNT BOGS (Balance of goods and services) + NPI + NSI

KAFA CAPITAL A/C + NET ERRORS

Key Formulas* KAFA + CA + Net Errors = 0

Current Account + Capital and Financial Account + Net Errors and Omissions = 0

Current Account, debits and credits Goods: credits are exports, and imports are debits, of merchandise. Exports are divided into rural and non-rural, while imports are classified as consumption, capital and immediate goods.  Services: credits are exports of services, debits are imports. Include tourism, travel, education, insurance, transport and finance.  Net primary income: refers to net (credits less debits) of income received and paid, mainly to service direct, portfolio and other investment and includes dividends, interest and profits.  Net secondary income: net (credit less debits) associated with government transfers (such as foreign aid), personal transfers of migrants (pensions) and workers remittances of wages. Credits – Debits gives the total on each section, and the sum all gives the total on the current account. Currently we have a current account deficit (debits > credits). 

Capital and Financial Account 

Capital account: records credits and debits for the acquisition and/or disposal of non-produced and non-financial assets such as net capital transfers of foreign aid and net capital brought into Australia by migrants. Intellectual property also. (basically includes nothing)

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Financial account: transactions associated with direct investment, portfolio investment, financial derivatives, other investment (e.g. loans) and changes in the value of Reserve Assets held by the RBA (such as trading foreign currencies and the Australian governments SDR holdings with the IMF). Basically, records foreign investment in Aus. And Australian investment abroad and is also broken into debt and equity. Increases in the capital and financial account surplus leads to a larger current account deficit (CAD) o Debt – interest payments (serving costs) o Equity – profits and dividends  Debit on the primary income account Currently in surplus. Net errors and omissions: Include statistic errors and adjustment calculations by the ABS, and also a surplus (or deficit) in the capital and financial account balance to exactly offset a deficit (or surplus) in the CA. When the two are added, they equal zero in a floating exchange rate. Aus. Having a large CAD, must finance with a CAFS. Conversely, countries like Germany or Japan run a CAS and must have an equal CAFD. Current account deficit countries like Aus. Borrow capital from current account surplus countries like Germany, Japan, China to finance deficits. Links between key Balance of Payments categories

Current Account 

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Australia usually has a deficit in the current account of the balance of payments – the size of the CAD is largely influenced by the deficit in the goods and services balance and size of the net primary income deficit. The goods and services balance is usually in deficit, but in 2008-09 and 2010-11 surpluses were achieved mainly because of strong mining exports – the G&S balance was in deficit in 2009-10 because the GFC reduced global demand for commodities. Slower world growth led to larger goods and services deficit between 2014 and 2016. The net primary income deficit – accounted for the majority of the CAD between 2007 and 2015 and represents the servicing cost of Australians net foreign liabilities. The net secondary income balance recorded small deficits – over 2007-16 reflecting income less expenditure on foreign aid, migrants funds and workers remittances (-$1b and -$2.3b).

Capital and Financial Account  

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The CA balance usually records a small deficit between -$200m and $650m. The financial account balance is always in surplus and mainly represents debt and equity borrowings (in the form of net direct and net portfolio investment) to finance some domestic investment and the CAD. The size of financial account surplus was $76.4b in 2015-16. The balance on capital and financial account was always in surplus to finance the persistent current account deficit in Aus.’s. BOP 2007-08 and 2015-16.

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Reserve assets vary depending on the profitability and nature of the Reserve Banks foreign exchange dealings and the value of Aus. SDRs held with the IMF. Graph

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Would the following transfers of money be in the Current Account (CA) or the Capital and Financial Account (KAFA) and why?

Examples of Multiple Choices The following table shows balance of payments data for an economy with floating exchange rate

Exports of Goods Imports of Goods Net Services Net Primary Income Net Secondary Income

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$billion 500 600

links between key Balance of Payments categories trends in the size and composition of Australia’s Balance of Payments – international competitiveness, terms of trade, international borrowing, foreign investment – effects of these trends on Australia’s Balance of Payments

Structural Factors:

BOGS Structural Factors

International Competitiveness (Structural) Theory International competitiveness refers to a country’s ability to compete with other countries in International markets. International competitiveness takes into account both price factors and non price factors (although primarily price factors) . International competitiveness impacts the: -

