Economic Issues

Economic Growth

Economic Growth involves an increase in the volume of goods and services that an economy produces over a period of time. It is measured by the annual rate of change in real Gross Domestic Product (GDP), i.e. the percentage increase in the value of goods and services produced in an economy over a period of time, usually one year, adjusted for inflation

EconomicGrowth (% )=realGDP (current year )−realGDP (previous year)

realGDP( previous year)× 1001

RealGDP=NominalGDP× Base Year IndexCurrent Year Index

Aggregate Demand

Aggregate Demand (AD) is the total level of expenditure in the economy over a given period of time. It includes consumption, investment, government spending and net export spending (export spending minus import spending).

Aggregate Supply (Y) is the total level of income in the economy over a given period of time. Part of national income is collected by the government through taxation and the rest is either spent on consumption or is saved.

Equilibrium

Sector of Economy Equilibrium when Conditions for equilibrium

1 sector Y = C (Y = C)

2 sector Y = C + S (S = I )

3 sector Y = C + I + G (G = T)

4 sector Y = C + I + G + X = C + S + T + M (X = M)

Whole Economy Y = C + I + G + X – MAggregate Supply = Aggregate Demand (X – M = CA)

Changes in leakages and injections are what influence the level of economic activity. If injections are greater than leakages, the economy will grow, but if leakages are greater than injections, economic growth will decrease and the economy will contract.

Injections and Withdrawals (I+G+X; S+T+M)

Influences on Consumption (C) and Savings (S)

Consumer expectations The level of interest rates The distribution of income Consumption by households makes up 60% of AD

Influences on Investment (I)

The cost of capital equipmento Changes in interest rateso Changes in government policies relating to investment allowances and tax

concessions on capital goodso Changes in the price of productivity of labour (labour being a substitute for capital in

the production process) Business expectations

o Changes in expected demand for their product o Changes in general economic outlooko The discovery of new resources or technologyo Inflation may lead to uncertainty

Investment makes up about 20% of AD but is very volatile and variable.

Influences on Government Spending (G) and Taxation (T)

One of the main goals of government spending and taxation is to maintain a strong and stable rate of economic growth.

That means that governments may increase/decrease spending or decrease/increase taxation to increase/decrease aggregate demand and hence boost/slow economic growth.

Government spending makes up about 20 – 25% of AD G will be used to compensate for volatility in investment

Influences on Exports (X) and Imports (M)

Because Australia’s trade balance is usually in deficit, net exports usually makes up a small negative contribution to aggregate demand.

Australia’s exports and imports will be most influenced by levels of overseas incomeo Overseas incomes rise export revenue rise

Australia’s net exports are also influenced by the exchange rate, levels of international competitiveness and consumer tastes and preferences

o Weak exchange rate domestic industries are more competitive net exports higher high aggregate demand boosted economic growth

Improving Australia’s trade performance is an important part of government policy to increase AD and improve economic growth prospects.

Equilibrium

The equilibrium level of national income is the level of production at which national spending plans are satisfied by national production levels (that is aggregate demand = aggregate supply) and there is no tendency to change.

Total leakages = total injections and if there is no autonomous change, the economy will remain at this increase level, which can be expressed in terms of its GDP.

Keynes demonstrated however that this equilibrium level of income is not necessarily the same level of income that is required for full employment. A deflationary gap occurs when an economy is at an income level lower than that required for full employment. The economy is at equilibrium but supply > demand and deflation may occur. Government will aim to stimulate one or all of the demand components to close this gap.

Conversely, if the equilibrium level of income is higher than that required for full employment (D>S) the government will be at pains to limit the components of demand on order to reduce this gap back towards equilibrium.

The calculation of the stimulation or contraction of the demand components and their effect on income is carried out by the simple multiplier.

The Simple Multiplier

MPC=∆C∆Y

MPC+MPS=1

∆Y=k ×∆ AD

k= 1MPS

= 11−MPC

Consumption Function

The standard Keynesian consumption function is as follows:

c (f )=a+cY

a = autonomous consumption. This is the level of consumption that would take place even if income was zero.

c = MPC

Y = income

The equilibrium level of income is where the consumption function cuts Y = C (in a one sector economy) or Y = C + I (in a 2 sector economy) and so on.

The effects of Economic Growth

Living Standards

Faster economic growth increase in real GDP per capita

Real wages rise more disposable income higher material living standards This is the main reason that countries pursue economic growth

Employment

Economic growth creates jobs and helps reduce unemployment Countries with higher economic growth usually have highly paid jobs leads to higher living

standards

Inflation

High levels of growth can lead to excessive price increases and wage claims, contributing to a rise in inflation

This can happen when spending is growing when the economy is close to full capacity and aggregate demand is greater than aggregate supply

A major aim of government is to have a “sustainable rate of economic growth” or economic growth at a level that does not cause an increase in inflation

External Stability

Strong economic growth is often associated with increased spending and as a result a higher level of imports

Higher spending on imports will add to a CAD and hence pose a risk to our external stability This is why the Balance of Payments is called the “speed limit” on economic growth

Income Distribution

Sometimes, the benefits of economic growth flow mainly to a particular group (e.g. shareholders, CEOs) rather than flowing more broadly to people through wage increases and improved public services

Therefore, higher economic growth can lead to higher income inequality

Environmental Impacts

If growth is pursued with little regard to its impact to the environment, it can result in pollution, depletion of non-renewable energy resources and damage to the environment

Business cycle – Trends

The trend in the business cycle generally shows overall growth in real GDP. But this is subject to a cycle of strong growth followed by downturn or recession. Macroeconomic policy (monetary and fiscal policy) is designed to even out these fluctuations. Sometimes, macroeconomic policy is referred to as counter cyclical policy. These policies are designed to keep inflation and unemployment low and economic growth at sustainable levels.

