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HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] TOPIC 3: ECONOMIC ISSUES 3.1 Economic Growth Aggregate demand and its components: Y = C + I + G + (X-M) Injections and withdrawals (I+G+X; S+T+M) The simple multiplier: k = 1/MPS or k= 1/1-MPC Measurement of growth through changes in real GDP Sources and effects of economic growth in Australia Business cycle – trends 3.2 Unemployment Measurement – labour force, participation rate, unemployment rate Trends in unemployment Types and causes of unemployment – cyclical, structural, frictional, seasonal, hidden, long-term Natural rate of unemployment Main groups affected by unemployment Effects of unemployment – economic and social costs 3.3 Inflation Measurement – current Australian Bureau of Statistics measure Trends in inflation Causes of inflation – demand inflation, cost inflation, imported inflation + inflationary expectations. Effects of inflation 3.4 External stability Measurement – CAD, net foreign debt and net foreign liabilities as a percentage of GDP Trends in external stability measures Causes and effects of external stability issues HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.5 Distribution of Income and Wealth Measurement – Lorenz curve and Gini Co-efficient Sources of income as a percentage of household income Sources of wealth Dimensions and trends, according to gender, age, occupation, ethnic background and family structure Economic and social costs and benefits of inequality 3.6 Environmental Management Ecologically sustainable development Private and social costs and benefits – market failure Public and private goods – free riders Issues: preservation of natural environments, pollution control, externalities, depletion of renewable/non-renewable resources HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.1 Economic Growth Measurements of Growth through Changes in Real GDP Economic growth refers to the increase in an economy’s productive capacity, a rise in the volume of goods and services that an economy produces over a period of time or the annual rate of change in real GDP. It is generally considered the most important measure of an economy’s performance, as it creates jobs, allows individuals to increase their consumption and raises living standards by allowing more wants and needs to be satisfied in the economy. Hence, the pursuit of economic growth has consistently been a major objective of government policy. Economic Growth (%) = Real GDP (current year) – Real GDP (previous year) x 100 Real GDP (previous year) The rate of economic growth is usually measured in terms of changes in real GDP, which is a calculation of the total value of all goods and services provided in the economy over a given period of time adjusted for changes in the level of inflation. Real GDP = Money GDP x Base CPI Current CPI (where the base CPI is always 100). Australia’s rate of economic growth is usually measured over three different time periods: 1. Every three months the ABS calculates the quarterly rate of economic growth. 2. Quarterly national accounts figures can be used to calculate a less volatile measure of economic growth, year-on-year growth (which measures the percentage change of GDP between one quarter and the corresponding quarter of the previous year). 3. Australia’s annual economic growth rate is calculated each year using GDP statistics for the financial year. The Components of Aggregate Demand: Y = C+ I + G+ X-M Most economics traditionally believed that the most important factor determining economic growth was the ability of firms to produce goods and services i.e. the level of total output, or supply. John Maynard Keynes developed a theory that stated the most important influence on economic growth was the total expenditure in the economy i.e. the level of aggregate demand. The Keynesian theory suggests that people would not necessarily spend their income just because goods were produced and businesses paid their workers for production – it also depended on the economic outlook for firms and households – if this outlook was pessimistic, individuals/households would tend to spend less (and save more) and firms would be more reluctant to invest in capital goods – this would result in a decline aggregate demand (or total expenditure), with falling production and higher unemployment. Aggregate demand (AD) = the total demand for goods and services within the economy and how much consumers, businesses and governments are willing to spend on goods and services at various price levels – components of AD include consumption, investment, government spending and net exports (X-M). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Aggregate supply (Y) = the total productive capacity/level of income in an economy, i.e. the potential output when all factors of production are fully utilized – components of Y include consumer spending by households, saving by households and taxation by the government. The economy is in equilibrium (stable) when the level of aggregate demand = aggregate supply (national income). Injections and Withdrawals (I +G+X ; S+T+M) Based on the equation above, economic factors can be identified as leakages or injections as they add or detract from the circular flow of income. Injections are investment, government spending and exports as they put money into the circular flow and help to boost domestic aggregate demand. Leakages are savings, taxation and imports as they take money out of the circular flow and lower the levels of domestic production, income and employment. If injections < leakages: aggregate demand is less than total production – output and income will fall. Hence, savings, taxation and imports (leakages) will fall until the point where leakages = injections. This is a DOWNTURN in economic activity – i.e. the economy will CONTRACT. If injections > leakages: aggregate demand is more than total production – output and income will rise. Hence, savings, taxation and imports (leakages) will rise until the point where leakages = injections. This is an UPTURN in economic activity – i.e. the economy will GROW. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Influences on Consumption Consumption is the total amount of goods and services demanded by individual consumers. Consumption is an important determinant of economic growth because household consumption typically makes up almost 60% of expenditure (or aggregate demand) in the economy (represented 56% of expenditure in 2007-08). Anything that boosts consumption is also likely to boost expenditure (or aggregate demand and hence economic activity (income or supply). The most important factor influencing the level of consumption is the level of income – people with higher incomes tend to consume more, and as an individual’s income rises, they tend to consume more (as do economies). Average propensity to consume (APC): the total proportion of income that is spent on consumption. Average propensity to save (APS): the total proportion of income that is not spent, but saved for future consumption. The three main influences on the proportion of consumption from a given level of income are: Consumer expectations: if consumers expect prices to rise quickly in the future, higher real incomes or future shortages of goods then they would spend more and save less in the short-term – but if consumers expect stable prices, lower incomes or an increased availability of goods/services in the future, they would be inclined to save more and spend less. Level of interest rates: an increase in interest rates would discourage individuals from spending their money and therefore encourage saving - a decrease in interest rates would encourage spending and discourage saving. The distribution of income: the more equitable the distribution of income, the higher the rate of overall spending because lower income earners tend to spend proportionately more of their income than higher income earners. Government policies aiming to reduce income inequality would have the effect of reducing savings and increasing spending in the economy (e.g. through social welfare benefits). Influences on Investment Business investment tends to be the most volatile component of aggregate demand, usually making up about 20% of AD (in 2007-08 it accounted for 24.4% of GDP, growing strongly between 05-06 and 07-08 due to the mining boom, the rising terms of trade, higher business profits and positive expectations. The main factors influencing business investment are: The cost of capital equipment affects the level of business investment and is affected by: o Changes in interest rates: falling interest rates = cheaper to borrow funds for capital equipment purchases; rising interest rates = more expensive to borrow funds for capital equipment purchases. o Changes in government policy relating to investment allowances and tax concessions on capital goods – e.g. ability to claim a higher rate of depreciation on capital equipment would reduce tax liabilities. o Changes in price/productivity of labour would affect the relative cost of capital compared to labour – if the cost of labour increased (and the cost of capital remained the same), the relative cost of capital compared to labour would have decreased, making it more attractive to firms. Business expectations will influence the level of business investment – the factors that affect expectations: o Any change in expected demand for their products – if entrepreneurs expected a future increase in demand, they would be more inclined to purchase new capital equipment to boost production and satisfy that demand. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] o Any change in the general economic outlook – if the outlook for the economy was one of strong economic growth/prosperity, entrepreneurs would be more inclined to invest in capital equipment due to falling risks associated with business expansion. o The discovery of new resources/increase in technology leads to improved production methods, inducing entrepreneurs to invest in more capital equipment. o Inflation leads to uncertainty about future prices and future costs of production – this is likely to reduce investment in productive capital equipment. Influences on Government Spending and Taxation Changes in government spending and taxation to influence economic activity and thus affect the level of aggregate demand and economic growth – government spending usually makes up approx. 20-25% of aggregate demand (expenditure) in the economy, while taxation is usually equal to about 20-25% of aggregate supply (income) in the economy. As governments, through their control of fiscal policy, have a responsibility to maintain economic growth at a stable rate, governments may increase their spending and/or reduce the level of taxation to increase aggregate demand and boost growth, as was seen during the GFC (expansionary stance on fiscal policy). Alternatively, governments may reduce their level of spending and/or increase the level of taxation to reduce aggregate demand and growth (contractionary stance on fiscal policy). Influences on Imports and Exports Imports and exports usually make up 20-25% of aggregate demand in the economy – as the trade balance is usually in deficit, net exports usually make a small negative contribution to aggregate demand. Australia’s imports and exports are influenced most by the level of overseas and domestic incomes – if overseas income levels rise, Australia’s exports tend to rise as well, and when Australian income levels rise (during periods of strong economic growth), import consumption tends to increase. Australia’s exports are affected by the exchange rate (when the exchange rate is low, domestic producers are more internationally competitive and gain increased export revenue because exports are easier to sell on world markets – hence export volumes will be higher, boosting aggregate demand and economic activity – however, if the exchange rate is high, domestic industries are less competitive and net exports will be lower, detracting from aggregate demand and reducing economic growth). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] The Simple Multiplier: k = 1/(1-MPC) or k = 1/MPS The Keynesian theory states that when there is a shock to the economy (e.g. a change in consumer/business expectations, interest rates, or government policies) there will be a change in leakages and injections, creating a situation of disequilibrium. However, the economy will ultimately move towards an equilibrium position where withdrawals = injections and aggregate demand = aggregate supply. The multiplier is the greater than proportional increase in national income resulting from an increase in aggregate demand. For example, lower interest rates will increase business investment and expenditure (aggregate demand), which will then provide increased income for individuals who then consume more, further increasing expenditure and income and so on. Therefore the initial increase in investment will have a multiplied impact on national income. However the increase in investment will not continue to increase income forever – each time the injection moves around the economy, its impact on expenditure gets smaller because some of the income