Volume of exports sold overseas Volume of imports purchased (import competing industries)

Thus, Australia’s international competitiveness increases, ^ Imports , decrease in exports, therefore deterioration of the BOGS and worsening of the CAD. Individual factors which can influence international competitiveness: - Exchange rates (has its own bit) - Inflation rates – higher domestic prices relative to the prices of competitor countries will increase costs of production. Firms will pass on these higher costs of production by raising the prices of G + S (decreased int. comp -> deterioration of BOGS -> worsening of CAD) - Trends: However, as the RBA has anchored inflationary expectations in the target band of 2-3% and implemented countercyclical macroeconomic policy to address inflation levels exceeding the target band, as occurred in 2007-08 where inflation exceeding 4% caused the government to lower the cash rate by 1% between September of 2006 to September of 2007, inflation has had an insignificant impact on the Australian BOGS in recent times.

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Wage growth – real wage increases outstripping productivity increases will lead to higher costs of production. Firms will pass on these higher costs of production by raising the prices of G + S (decreased int. comp -> deterioration of BOGS -> worsening of CAD) In trend terms, real unit labour costs fell in Australia between 2001 and 2009 as inflation remained between 2% and 3% and minimal wages growth fell by 2% between 2014 and 2019 as wages growth slowed to around 2.3% per annum.

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Productivity

- Movements in the exchange rate of the Australian dollar against the currencies of Australia’s trading partners will also influence international competitiveness - Australia will become more internationally competitive if a depreciation occurs, and less international competitive if an appreciation occurs (see its own section below)

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The real exchange rate appreciated strongly between 2003 and 2007, due to high commodity prices and a rising terms of trade, reducing the competitiveness of Australia’s manufactured and service exports. -

Narrow Export Base -

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Historically, the structure of Australia’s export base has been relatively narrow, comprising predominantly of low value added primary commodities (accounts for 2/3rds of Australia’s export earnings) As the prices of these commodities is volatile, this leads to large fluctuations in the BOGS, which in turn, causes fluctuations in the Current Account Deficit

However, structural changes to the Australian economy have led to the diversification of Australia’s export base -

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The use of the latest technology in the production process has broadened Australia’s export base and increased the competitiveness of Australia’s export competing industries In particular, the use of Elaborately Transformed Manufactured Goods and services (ETMs) has led to  Eg. Tourism and education Manufactured exports and services now account for about 40% of the total exports of goods and services

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As these are high value added goods, as opposed to low value added goods such as metals and mineral ores, this structural change has helped to improve Australia’s TOT, and therefore improving the BOGS, and helping Australia to achieve a CAS.

BOGS – Cyclical Factors TOT Terms of Trade (cyclical) -

The income received from the sale of exports depends of the prices received for exports and the volume of exports sold. The expenditure on imports depends on the prices paid for imports and the volume of imports purchased. - The terms of trade refer to ratio between a country’s import and export prices Calculation TOT: Export Price Index Import Price Index favourable movement (improvement) in TOT occurs when export prices rise faster than import prices ( or export prices fall less quickly than import prices). - means that a country can finance greater volumes of imports with an existing volume of exports.(BOGS improvement + decrease in the CAD) -However, unfavorable movement/deterioration in the terms of trade occurs when export prices rise less quickly than import prices. (fall faster) - means that a country can finance a lower volume of imports with an existing volume of exports. (BOGS deterioration + increase in the CAD) Exchange Rates

Movements in the exchange rate of the Australian dollar against the currencies of Australia’s trading partners will nfluence international competitiveness - Australia will become more internationally competitive if a depreciation occurs, and less international competitive if an appreciation occurs

J Curve:

The J Curve captures the short and long terms effects of a depreciation of the Australian dollar. Thus, in the long term, there will be a positive impact on the Balance of Goods and Services and the Current Account Domestic consumers will move their spending to domestic goods. Import spending decrease, and improved BOGS (decreased CAD) In the short run: - (Depreciation) decreased price of goods and services in foreign currency terms causes a decrease in export revenue and an increase in import spending. This is because in the long run: - Depreciation of the AUD decreases the foreign currency price of Australia’s exports, increasing international competitiveness. - Depreciation of the AUD discourages consumers from purchasing imports, causing an improvement in the BOGS (Opposite applied to appreciation although not the J curve) -