Australia began the 1990s with a recession (two consecutive quarters of negative growth). Since then the economy has experienced 18 consecutive years of economic growth. At the moment Australia is not technically in a recession but is widely tipped to enter a recession in 2010 due to the global financial crisis.

Australia’s period of growth in the 1990s and 2000s has been attributed to:

Strong global economic conditions. Growth in the USA stimulated growth in China and India thereby, increasing demand for Australian exports of commodities.

Australia’s terms of trade has improved due to rising commodities prices (exports) and a fall in the prices of manufactured consumer goods (imports)

A major goal of economic management has been to achieve economic growth at sustainable levels

The RBA has followed a low inflation policy, which has kept the rate of growth sustainable by avoiding the shocks necessary to control inflation

Low inflation has kept interest rates down encouraging consumer spending and business investment

Rises in the value of real estate have encourage people to borrow and consume (the wealth effect)

Microeconomic reforms have increased productivity Adoption of new technologies has improved productivity

To continue this trend Australia needs to focus on the three Ps, i.e. population increase, productivity improvements and increased participation rates.

Unemployment

Measuring Unemployment

Labour Force

The Labour Force (or workforce) can be defined as the part of the population 15 years of age and above who are working or actively seeking work.

Includes:o Persons 15+ who are currently employed (or self employed) for at least one hour per

weeko Those on paid leave, on strike or on worker’s compensationo Unemployed persons (15+) that are actively seeking work

Does not include:o Children under 15 yearso Full time, non-working students (15+)o People who perform full time domestic duties. (stay at home mums/dads)o Unemployed people that are not actively seeking worko Retirees

Currently:o 11.5 million people

Participation Rate

The working age population is everyone over the age of 15

The Labour Force Participation Rate can be defined as the percentage of the working age population who are in the labour force

o i.e. either working or actively seeking work. Currently:

o 65%

Unemployment Rate

Unemployment refers to those in the labour force, who are out of work, but are actively seeking work.

o i.e. answering job ads, going for interviews, registering with an employment agency Currently:

o 5.3%

Recent Unemployment Trends

The level of unemployment peaked in the early 1990s – the 10.7% unemployment rate in 1992-93 was the highest level since the Great Depression. The main reason for this was a severe recession in Australia and the global economy. Falling aggregate demand saw cutbacks in production and the closure of many firms, which led to the shedding of labour and an increase in unemployment.

Since then, there has been a steady decline in Australia’s unemployment rate during the 17 consecutive years of economic growth. Unemployment fell to its lowest level in 34 years, to 3.9% in 2008. During this era of sustained low unemployment, shortage of skilled workers became a significant economic problem facing Australia.

However, following the onset of the GFC, Australia’s economic slowdown reduced the demand for labour. Despite the government’s stimulus packages, unemployment rose to a peak of 5.9% in July 2009. Since then, however, Australia’s unemployment rate has steadily decreased to its current rate of 5.2% (June 2010). This is a reflection of Australia’s relatively better off economic condition compared to other global economies whose unemployment rates are still rising.

However, the extent of the recent fall in demand for labour may not have been fully captured by official unemployment statistics, owing to an increase in the rate of underemployment. The decline in full-time jobs has been partially offset by a similar rise in part-time jobs, a fact that is not shown in ABS statistics which don’t take into account the number of hours people work (these people are known as underemployed). This situation occurred because businesses which needed to lay off employees did not want to lose skilled workers and experience a future skills shortage and so moved these workers from full-time to part-time.

Summary:

Unemployment peaked in 1992-93 (10.7%) because of a recession

After 17 years of economic growth, unemployment steadily declined to a low of 3.9% in 2008

Due to the GFC, unemployment rose again, peaking at 5.9% in July 2009 Since then it has steady declined to its current level of 5.2% (June 2010)

Main types of Unemployment

Cyclical Unemployment

This occurs because of fluctuations in the business cycle During a downturn in the economy, fewer goods are demanded (and since labour is a

derived demand) there are fewer employment opportunities

Structural Unemployment

This occurs because of structural changes within the economy – caused by changes in technology or the pattern of demand for goods and services

This is when the skills acquired by workers do not match the skills needed by new industries Australia’s long term unemployed can be attributed to structural employment Structural unemployment increases with reduced mobility of labour, both occupational and

geographical.

Frictional Unemployment

Frictional unemployment represents the people who are temporarily unemployed as they change jobs

They have finished one job but have not started a new one Frictional unemployment is inevitable, although it is increased by delays in matching

unemployed people to available jobs

Seasonal Unemployment

This occurs at predictable and regular times throughout the year because of the seasonal nature of some kinds of work (e.g. fruit picking, Santa Clauses)

It also takes into account the large influx of school students graduating and moving into the workforce

Hidden Unemployment

This includes those people who can be considered as unemployed but do not fit the ABS definition and therefore do not show up in unemployment statistics

This includes those individuals who have been discouraged from seeking employment and are no longer actively looking for a job

They are not classified as unemployed but as not participating in the labour force These people are known as the hidden unemployed or discouraged job seekers E.g. a woman who has a baby and never returns to work An increase in hidden unemployment may show up in statistics as a decrease in the

participation rate

Underemployment

This refers to people who work for less than full time hours per week (35 hours) but would like to work longer

ABS estimates that underemployment affects more people (787 800 in 2009) than unemployment does

This is a result of the fact that many jobs created in recent years have been part time or casual

Long term Unemployment

This refers to those out of work for more than 12 months, usually as a result of structural unemployment

Once a large pool of long term unemployment exists, it can be difficult to reduce it This is because the long term unemployed tend to lose their skills, job contacts and

motivation to work after extended periods of time out of work Long term unemployed also find it harder to find work because employers prefer younger

workers with more up to date skills

Hardcore Unemployment

This refers to long term unemployed people why may be considered unemployable because of their personal circumstances such as mental/physical disabilities, drug abuse and anti-social behaviour

Natural Rate of Unemployment

Total unemployment = Cyclical unemployment + Non-cyclical unemployment (structural, frictional, hard core, seasonal)

Natural Rate of unemployment = Total unemployment – cyclical employment

Therefore, the natural rate is comprised of the non-cyclical components of unemployment - structural, frictional, hard core and seasonal unemployment.