is not consumed but saved. This savings component is a leakage that reduces the effect of the higher investment on national income. The number of times the final increase in national income exceeds the initial increase in expenditure is the MULTIPLIER. Marginal propensity to consume (MPC) = the proportion of each extra dollar of income that is spent on consumer products. Marginal propensity to save (MPS) = the proportion of each extra dollar of income that is saved. MPC + MPS = 1 (since each extra dollar of income must be spent OR saved). Example – Simple Multiplier Process Assume for each extra dollar of income, consumers spend 80 cents and save 20 cents – therefore MPC = 0.8; MPS = 0.2. Investment in the economy has increased by $10,000 – this represents an increase into the circular flow of $10,000 (i.e. an initial increase to aggregate demand of $10,000). If the economy was previously in an equilibrium position, aggregate demand will now exceed output in the economy, hence there is an excess of aggregate demand. Producers will respond by increasing output and national income will initially increase by $10,000 (since this was the value of the initial increase in AD). The multiplier process ensures that national income will ultimately rise by much more than the original injection (in this case, national income will ultimately rise by much more than $10,000). The process occurs like this: o National income will increase by the initial $10,000. o Of that $10,000, $8000 will be spent (since MPC = 0.8) and $2000 will be saved (since MPS=0.2) – the $8,000 that is spent will be income to those who receive it as payment for goods and services. o Of that $8000, $6400 will be spent (0.8 x $8000), while $1600 will be saved – and this $6400 that is spent will be income to those who receive it. They in turn spend 80% and save 20% and so on. This process will continue, but the amount of additional consumption spending will decline each time until it eventually becomes insignificant. The final increase in national income is equal to the initial increase in aggregate demand multiplied by the ‘multiplier’. The size of the multiplier is determined by the MPS and can be expressed as: k = 1/MPS OR k = 1/1-MPC Hence, on the basis of the above example, k = 1/0.2 = 5. Therefore, the total increase in income generated by the $10,000 increase in aggregate demand is 5 x $10,000 = $50,000. The larger the MPS, the smaller the value of the multiplier – if individuals save proportionally more of their extra income, they will spend less and therefore generate less additional income. The smaller the MPS, the larger the value of the multiplier. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Any change in the level of planned expenditure (due to changes in investment, government spending, consumer spending or net export spending) will have a multiplied effect on the level of national income. For this reason, the Australian government attempts to exercise some influence over the level of spending in the economy. Sources and Effects of Economic Growth in Australia Sources of Economic Growth in Australia Australia’s economic growth rates are usually well below those of newly-industrialising economies such as China, India and Vietnam – this is because high-income nations such as Australia already make widespread use of machines/updated technology and thus radical improvements in labour/capital productivity are not likely. Therefore, most of Australia’s economic growth comes from improvements in productivity – the rate of technological change drives economic growth because it can lead to improvements in productivity. Improvements in labour and capital productivity allows for existing resources to be utilised more efficiently in production. Higher productivity in the last two decades (reaching record levels as a result of extensive micro-economic reforms) was one of the main reasons for Australia sustaining higher rates of economic growth in the 1990s and 2000s compared to the 1980s – this led to rising levels of real income per capita, employment growth and improvements in living standards. However, in the last 10 years, productivity growth has slowed dramatically has economic activity has become more subdued. Australia is a major importer of information and communications technology (ICT) and other types of specialised capital equipment which has spread throughout the mining, agriculture, manufacturing and service industries of the Australian economy. This capital has helped to raise both single favor (e.g. labour and capital productivity) and multifactor productivity which in turn increases the rate of sustainable economic growth. Australia adopted these technologies quickly relative to the rest of the world. Other important sources of economic growth include: o o Increased efficiency in the use of resources/factors of production as a result of: Firms responding to increased competition including global competition by improving efficiency – this usually requires both better management and improved attitudes of employees, as well as capital deepening. Government policies promoting increased efficiency – e.g. by privatisation and encouraging wage rises to be linked to the performance of workers in each firm – these represent changes in institutions which make them more supportive of economic growth. Institutional improvements aiding growth, including: Encouraging export industries by reducing protection and providing strong trade information and relations. Government economic management policies which minimise threats to Australia’s international competitiveness (policies of inflation and CAD issues) – however, the recent slowdown in productivity growth in Australia has been interpreted by some experts as a sign that government attempts to improve efficiency and other institutional changes have been less effective in the 2000s. o Population growth: a steady increase in a nation’s population leads to an increase in the demand for goods and services alongside an increase in the supply of labour – after WW2 for example, the government introduced policies for population growth for the dual purpose of bolstering national security and increasing economic growth – a poorly managed increase in population can have negative economic consequences such as unemployment alongside escalating environmental pressures. o Favourable economic conditions – factors such as low inflation, low interest rates and a stable currency and terms of trade are necessary for initial growth and assist in keeping it on track. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Other factors usually promoting economic growth include strong aggregate demand fed by: o Consumption spending being encouraged by falling unemployment rates, increases in wealth (especially shareholder & real estate wealth), rises in investment spending (encouraged by high and rising consumer sales levels as well as profit opportunities created by increased efficiency and technological change) and government spending (which has been important in maintaining the strength of aggregate demand when net exports weakened significantly). Effects of Economic Growth Economic growth is seen as the most important objective for economic management as it helps to achieve other economic aims. BENEFITS of Economic Growth Economic growth is keenly sought after as it provides numerous benefits to Australia and other economies such as: 1. Improvement in living standards: an economic system which achieves economic growth is becoming more successful in solving the fundamental economic problem – more wants can be satisfied through the increased capacity to produce more goods and services. Faster economic growth results in rising real GDP per capita – real wages and household disposable incomes rise, leading to higher material living standards. This is generally the main reason that countries pursue high levels of economic growth. Faster economic growth in Australia resulted in 2.2% annual growth in per capital real incomes in the decade between 1998 and 2008 compared with 1.8% in the previous decade. 2. Employment: economic growth creates jobs and potentially allows all individuals willing and able to work to find employment. Economic growth also changes the nature of employment and jobs available – countries with higher levels of economic growth can ultimately create more highly paid and highly skilled jobs. Economic growth even raises the likelihood of poorer individuals gaining employment, generating some income to alleviate absolute poverty even if the wages earned are quite low and moving the situation to one of relative poverty (whereby their income is still below the average income in the economy, but they can gain the bare necessities of life) – this process has been labelled the ‘trickle-down effect’ of economic growth and development. Economic growth may also provide opportunities for underemployed workers who may switch from part-time to full-time jobs and enjoy a rise in their real incomes, whilst those in full time employment may work overtime/second jobs to increase real incomes. 3. Greater productivity growth & technological progress: this arises from more efficient resource use, as producers are able to reduce production costs and innovate in keeping pace with the rising demand for goods and services – higher productivity, especially labour productivity, can lead to increased demand for labour by employers, helping to reduce the level of unemployment in the labour market. 4. Increased taxation: economic growth raises total income in the economy and therefore increases the capacity of households to pay taxes – higher taxation revenue makes it possible for the government to provide a greater quantity and wider range of collective goods and services. This means the government can use the additional revenue to provide social and economic infrastructure (better education, health facilities, water and sanitation and other government services). Higher taxation through economic growth also adds to a society’s ability to improve social welfare and maintain disadvantaged/deprived community groups, expanding the social welfare safety et. 5. Increased savings from increases in income in the public and private sectors: in the private sector, increases in real income can lead to a rise in the household savings ratio, with households able to reduce their levels of debt and save for retirement. With the introduction of compulsory superannuation in 1991, households have accumulated more retirement savings which has been assisted by rising real incomes. Businesses can also increase their saving rates because due to higher economic growth – this comes about from the retention of business profits, which can provide a source of funds for future investment in productive capacity. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 6. Lifestyle benefits: economic growth reduces the need for workers to spend almost all their time working, making leisure time more possible. For instance, over the last century, the standard working week fell from 48 hours/week to 32-36 hours a week in most Australian industries, allowing for longer vacations and options for long-service leave. Economic growth fundamentally flows on to economic development, providing improvements in social welfare such as benefits to personal lifestyles from greater real income and reduced class hostility between the rich and the poor within a nation. COSTS of Economic Growth The benefits of economic growth for Australia must be balanced against the costs of structural change which occurs as the economy grows in real terms. Economic growth should not be pursued as an end in itself but as a process of assisting the Australian economy to achieve higher living standards and improvements in the physical and human quality of life and human development. A number of problems (including externalities) can result from the pursuit of economic growth as an end in itself and it may also produce situations that represent disadvantages within an economy: Economic Disadvantages 1. Inflation: higher levels of economic growth can result in price increases, contributing to a rise in the level of inflation – excessive rates of economic growth can therefore lead to demand pull and cost push inflation as resources become scarce in relation to the increased demand for goods and services. This is particularly true if spending is growing at times when the economy is close to its full capacity and the growth is aggregate supply cannot keep up with the growth in aggregate demand. A major aim of government policies relating to economic growth is to keep growth at a level that is not so high that it prompts a surge in inflation – this is the ‘sustainable rate of economic growth.’ 2. External stability: stronger economic growth in Australia is often associated with increased consumer and business spending and as a result, a higher level of import consumption. Australian consumers spend a high proportion of their disposable income on imported goods and services, and this means that stronger economic growth can often cause a rise in the CAD. Thus high levels of economic growth can pose a risk to the external stability of the economy, and this is why the balance of payments has often been regarded as a ‘speed limit’ that constraints the level of economic growth due to the need to keep a CAD sustainable. 