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The international competitiveness of many Australian industries has been impacted by the ‘Dutch Disease’, whereby increases to the exports in one particular sector have caused an appreciation in the Australian dollar, which has negatively impacted the international competitiveness of Australia in other industries For example, during the commodity boom an increase in the demand for Australian exports of metals and minerals driven by rising resource demand in China caused a spike in the Australian dollar, trading at 1.10 USD in July of 2011 Thus, although exports improved in the mining sector, all other sectors of the Australian economy where negatively impacted by this appreciation, facing reduced international competitiveness

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Domestic Growth An increase in the level of domestic growth causes higher business investment and higher disposable income, leading to higher consumption in the economy This increase in both business investment and household consumption leads to an increase in import spending (imports constitute a large proportion of both capital and consumer spending) and worsening the BOGS Examples: High levels of growth in investment (especially in the resources sector) and household disposable income levels during the commodities boom both contributed to Australia’s poor BOGS performance in the mid to late 2000’s despite a rising TOT More recently, subdued domestic growth (avg. 2.7% 2016-19) has caused a decreased in disposable income levels and decreased import spending, resulting in an improvement in the BOGS International Business Cycle

NPI – Structural Factors Savings Investment Gap The Australia’s savings investment gap is the primary structural factor which has contributed to the CAD. Australia has a relatively small population of 24 million people, and a low household savings ratio (the ratio between funds saved and spent by households from net disposable income) of 2.5% in 2018-19, although historically it has fluctuated from -1.7% to 12.5% from 1990-2018. However, Australia’s most significant industry, in the mining of minerals and ores, requires large levels of capital investment. As such, Australia has always been a net borrower of funds from overseas, necessary to finance investment, and

corresponding to a deficit in the NPI.

NPI – Cyclical Factors Exchange rates (valuation effect) Changes to domestic and global interest rates

CONSEQUENCE OF A HIGH CURRENT ACCOUNT DEFICIT

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Growth of foreign liabilities

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High CAD will contribute to an increased level of foreign liabilities Deficit on the current account will

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Increased servicing costs Increased servicing costs associated with the high levels of foreign liabilities lead to larger outflows on NPI, worsening the CAD. Foreign debt must be serviced through interest payments that vary according to the level of interest rates in Australia and overseas, and profits must be return on foreign equity investment Higher levels of foreign debt can result in foreign lenders demanding a “risk premium” on loans, increasing interest rates

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Increased volatility for exchange rates

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High CADs may undermine the confidence of overseas investor in the Australian economy, and by reducing demand for Australia’s currency, may result in a depreciation of the Australian dollar However, in Australia, high levels of FDI and foreign portfolio investment into the economy has financed the development of capital assets which have expanded the productive capacity of the economy. In the mining sector, strong levels of FDI have Constraint on future economic growth Sustained levels of high economic growth lead to increases in import spending, and therefore, a deterioration of the BOGS and an increase in the CAD. As such, government’s will often try to slow economic growth in order to decrease the CAD, known as the balance of payments constraint. Loss of international investor confidence Economic crises can sometimes be triggered by a sudden shift in the attitude of global markets towards a country whose external imbalance appears unsustainable

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NPI - Increases in the value of our debt that is in foreign currencies – deterioration of the NPI – increases CAD (Valuation Effect) - Can be argued that a large amount of this debt will be hedged or in AUD, thus reducing the effect of a depreciation.

- Movements in the exchange rate of the Australian dollar against the currencies of the Australia’s trading partners will also influence international competitiveness Appreciation -Money from exports increases and goods and services become more expensive, BOGS increases in the short run -In the long run

NPI – changes the value of our debt (valuation effect) -Will decrease the value of our debt that is in foreign currencies, improvement in NPI, decrease in CAD

International Competitiveness (Structural) Theory Changes in domestic prices relative to the prices of competitor countries will influence competitiveness in export markets. Australia will become more competitive if its prices rise more slowly than those of its competitors. Changes in international competitiveness over time will effect the volume of imports purchased. - Changes in domestic prices relative to the prices of competitor countries will influence competitiveness in export markets. - Movements in the exchange rate of the Australian dollar against the currencies of Australia’s trading partners will also influence international competitiveness - Australia will become more internationally competitive if a depreciation occurs, and less international competitive if an J Curve:

The J Curve captures the short an...