Since there is little a government can do about cyclical unemployment (other than reducing the effects of it through macro policy), the natural rate is referred to the level of unemployment at which the economy is at full employment.

Full employment is one of the government’s main economic objectives and the term “full employment” implies that there is a level of unemployment that must be accepted i.e. it is impossible to have unemployment at 0% because there are some people that cannot participate in the labour market and even if jobs were created for these people they would not be able to fill them.

Those unemployed individuals that are included in the natural rate are not part of the effective supply of labour as they do not exert pressure on wages in the labour market. The natural rate of unemployment in effect represents the supply constraint of the economy i.e. the limit of the labour resources that the economy can use.

If the natural rate of unemployment in the economy was 5% and unemployment was running at 6%, then expansionary macroeconomic policy (low interest rates and higher government expenditure)

would only reduce the unemployment level to 5%. Any further macroeconomic stimulus to increase aggregate demand and push the unemployment rate under 5% would simply cause prices to rise i.e. increase inflation.

This is why the natural rate is also called the NAIRU (Non-Accelerating Inflation Rate of Unemployment), since, at the natural rate, inflation is 0%.

As seen in the example above, macroeconomic policies can only cause unemployment to reach the NAIRU, it cannot actually lower the NAIRU since the natural rate includes those people that are not part of the labour market. Hence, the only way the NAIRU can be lowered is in the longer term with microeconomic policy – through education and training policies that improve the skills of unemployed individuals.

There is a trade off between inflation and unemployment indicated by the Phillips curve. This trade off only exists in the short term. The expectations augmented Phillips curve analysis shows that there is no such trade off in the long term and attempts to reduce unemployment through macroeconomic stimulus will, in the long term cause inflation to rise. The only way to reduce inflation long term is to make the economy more productive through microeconomic reform.

Policies affecting unemployment

Macroeconomic policies

Governments use macroeconomic policies – monetary and fiscal – to “fix” cyclical unemployment. Although the government cannot “fix” the cyclical nature of the business cycle – a certain level of cyclical unemployment must always remain – through the use of macroeconomic policies, it can limit the effects of large booms (high inflation) and large recessions (high unemployment).

Monetary Policy

Monetary policy aims to influence the cost and supply of money in the economy in order to influence economic outcomes such as economic growth

The RBA does this by influencing the level of interest rate (the cash rate) The RBA will decrease interest rates during a recession in order to stimulate consumption

and aggregate demand increase in economic growth decrease in (cyclical) unemployment

The RBA will also increase interest rates during a boom in order to limit aggregate demand and hence bring inflation under control

Fiscal Policy

Fiscal policy aims to influence resource allocation, redistribute income and reduce the fluctuations in the business cycle

The government does this through spending and taxation and the Budget outcome During a recession, a government will increase expenditure (a component of aggregate

demand) in order to increase economic growth and decrease unemployment

Macroeconomic policies

Governments use microeconomic policies such as structural change and reforms to “fix” non-cyclical – structural, frictional, hard core, long term and seasonal – unemployment. By reducing the number of individuals who are unemployed in these brackets, governments can lower the natural rate of unemployment. Since these people are not in the labour force, programs must be undertaken to help these individuals acquire skills that will allow them to enter - and stay in - the workforce,

Education and training policies can improve the skills of unemployed individuals and help to reduce structural unemployment.

Better, quicker and more efficient employment agencies could reduce the number of people that are frictionally employed.

Programs to encourage individuals back into the workforce through acquiring new skills can help reduce the number of long term and hardcore unemployed.

The structure of the economy refers to how we use our resources to produce goods and services to give what is demanded by the population. Structural change refers to the process by which the pattern of production in an economy is altered over time, and certain products, processes of production, and even industries disappear, while others emerge.

Main groups affected by unemployment

Unemployment does not affect all Australians or groups of Australians equally. Certain groups tend to suffer higher rates of unemployment than others.

Indigenous Australians o 4 times the national average and low participation rates

Some categories of migrants o recently arrived, low English language skills, low work skills o double national average of unemployment

Young Australians o Teenage unemployment is 3 times national average due to lack of skills and

experience Mature aged workers

o 45 – 64 years oldo Find it difficult to retrain when structurally unemployed. o Negative perception by employers who want young workers with current skills

Geographical regions o isolated areas or areas with youth and migrant populations o regional centres where industries have closed down and moved offshore

Occupationso lower skilled jobs have higher rates of unemployment

Effects of Unemployment

Economic Costs

Opportunity cost of unemployed resources economy’s productivity decreased Lack of aggregate demand (less consumers) Lower levels of production GDP Costs to the government

o Less tax revenue from progressive tax systemo Increased expenditure through welfare payments

Deskilling of workforce Financial and economic hardship for individuals

Social Costs

Increased income inequality Severe financial hardship and poverty Homelessness Loss of self esteem, shame Drug and alcohol issues Increased crime Poor example for children (unemployment becomes generational) Social divisions

These social problems have an economic cost because funds must be allocated to deal with these issues e.g. health care, welfare services, police services, correctional centres etc.