3. Unemployment issues: unbalanced economic growth is almost inevitable, causing the rate of economic growth to vary between sectors and industries in the economy. Some sectors can experience declines in production and employment, leading to labour skills/capital equipment becoming under-utilised or even redundant in lagging industries as structural change occurs. This structural adjustment process results in structural unemployment, increasing unemployment and reducing income levels in the short-term (through the loss of a job) but also in the long-term (with the possibility that any new job may be a low-paying, unskilled job) – this means that governments will need to fund retraining schemes to re-skill the structurally unemployed for future employment in other industries. 4. Governments tend to concentrate resources on the faster developing sectors of the economy and neglect the needs and wants of the slower growth or stagnant regions of the economy. This is a force increasing inequality within economies. Economic growth can lead to conflict with the objectives of price stability (inflationary pressures), full employment (as technical progress may lead to structural unemployment) and external balance (as the economy will often increase its demand for imported goods when the economy grows, leading to an increase in the CAD and the level of net foreign debt to finance the deficit. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Social Disadvantages 1. Income distribution: though economists generally assume that economic growth contributes to higher living standards and therefore better outcomes for everyone, this is not necessarily so – sometimes, the benefits of economic growth flow mainly to a particular group in society, such as shareholders or company executives, rather than flowing more broadly to people through wage increases or improved public services. This further amplifies the problem of income inequality, where the benefits of strong economic growth may flow to the higher income earners while living standards of the bottom quarter of society barely improve. Therefore inequality may lead to widening income inequality if the benefits of increased economic growth do not ‘trickle down’ to the middle and working classes but are concentrated in high-income groups. However, despite the possibility of some people missing out on the benefits of economic growth, a nation with high rates of economic growth is more likely to be able to reduce the extent of absolute poverty existing within that economy. 2. Environmental impacts: economic growth can potentially have a negative impact on the environment, leading to a rise in negative externalities – if growth is pursued with very little regard for its impact on the environment, it can result in pollution, depletion of non-renewable resources, deforestation and land degradation, damaging the local environment – this is because more natural resources are needed to sustain higher levels of economic growth. Economists are increasingly recognising that the threat of climate change will require economies to break the link between higher rates of economic growth and increased greenhouse gas emissions – otherwise continued economic growth will have catastrophic effects on the global environment in the next century. Government policies have increasingly sought to maintain a growth rate that is not so high that it causes irreparable damage to the environment – this is ‘ecologically sustainable development’. However, the negative externalities are often ignored until they become major health/environmental concerns as societies have been reluctant to restrain economic growth opportunities. Business Cycle – Trends in Australia’s Economic Growth Performance A market economy such as Australia is subject to the fluctuations of the business cycle (general level of economic activity) caused by changes in the levels of aggregate demand and supply in the economy. Trends in the Business Cycle in Australia The trough of the business cycle is where output and employment ‘bottom out’ to their lowest levels (the lowest point). Unemployment is at its highest level – e.g. the 1990-91 recession in Australia was characterised by negative economic growth of -0.2% real GDP and the unemployment rate rose to 11%. The 19901-91 recession was caused by excessive monetary policy tightening which reduced economic growth and raised unemployment. A recession is defined as two consecutive quarters of negative economic growth – the Australian economy was forecast to enter a recession in 2009-10 with -0.5% growth because of the global financial crisis and recession. The recovery/upswing of the business cycle is a phase between the peak and trough, characterised by an expansion in the economy’s level of output and employment towards full employment – unemployment falls because higher spending creates new job opportunities. For example, between 1992 and 1994, an upswing led to real GDP in Australia rising by 2.7% on average, and the unemployment rate falling to 8.9% due to recoveries in both domestic and global economic activity. Another economic recovery or upswing in Australia occurred between 2002 and 2004 when the economy recorded growth of between 3% and 4% after slower growth of 2% in 2001-02. The peak or boom of the business cycle is the upper turning point, where the economy has grown to its capacity and income, employment and output are at a maximum – aggregate demand exceeds aggregate supply causing over full employment of resources. Inflation may rise because resources are scarce and their prices are bid up by competing users. Between 2003 and 2004, the Australian economy boomed with real GDP averaging over 4%, and unemployment fell below 5% - but inflationary pressures increased with the CPI rising to 3.2% in 2005. Excess demand in the economy also led to higher import spending and an increase in the CAD from -5.1% of GDP in 2002-03 to -6.2% of GDP in 2004-05. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] The downswing of the business cycle is characterised by falling output and employment – spending falls in a recession and unemployment rises, as aggregate demand is insufficient to generate full employment. The recent financial crisis was a global downswing as the global economy experienced the worst recession since the Great Depression of the 1930s – world GDP growth was forecast by the IMF to contract by -1.5% of GDP in 2009, before recovering in 2010 with growth of 2.25% of GDP. This diagram of the business cycle reveals that over time, market economies such as Australia usually experience an overall trend of growth in real GDP. However, they are subject to a continuous cycle of strong economic growth followed by recession (decreased economic activity, generally associated with rising unemployment). Government macroeconomic management is designed to minimise these fluctuations so that the economy experiences a low rate of inflation, a low rate of unemployment and relatively stable economic growth, demand management policies which are referred to as counter—cyclical or stabilisation policies. A major priority of economic management is the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of economic activity and achieving specific goals. In a trough or recession the government could use expansionary monetary and/or fiscal policies to support growth in aggregate demand and reduce unemployment; in a peak or boom, the government could use contractionary monetary and/or fiscal policies to reduce the growth of aggregate demand ant to contain inflation. Trends in Australia’s Economic Growth Between 1991 and 2008, Australia experienced its longest period of sustained economic growth on record, with 17 years of uninterrupted economic growth averaging 3.6% per annum. During the 1990s in particular, Australia’s growth rates surpassed the 2.7% averages of advanced industrialised economies – therefore, Australia’s growth was higher than every other high-income economy except for the rapidly industrialising economies of Singapore, Ireland and South Korea. Australian growth rates slowed to 3.1% per annum during the 2000s decade, which although slower than its 1990s performance, was still well above the average for OECD economies – this was helped by the stimulus of the global resources boom and the rising terms of trade between 2003 and 2008 in Australia. Throughout the 1990s, government macroeconomic policies encouraged continued growth through budget deficits and lower interest rates – by 1995, the economy was growing at a rate of approx. 6%, which was considered unsustainable due to the growing CAD – interest rates were then raised in response to slow growth in aggregate demand, followed by the 199596 Budget which reduced the deficit to reduce demand. Until the onset of the global recession in late 2008 following the outbreak of the global financial crisis, Australia had avoided a major downturn since the early 1990s. However in 2009, Australia faced an uncertain economic future following the turbulence of the economy in late 2008 – despite the negative effects from the global recession, the Australian economy proved resilient and experienced a comparatively milder slowdown than its other OECD counterparts. Ross Gittins, an economic reporter, would suggest that Australia did go into recession even though our negative growth was only in one quarter, the December quarter of 2008 where we experienced -0.9% growth – a recession is the stage of the business cycle HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] where there are two consecutive quarters of negative economic growth or a fall in GDP, and thus by definition, Australia did not fall into recession. In the December quarter of 2009, Australia experienced 0.9% economic growth and 2.7% growth over the year to December. This has been attributed to government stimulus spending which was designed to encourage consumer and investment spending to keep the economy going – according to the Treasury, without budgetary stimulus, the economy would have instead contracted by 0.7% for the entire year of 2009. Australia’s robust economic performance throughout the 1990s and early 2000s decade, as well as the resilience after the onset of the GFC in 2009, reflects a combination of domestic and external factors, as well as a strong economic policy and management framework. Factors that have contributed to this growth include: o Global economic conditions have generally been favourable since the early 1990s, with greater macroeconomic stability worldwide – the US was performing strongly during the 1990s which contributed to Australia’s sustained growth cycle, and this has then been followed up by strong Chinese and Indian growth in the 2000s. The increased global demand for resources (where demand exceeded supply hence pushing resource prices up significantly) has fuelled Australia’s economic growth through increased export revenue from commodity exports, which has also led to the largest improvement in our terms of trade since the 1950s. China’s continued economic growth despite the GFC helped to underpin demand for Australian commodity exports, boosting export volumes by 2% in the early half of 2009 and providing a buffer against deteriorating global economic conditions. o Terms of trade – a sustained improvement in Australia’s terms of trade has lifted domestic incomes and increased Australia’s economic growth. Australia’s terms of trade reached an all time high in September 2008 at the height of the resources boom, driven by soaring commodity prices due to the insatiable demand for commodities from industrializing economies such as China – in the give years to 2008-09, Australia’s terms of trade rose by 47%. However, the terms of trade fell by 17% over 9 months to June 2009 – it has since improved by 4% with the RBA expecting a further improvement of 1% this year. An improved terms of trade adds to Australia’s real income & jobs. o Economic management has generally focused on maintaining economic growth within a sustainable range – a level that does not push inflation above the target zone of 2-3% and does not push the CAD so high that financial markets react negatively. The Australian Treasury estimates that Australia’s long-term sustainable rate of economic growth is approximately 3.25% of GDP. o Fiscal policy has played a more active role in economic management to lift economic growth during periods of economic downturn. Within weeks of the meltdown on global financial markets in September 2008, the Australian Government announced a major economic stimulus that by the 2009-10 budget added up to $77 billion – this was intended to boost economic growth by 2.75% in 2009-10 and 1.5% in 2010-11 whilst supporting 210000 jobs as a result. The stimulus included cash payments to increase household consumption in the short-term, spending on school infrastructure, social housing and home insulation subsidies in the medium-term, and long-term transport infrastructure. o The RBA’s focus on maintaining low inflation within the range of 2-3% of GDP over the business cycle since the mid-1990s has meant that the RBA has taken quick action