Inflation

Measuring Inflation

Inflation is a sustained increase in the general level of prices in an economy. High inflation makes it difficult to achieve the other economic objectives (such as economic growth, international competitiveness, exports and income inequality). Therefore reducing high levels of inflation is the highest prioritised objective of economic management, the Australian government – through the RBA – makes low inflation a priority.

The best known and most widely used measure of inflation in Australia is the percentage change in the Consumer Price Index (CPI). The CPI is a measure of the change in the price of a ‘basket of goods’ which is representative of the way consumers spend their income. It does not include all items of expenditure but items which represent the overall expenditure of consumers. The highest ‘weighted’ items in the CPI are food, housing, transport and recreation.

InflationRate (% )=CPI ( current year )−CPI ( previous year )

CPI ( previous year )× 1001

The CPI change is established from a base year, in which the CPI is called 100. If the CPI moves from 100 to 105 in the next year, then inflation is 5%. The inflation rate is measured by the ABS quarterly and is expressed as an annual rate (current quarter and prior 3 quarters added together).

Headline Inflation and Underlying Inflation

The official or ‘headline’ rate of inflation, calculated using the CPI, can be a misleading indicator of ongoing price pressures in the economy because it includes some goods and services whose prices may be highly volatile or may be affected by one-off factors. Economists, including those at the Reserve Bank, therefore prefer to look at the level of underlying inflation (also known as 'core' inflation). Underlying inflation removes the effects of one-off or volatile price movements. As a result, measures of underlying inflation tend to be less variable than headline inflation.

There is no single measure of underlying inflation in Australia and both Treasury and the Reserve Bank have their own calculation of the underlying inflation rate. Most economists focus on two measures of the underlying inflation rate published by the RBA, the trimmed mean and the weighted median. These measures adjust the official CPI figures to give less weight to goods and services that experienced very large rises or falls in price. Although the calculation of these measures is a highly technical exercise, the logic behind each measure is quite straightforward.

Trimmed mean inflation is determined by calculating the average inflation rate after excluding the 15 per cent of items with largest price increases and the 15 per cent of items with the smallest price increases (or largest price falls) from the CPI.

Weighted median inflation is calculated by comparing the inflation rate of every item in the CPI and identifying the middle observation. The inflation rate of half of the items in the CPI will be greater than the weighted median inflation rate, and the inflation rate of the other half will be less than it.

When the RBA refers to its own estimate of underlying inflation, it is referring to the average of its two measures - i.e. the trimmed mean and weighted median added together and then divided by

two. Underlying inflation is important in providing a longer term view of inflation trends in the economy, and so the RBA still focuses much attention on the underlying inflation rate than the headline rate.

Recent Inflation Trends

Australia, like many other industrialised nations, experienced high levels of inflation during the 1970s and 1980s. This came to an end because of the recession of the early 1990s. Australia emerged from the recession with low inflation rates and in 1993, the RBA began to use a 2-3% inflation target to guide its monetary policy decisions.

Since then, inflation has pretty much stayed in the target region, although in 2000, the introduction of the Goods and Services Tax (which led to many people rushing to buy items before the GST increased prices) and a fall in the value of the $A (causing a sharp rise in the prices of imported goods) caused a one-off increase in the headline rate to 6.1% (?).

Over the past decade Australia has had an outstanding inflation record compared to earlier periods. The average inflation rate from 1996 to 2009 has been 2.7%. The surprising feature of the relatively long cycle of economic growth of the 1990s and 2000s is that inflation pressures remained constrained and monetary policy was relatively successful in addressing inflation pressures when they emerge.

This has been due to:

Inflation targeting by RBA since 1993 Productivity improvements increasing supply via microeconomic reform Increased competition in markets keeping prices down Falling prices of imported goods (an appreciation of the Australian dollar)

From the RBA website:

“The inflation target is defined as a medium-term average rather than as a rate (or band of rates) that must be held at all times. This formulation allows for the inevitable uncertainties that are involved in forecasting, and lags in the effects of monetary policy on the economy. Experience in Australia and elsewhere has shown that inflation is difficult to fine-tune within a narrow band. The inflation target is also, necessarily, forward-looking. This approach allows a role for monetary policy in dampening the fluctuations in output over the course of the cycle. When aggregate demand in the economy is weak, for example, inflationary pressures are likely to be diminishing and monetary policy can be eased, which will give a short-term stimulus to economic activity.”

Inflationary pressures dropped during the GFC because of reduced demand and hence reduced ability for producers to increase prices. However, since then, they have slowly crept up to their current level of 3.1%. (?)

Main causes of inflation

Demand-Pull Inflation

In the short term, supply is fixed, so demand is the major factor affecting prices When aggregate demand exceeds the productive capacity of the economy (aggregate

demand) prices rise as output cannot expand any further in the short term This occurs during booms when a sudden increase in demand cannot be satisfied because of

a lack of infrastructure (capacity constraints) Simply, demand-pull inflation is when “too much money is chasing too few goods” Without government intervention, demand-pull inflation can only be solved when supply is

allowed to increase to match the demand Because supply is fixed in the short term, there is a time lag between when the initial jump

in demand and when the particular good or service can be supplied Governments may use macroeconomic policies – mostly monetary policy – in the short term

to stop demand-pull inflation before it starts If a government suspects that aggregate demand may increase to a point which cannot be

matched with the current levels of supply, it will raise interest rates less consumption lower aggregate demand

In the long term, microeconomic reform can be to increase productivity and the productive capacity of the economy (aggregate supply), which would mean that if demand does spike up in the future, there will be sufficient supply to match it

Cost-Push Inflation

This is caused by an increase in the cost of factors of production As production costs rise, firms increase the prices of their products to protect their profit

margin Labour is a factor of production, so when wages increase faster than increases in

productivity, the cost of labour increases Because wages are around 60% of the firm’s costs, wage rises are passed down to customers

as increased prices Increased prices higher levels of inflation increased wage demands increased prices

and so on. This is known as the wage-price inflationary spiral and is very hard to control A good example of cost-push inflation is the cost of oil or energy. When the price of electricity or fuel jumps suddenly, since all businesses use electricity and

petrol, their running costs will also jump, causing them the increase the price of their products as well

One way to solve cost-push inflation is to make markets more competitive and hence limit relentless price increases.

o Increase competition for product this will cause firms to try and limit pointless price increases because they are at risk of losing customers to their cheaper rivals

o Decrease union power this will decrease the number of wage increases demanded

If wages rise at the same rate as productivity growth then the real cost of labour will not change firms will not have to pass down any increased costs to consumer

Because of this, governments may use microeconomic reform to increase productivity in the long term and hence limit the effect of “supply shocks” on inflation and the economy

Inflationary Expectations

If individuals in the economy expect higher inflation in the future, they may act in a way that causes an increase in inflation

If prices are expected to increase, consumer will rush to buy them before, leading to an increase in demand and hence causing demand-pull inflation

o This was the case when the GST was introduced it lead to the one off spike in the inflation rate to 6.1% (?) in 2000.

If inflation is expected to rise, employees will ask for a wage rise to match inflation, firms will then raise their prices, leading to cost-push inflation

Inflationary expectations are particularly hard to deal with because micro and macroeconomic policies are both largely ineffective in battling it

o i.e. once inflationary expectations become embedded within an economy they are very hard to remove and it may a large recession to bring expectations down

In the 1980s, because of inflationary expectations, Australia experienced “stagflation” which is high levels of unemployment and inflation

This was hard to combat because, according to the Phillips Curve and macroeconomics, in the short term an economy could only have one or the other – i.e. high unemployment and low inflation or low unemployment and high inflation

CHECK INFO

o The government was forced to intervene and use prices and income policy to limit prices and/or incomes

o In the end, the recession of the early 1990s was large enough to bring expectations down, and Australia emerged from the recession with a low rate of inflation

o CHECK WHICH DOT POINT IS RIGHT WHY WAS IT THE “RECESSION WE HAD TO HAVE?”

Imported Inflation

This type of inflation is transferred to Australia through international transactions The most obvious cause of imported inflation is rising import prices We import goods because we cannot produce these goods with our factors of production, so

when import prices increase, it is similar to cost-push inflation An example of imported inflation is the “oil crisis” of the 1970s

o The price of oil was increased by OPECo Since many countries import their oil, they suffered from imported inflation which

had many consequenceso Oil rich countries benefited

A depreciation of the Australian dollar will also increase the domestic price of imports and will lead to inflation

Other Causes

Government policy may affect inflation Increasing indirect taxes (e.g. GST) can increase the general level of prices (cost-push

inflation) Excessive increases in the money supply can also lead to an increase in inflation When the increase in the money supply outstrips the growth of the economy, an increased

volume of money is chasing the same amount of goods and services, hence demand-pull inflation increases

Therefore increasing the money supply without any increase in the real production will cause inflation (“monetary inflation”)

The effects of inflation

Inflation can have significant impacts on the economy in both the short term and the long term.

Economic growth and uncertainty

Inflation is the main constraint on economic growth High economic growth raises inflationary pressure through increased wage demands and

higher aggregate demand High inflation distorts economic decisions, making consumers and producers change their

spending and investment decisions to minimise the effect of inflation on themselves (e.g. buying assets)

Inflation distorts resources allocation and encourages speculative investment since speculative investment is fuelled by reduced confidence in holding currency that is losing valued (e.g. investment in capital goods)

High inflation uncertainly about future prices and costs and therefore profits discourages business investment

High inflation reducing purchasing power of money over time more people spend than save in the short term

Wages and Income Distribution

Inflation redistributes real income, because if inflation rises faster than nominal income then, real income will fall. High inflation larger wage demands to compensate for decreased purchasing power increased prices cost-push inflation wage-price inflationary spiral

Some income groups will experience a rise in real income, namely:

Wage earners in strong unions Asset owners whose capital gain exceeds the inflation rate e.g. real estate and shares Business owners whose higher prices feed into higher profits Borrowers whose interest repayments are less than the inflation rates

There are income groups however whose real income will fall. These are:

Those on fixed money incomes e.g. non-indexed super Wage earners on award wages e.g. retail Export industries that become less competitive Creditors where the inflation rate outpaces the non-real interest rate

International Competitiveness

Inflation also reduces international competitiveness, particularly if our inflation rate is higher than those of our trading partners.

High inflation higher costs must be passed down Australian exports are more expensive reduced international competitiveness and quantity of exports job losses, loss of export income and rise in CAD

Exchange Rate

Over the long term, sustained low inflation will foster greater international confidence in the Australia dollar, strengthening the value of the dollar

Unemployment

In the short term, inflation and unemployment are linked through the Phillips Curve i.e. high inflation means low unemployment

In the long term, the Phillips Curve relationship breaks down and inflation and unemployment are linked through the natural rate of unemployment or the NAIRU

Whilst there are many disincentives associated with inflation, some inflation is beneficial. Higher prices represent higher incomes to some groups, which in turn may lead to incentives t increase production and so expand the economy. It is difficult to nominate an acceptable inflation level given our trading partners inflation positions.

External Stability

External Stability refers to a number of indicators relating to the external sector – the current account, external debt (national + foreign) and the exchange rate. It is the ability to trade with the rest of the world without impediments in the external sector that may constrain full employment, economic growth and low inflation. Both the size of the CAD and the foreign debt when compared to GDP are indicators of this stability.

There are 4 main indicators of Australia’s external performance.

The CAD as a % of GDP should not be kept at an acceptable level, around 3-4% in the 1990s The value of the exchange rate should not fluctuate in comparison to the TWI, rather than

compared to an individual currency e.g. $USD The level of net foreign debt to GDP should be kept at a reasonable level – 40% in the 1990s

o A measure of the ability of an economy to service its foreign debt is the debt servicing ratio

o This is the proportion of export revenue that must be spent on interest repayments. Net foreign liabilities (foreign debt + foreign equity inflows) is a long term measure of

external stability

External stability is important because it can impact on economic growth, full employment and low inflation which are measures of internal balance and are macroeconomic objectives of government.

Excessive economic growth can spill over into imports and cause large and continuing CADs that have to be funded by foreign debt. This can cause a balance of payments constraint which in turn will trigger restrictive macro policies that may contain the CAD but will force up unemployment and decrease economic growth. If the government doesn’t restrict the CAD imbalance investors may lose confidence in the Australian economy, there will be a downgrading in our credit rating, there will be sharp downward movements in the value of the Australian dollar and the servicing cost on our existing debt will explode.

Ongoing CADs reflect a structural problem in terms of high net liabilities and ongoing KAFA requirements. These liabilities have contributed to CADs throughout the 1990s and early 2000s. They are reflective of:

1. Higher economic in Australia, compared to trading partners, which has seen imports grow faster than exports, worsening the CAD

2. High net income transfers in the current account as a result of KAFA inflows which has led to increasing interest and dividend transfers – net income transfers account for between 60% and 80% in any given year

3. Structural problems associated with Australia’s export mix which leaves Australia’s terms of trade, particularly with commodities, vulnerable to a shift in Asian demand

4. Increased globalisation and decreasing protection leaves Australia vulnerable to cheaper imports which add to the CAD

5. The savings-investment gap which increases our reliance on imported capital given our low households ratio

Whilst the Pitchford Thesis would maintain that a large CAD is not a problem because it would contribute to higher economic growth, it assumes that imports are used for capital widening. If however, imports are consumer based, the Thesis falls down and more liabilities are required (imported capital) to bridge this gap.

Normally the structural problems Australia experiences in its external accounts – high CAD to GDP, high net foreign liabilities to GDP, high foreign debt to GDP and expanding debt servicing ratios – would signal external instability, the selloff of the currency and investor doubts.

External stability however doesn’t appeared to have affected Australia’s ability to attract overseas capital and one would doubt the continued importance of external stability as a major issue for Australia.

Policies to Achieve External Stability

(NOTE: THIS HASN’T BEEN IN THE HSC FOR A WHILE)

1.

If a government runs a budget surplus it is involves in national savings, that is, it is not drawing on funds available to the private sector for expenditure. A budget deficit however may crowd out the private sector because whilst this deficit expands the economy, private sector investment costs increase and private investment must inevitable fall.

In a globalised economy multinational companies may seek overseas finance but this is an option not available to all business.

External stability cannot always be achieved by monetary/fiscal policy. External stability is now viewed as a long term objective of economic policy and is outside the realm of macro settings.

The micro settings are the ones which aim to achieve external stability and promote international competitiveness, increase exports, encourage savings, to contain the growth of foreign debt and maintaining investor confidence in Australia.

2.

External Stability is subject to exposure of the Australian economy to international financial markets, because markets are risk adverse and will mark down a currency that has the potential for default.

Despite the “consenting adults” theory that the private sector should be made liable for its own debts, failure and the collateral damage is too great for the government to ignore particularly in terms of debt default, loss of confidence and the challenge to raise additional finance without significant premiums.

As a small economy with a relatively narrow export base and a high level of net external liabilities, Australia is vulnerable to a change in overseas perceptions of its economic performance and its prospects. Perceptions may change because of developments within Australia or overseas.

Distribution of Income and Wealth

Income is the amount of funds that flow to individuals or households from the sale of factors of production over a period of time. Wealth is the value of the stock of assets held by individuals at a point in time. Income flows create wealth but existing wealth stocks encourage income flows.

Income and wealth distribution refers to the degree of equality that income and wealth is shared out amongst the population. The government desires this to be fair but not take away incentive and reward for effort, risk, innovation and hard work.

Income is a flow of money. Wealth is stock of assets and it delivers income. Thus, the distribution of wealth is far more unequal than the distribution of income because wealth is a stock built up over time and is hence less transferrable. Australia is one of the most socially mobile countries in the OECD i.e. the level of income that your parents earned, has very little effect on your own earnings.

The distribution of wealth and the distribution of income are very closely related. When a household reaches a certain threshold of disposable income, it may use this extra income to generate wealth. The more wealth a household has, the greater its capacity to generate income. Thus individuals with high incomes tend to also enjoy greater levels of wealth compared to low income earners. Due to this, an increase in income inequality can result in the widening of wealth inequality.

Measuring Income Inequality

The population can be divided into groups called quintiles (each group is 20% of the population). These quintiles can be ranked by income from lowest to highest to give us measurements of the level of income inequality.

Lorenz Curve

The line of complete equality if the 45° lineo i.e. 20% of income recipients = 20% of income earnedo This is contrasted to the global economy where high

income earners (only one-sixth of the world’s population) earn more than half of the world’s income

The further away the curve is from the 45° line denotes the level of inequality

Gini coefficient

The Gini coefficient is the single statistic that summarises the distribution of income across the population

The Gini coefficient is derived by the formula from the Lorenz Curve The coefficient ranges between 0 when all incomes are equal and 1 when a single household

receives all the income Australia’s GINI Coefficient is about 0.3 and has not changed much in the last ten years.

GiniCoefficient= AA+B

= Areabetween line of completeequality∧the LorezCurveTotalarea under the lineof equality

Sources of income

Wages from the sale of labour Rent from land Earnings from capital Profit from the sale of entrepreneurial skills Social welfare

Sources of wealth

Net worth is the extent to which the value of household assets such as houses and savings (i.e. the things they own) exceeds the value of their liabilities such as loans (i.e. the things they owe)

To calculate net wealth, liabilities must be subtracted from the value of assets.

In 2005-06, the average household has assets worth $655 000, liabilities worth $92 000 and hence an average net worth of $563 000

The major sources of wealth in Australian households are property (the family home) and superannuation investments.

The most significant household liabilities are loans taken out to purchase property – they account for 85.5% of household liabilities in Australia.

Dimensions and trends in the Distribution of Income and Wealth

Since Australia is a very socially mobile country, it is plausible to say that any individual within the country has the potential to be a high income earner. This would mean that the level of income an individual earns is very much independent of the level of income that their parents earned.

However, this is not the case. Wealth – unlike income – can be passed down generations, causing wealthy families to stay wealthy and allows easier income flows for further generations. Income is unequal because of access to wealth – which in turn depends on education, occupation, often family structure, sometimes a cultural background and favourable geography.

Recent Trends

There may be an increasing trend in the inequality of wages due to:

Growth of part time and casual work Loss of middle management jobs due to flattening corporate structures Globalization of the economy has put downward pressure on low income low skilled jobs Unemployment in the 1990s Labour market reform reduced bargaining power of employees, reduced union membership

is a factor

Age

Income varies throughout the course of a person’s life It remains highest between the ages of 25 and 64 – the main years of a person’s working life Income levels are usually lower in the early years of working life – because of a lack of

experience and skills Similarly, income levels tend to decrease as people get older and need to rely more on

pensions or other forms of retirement income The distribution of wealth follows a similar pattern according to a person’s age – rising for

most of their lifetime, and falling away as people get older and move into retirement

Gender

Gender is another important influence on income distribution In 2008-09, the average weekly earnings of women ($720) were only two-thirds of those of

males ($1104) Furthermore, there seems to be little change in wage relativities since the early 1990s Even after taking into account differences in jobs and working hours, the average weekly

earnings of females are still lower than those of males, suggesting there is still discrimination in the labour market

Even after we taken occupational categories into account, on average, female employees earn less than their male counterparts, regardless of whether they have the same qualifications and experience as men

Education and Occupation

Educational qualifications also greatly influence a person’s income

Those with higher qualification (e.g. uni degrees and diplomas) enjoyed income levels that were much higher than those with no vocational training nor no qualifications beyond high school

This makes sense because those that acquire more skills or sought after skills will be more in demand by employers and hence will enjoy high incomes

Inequality also exists between different occupations Jobs that require higher levels of education, training and experience (e.g. managers) enjoy

higher income levels than those that do not

Ethnic and cultural background

Income distribution is strongly influenced by the length of time that migrants have been in Australia and the countries from which they migrated

Recent migrants from non-English speaking countries earn lower incomes than those born in Australia, long standing migrants from both English and non-English speaking countries and recent migrants from English speaking countries

This may reflect the fact that without a decent command of the English language, it is difficult t obtain a high paid job.

Indigenous Australians also experience greater levels of disadvantage than other groups in Australia

Household income for Indigenous Australians is only 65% of non-Indigenous people

Family Structure

Due to recent demographic changes within Australia, family structure has also become an important factor influencing income inequality

Single parents and single person households receive weekly incomes significantly lower than the median income across all households

Whereas, couples (with and without dependent children) were better off compared to the national average

In summary, distribution can vary according to:

Gendero average female earnings lower than average male earnings

Ageo Younger and older people earn less than those between 25 and 64

Education and Occupation o level of skill affects income

Ethnic backgroundo migrants from non English backgrounds and Aboriginals earn lower incomes

Family Structureo Single parent families with dependent children are in lower quartiles.

Costs and Benefits of Inequality

Economic

Benefits

Economic benefits are mainly derived from the incentive effects of inequality i.e. people working harder so they can work their way out of low incomes. E.g. If all incomes were equal, there would be no incentive to increase productivity because there is no higher income as a rewarding

Inequality:

Encourages the labour force to increase education and skill levels Encourages the labour force to work longer and harder (increase productivity) Makes the labour force more mobile Encourages entrepreneurs to accept risks more readily Creates the potential for higher savings and capital formation

o High income earners save more reduced reliance on overseas funds

Costs

Economic costs are mainly derived from the relationship between consumption and income inequality. Low income earners spend most of their incomes and save very little. High income earners spend very little of their incomes and save most of it. Therefore, the spending (consumption) of low income earners drives the growth of the economic.

Inequality:

Reduces overall utilityo High income earners gain less utility from an increase in income than people on

lower income Can reduce economic growth

o High level of income inequality low consumption and high savings Creates conspicuous consumption Creates poverty and social problems

o Governments must reallocate funds to deal with these problems Increases the cost of welfare support

o Governments must reallocate funds provide welfare for low income earners

Social

Costs

Social class divisions Poverty (relative poverty)

o crime, suicide, disease and reduced life expectancy

Effects of the Distribution of Income (Carter notes)

One of the most disturbing trends in the distribution of income has been the change in the nature of poverty. Poverty refers to the situation in which income units has an income that is low in comparison to the income of other households in the economy – in Australia relative poverty.

In Australia, poverty is measured with reference to a minimum or benchmark level of income. This is known as a poverty line and any income unit below is living in poverty.

The Henderson poverty line is the most commonly used measure and is set at 56.5% of average weekly earnings. In 1995-96, 1.8 million families were viewed as being below the poverty line, which translated to 20.5% of families or 3.4 million people. This included 1 million children.

Since poverty was first measured in 1973, the spectre of poverty has changed. In 1973 those most in poverty were the ages but by 1996 the main poverty group were either the unemployed of those in low paying jobs. The real dilemma for government is not only to reduce poverty but, just as importantly, to reduce poverty traps.

Poverty traps are the situation of being unable to escape poverty because of being dependant on welfare, which is in turn reduced by the same amount by any extra income earned. This extra income provides a loss which is disproportionately higher than the extra income received.

The dilemma for government in Australia is trying to eliminate poverty traps without a rise in welfare dependency, as opposed to an increase in self reliance by moving out of welfare and so increasing the supply of labour.

The Henry Tax Review proposed to solve this issue by reducing penalties on income earned while still providing welfare as a springboard to independence.

Environmental Management

The natural environment represents the totality of the physical environment in which human society lives, and includes the whole interaction of the climate, soils and plant and animal life. Environmental management refers to actions to protect and enhance the natural environment, including by protecting the quality of air, water and soil, preserving natural environments and biodiversity, ensuring the sustainable use of renewable and non-renewable resources, and minimising the negative environmental consequences of economic activity.

Ecological, Sustainable Development

This is the maintenance of economic growth which does not result in long term damage to the environment or depletion of natural resources. ESD encompasses intergenerational equity. This implies that whilst pursuing economic growth, it should be on the basis of maintaining a viable natural environment for future generations.

The basis of ESD involve:

Integrating economic and environmental goals in government policies Giving a monetary value to environmental assets e.g. fresh air Intergenerational equity Managing environmental risks with caution Taking into account the global effects of environmental issues

Private and Social Costs/Benefits of Market Failure

Environmental resources and objectives often clash with the priorities of business, consumers and government. Market failure occurs because the price mechanism only takes into account private benefits and costs but excludes social costs, particularly those that involve environmental damage.

The big problem with the environment and the consequent social cost associated with damage are that there are no signed property rights, and the environment can be destroyed and no one effectively pays. This market failure is known as the “the tragedy of the commons”. ESD treats the environment not only as an asset, but as a resource worth protecting.

Government’s can manage the environment via:

Regulationso E.g. zoning, clean air and water legislation

Market based economic instrumentso Tradeable pollution permits, fishing quotas, incentives for the use of green

technology etc.

Society’s supply curve takes into account all costs of production (including environmental and social costs) and it lies above the producer’s supply curve. The socially optimum price level is above the market price (indicating that the price mechanism undervalues the natural environment) and the socially optimum quantity is below the market level (indicating that market forces result in the overuse of natural resources). Therefore, is social costs were taken into account, there would be a higher price and a lower quantity produced.

Public and Private Goods - Free Riders

Public goods are non-excludable. Once public goods are provided, the provider cannot exclude consumers from enjoying the benefit of that good, even if they are not prepared to pay for it e.g. national parks

Public goods are non-rival – consumption of the good by one individual consumer does not reduce the quantity of the good available for other consumers. Public goods create the opportunity for free riding behaviour to occur. People who use public goods without paying for them are free riders.

The possibility of free rider behaviour means that private markets either don’t provide public sector goods or under provide them. In other words, the incentive for free riders would tend to undermine any attempts nu the private sector to protect or clean up the environment from overuse and depletion.

Preserving Natural Environments

A major goal of environmental protection is to preserve the natural environment in as near as possible to its natural state by limiting externalities (e.g. pollution) and by restraining the use of non-renewable resources.

Governments however face significant problems because by trying to save the natural environment, they may stifle economic growth by enforcing environmental safe guards. In the short run, intervention may likely distort the price mechanism by increasing costs and decreasing growth which may cause a flight of industry to a less restrictive regulatory regime. In the king run, government action may encourage the growth of new industries. But we have to be competitive in order to take advantage of these new opportunities.

The cost of repairing damage to the environment is often borne by tax payers rather than those who have caused the damage.

Controlling Pollution

Pollution occurs when the environment is degraded because of both production and consumption. Pollution can harm economic activity. Essentially firms pollute because they are able to pass off some of their production costs to others. They are an unavoidable element of the production process and the consequences tend to grow disproportionally with the level of economic activity.

If producers are made to pay the full social costs of waste disposal or at least a part thereof then they will be encouraged to at least try and decrease their waste levels and recycling will lead to tax advantages.

Externalities

The social and environmental costs associated with economic activity which are not reflected in the actual costs of production are referred to as externalities. Externalities lead to costs and benefits that affect society as a whole but are not accounted for by the price mechanism. They tend to be passed on to society and represent market failure and hence negative externalities which are generally not paid for by the perpetrators. In the environment the community experiences a loss of amenity and it represents a misallocation of resources

Depletion of Natural Resources

Renewable resources naturally regenerate or may replace themselves over a short time frame. A sustainable usage pattern can be established. Non-renewable resources however are limited in supply; they cannot regenerate over a short term and may be exhausted.

All resources however which are renewable may become non-renewable if they are over exploited/polluted/made extinct e.g. world fish stocks. Non-renewable resources may also have the capacity for recycling and advancements in technology that may increase the productivity of such as resource. Or otherwise, lead to the development of alternatives, so extending the life of the resource.

For non-renewable resources, the optimal rate of usage that allows resources to regenerate so that they don’t decline is a critical objective. With non-renewable resources, however, allowing for an acceptable rate of decline that allows the use by future generations must be the main objectives.

Once an accepted level of resource depletion for a specific item has been determined, government policies (e.g. incentives, taxes, quotas) come into effect.