to ward off inflationary pressures. This helped to keep the economy growing at a sustainable rate and to avoid the need for larger interest rate increases that might have caused more prolonged downturns in economic growth. Sustained low inflation has helped to keep nominal interest rates low, encouraging consumer and investment spending and stimulating economic growth. o Large increases in asset prices such as real estate and shares during the early 2000s increased the wealth of households, encouraging greater borrowing and consumption. This is known as the wealth effect. This has been reversed more recently due to the fall in global stock-markets which reduced the value of investments and superannuation assets. o Productivity growth reached record levels in the 1990s, with labour productivity averaging 2.6% per year in the 1990s – this was helped by micro-economic reforms which helped to overhaul many sectors of the economy and introduce competitive pressures, as well as encourage the take-up of new technologies. However, productivity HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] growth has fallen below its long-term averages in the 2000s decade, with labour productivity growth averaging just 1.7% per year in the private sector in the decade to 2009. o New technologies have helped to raise productivity and efficiencies in many industries. Australian firms have been quite quick to adopt new technologies, and this has contributed to overall higher productivity across most industries. With the Australian economy becoming increasingly integrated into the global economy, Australia’s future economic growth prospects will be significantly influenced by global economic conditions – more specifically, Australia’s outlook for future growth is tied to China, whose demand for resources has substantially lifted national income in recent years. Australia’s success in managing a range of economic challenges, from the inflationary risks of an enormous trade boom that peaked in 2008, to the impacts of the GFC which threatened to drag Australia into a deep downturn, has contributed to increased confidence in Australia’s long-term economic future. In the long-term, Australia’s economic challenges have been described by the Australian Treasury as the ‘3 Ps’ – productivity, participation and population. Sustaining long term productivity growth, high levels of workforce participation and continued population growth from natural growth and immigration will help Australia to achieve the highest rates of economic growth possible. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Policies to Sustain Economic Growth A major aim of the Australian Government’s economic policy is to sustain high rates of economic growth to allow national wealth to grow and individuals to experience a higher standard of living. To achieve this and to influence rates of economic growth in Australia, the government is able to use macroeconomic policies (consisting of fiscal policy and monetary policy). The main role macroeconomic policies play in influencing economic growth is to affect the growth rate in the short-term with the aim of smoothing fluctuations in the business cycle and achieving the highest level of growth that the economy can sustain in the short to medium-term. Macroeconomic policies will ultimately only have a limited impact on the level of long-run growth that the economy can achieve. Macroeconomic Policy Measures for Economic Growth Australia’s sustained economic growth from 1991 to 2009 can in part be attributed to the more effective conduct of macroeconomic policy in keeping inflation and interest rates low, which has led to more certainty and underpinned consumer and business confidence in their spending decisions. The main macroeconomic policy instruments used by the Australian government include monetary and fiscal policies. A. Fiscal Policy Fiscal policy involves the use of the Commonwealth Government’s Budget to achieve economic objectives. Government expenditure in the Budget is an injection into the economy; government revenue (taxation) is a leakage from the economy. By adjusting the level of expenditure and revenue, the government can influence the rate of economic growth in Australia. - If the government wants to increase economic growth, it can reduce taxation and increase expenditure (or both) – this would cause an increase in the level of injections relative to leakages and hence result in an upturn in economic growth. - If the government wants to decrease/constrain economic growth, it can increase its taxation or reduce government expenditure. The Government has generally achieved budget surpluses since 1996 and paid off Australia’s public debt in 2005-06 – it used budget surpluses to fund tax cuts and to implement a range of reforms in health, education, social security, infrastructure, superannuation and the labour market. The achievement of budget surpluses and the retirement of public debt led to a lower interest rate environment, which supported higher rates of sustainable economic growth by encouraging private consumption and investment spending and employment growth. Fiscal policy is generally more effective in stimulating growth during a downturn rather than slowing down an economy that is not growing sustainably. This was seen during the global financial crisis which impacted on Australia’s rate of economic growth in the second quarter of 2008, with the Australian economy recording -0.5% growth in the December Quarter and 0.4% in the March quarter of 2009. The Australian Government used discretionary fiscal policy to introduce fiscal stimulus measures to support aggregate demand, employment and growth in real GDP – these included short-term cash transfers to low and middle income households in November 2008 and February 2009, and new spending on infrastructure projects in the 2009-10 Budget. These measures were estimated to boost real GDP by 2.75% in 2009-10 and 1.5% in 2010-11. The Treasury estimated that without these fiscal measures, the impact of the global recession on Australia would have led to the unemployment rate reaching 10% of the workforce. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] B. Monetary policy Monetary policy involves the RBA influencing the level of interest rates in the economy, which in turn influences the rate of economic growth. If the RBA wants to increase growth, interest rates can be reduced (which would encourage consumer/business spending and investment). Conversely, to decrease growth, interest rates can be increased to discourage spending and investment. Since 1996, the RBA has set an inflation target of 2-3% CPI inflation over the economic cycle for conducting monetary policy – the achievement of this target has been important in containing inflationary pressures and expectations in the economy which could threaten the achievement of the goal of sustainable economic growth and the maintenance of Australia’s international competitiveness. In recent years, monetary policy has been the most important macroeconomic policy tool for influencing the rate of economic growth – however, amidst the recent GFC, fiscal policy (through stimulus packages and cash payments and other government investments in infrastructure) played a more significant role than it has in the past in bolstering the economy and helped to stimulate growth and keep the economy out of a technical recession. In a trough or recession, the Government uses expansionary fiscal and/or monetary policy (RBA) to support growth in aggregate demand and reduce unemployment, whilst in a peak or a boom, the Government uses contractionary monetary (RBA) and/or fiscal policy to reduce the growth of aggregate demand and to contain inflation. Microeconomic Policy Reforms for Economic Growth While macroeconomic policies can be used effectively to promote and sustain economic growth in the short to medium term, microeconomic policy reforms can be used in the LONGER-TERM to address specific structural problems in the economy which may prevent the achievement of growth in the future – it aims to increase the economy’s sustainable growth rate by reducing the extent to which higher growth causes inflationary and current account problems, factors that may constrain growth. In effect, microeconomic policy reforms increase aggregate supply in order to keep up with the strong aggregate demand. Some of these MER include: - Cuts to protection such as tariffs and quotas – this has increased import competition and encouraged greater efficiency in industry and more exports of manufactured goods. - Widespread taxation reform including the introduction of the broad-based consumption tax (GST) in 2000 which has secured adequate tax revenue for the government to fund its spending on goods and services, infrastructure and welfare payments. - As well as broadening the tax base and shifting more emphasis on to indirect taxes, the Australian Government has also cut marginal rates of income taxation and increased income tax thresholds to reduce the tax burden on income earners – these measures have increased the incentives to raise productivity and the levels of saving and investment. The Productivity Commission argues that the fact that Australia achieved higher rates of growth in the 1990s is evidence that Australia benefitted from its expensive program of microeconomic reform during that period. Greater investment in workforce skills programs and physical infrastructure in recent budgets have aimed to overcome shortages experienced across the Australian community that have contributed to inflationary pressures in recent years. Since 2006, the Council of Australian Governments has expanded its reform agenda to boost productivity, increase labour force participation, develop human capital and improve international competitiveness. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.2 Unemployment The problem of unemployment is an important challenge facing economic systems. It is a major cost to the economy because it results in the opportunity cost of lost production as well as increased social welfare payments/loss of taxation revenue. Measuring Unemployment – Labour Force, Participation Rate & Unemployment Rate Labour Force The labour force (or workforce) consists of all the employed and unemployed people in the economy at any given time. It is the section of the population 15 years and above who are either working or actively seeking work. The labour force consists of: people over 15 years of age who are employed for at least one hour per week of paid work + self-employed individuals working for at least one hour per week in their own business/family business + unemployed people aged 15 and over who are currently available for work and are actively seeking work. LABOUR FORCE = Employed people (part-time and full-time) + Unemployed people (actively looking for work) Labour Force Participation Rate The labour force participation rate refers to the percentage of the population, aged 15 and over, in the labour force, that is either employed or unemployed. It represents the willingness of people in an economy to participate in the labour force. The average participation rate in 2008-09 was 65.3% - the participation rate tends to vary with economic activity, rising during booms when more jobs are available and falling during recessions when unemployment rises and job vacancies fall. The male participation rate for males fell from 72.1% in 2000-01 to 71.6% in 2003-04, before rising to 72.5% in 2007-08 because of strong jobs growth in the economy. However, due to weaker labour demand brought on by the GFC, male participation fell again to 72.1% in 2008-09. Female participation rose from 54.9% in 2000-01 to 58.7% in 2008-09, reflecting the rising participation of women in the workforce. LABOUR FORCE PARTICIPATION RATE (%) = Labour Force x 100 Working age population (15+) 1 Unemployment Rate Unemployment refers to a situation where individuals are willing and able to work, actively seeking work (by checking and responding to advertisements and registering with an employment agency), but are unable to find suitable employment – thus, labour resources in an economy are not utilised to their full capacity. UNEMPLOYMENT RATE (%) = Number of Persons Unemployed Total Labour Force x 100 1 HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] There are TWO main issues with current labour force statistics and the methods used to measure unemployment in Australia: 1. By classifying people as employed or unemployed, official statistics do not take into account the number of hours worked – some unemployment people with a limited amount of work want to work longer hours – they are underemployed. 2. By classifying people as either in the labour force or not in the labour force, unemployment statistics do not include people who have not been able to find work an d have left the labour force – they are hidden employed. The ABS releases a quarterly labour force underutilization rate which was 13.4% in 2009 up from 10% in 2008 to overcome these issues. This alternative indicator suggests that Australia’s unemployment problem may be twice as high as that revealed by official statistics. Types of Unemployment The main types of unemployment are: 1. Structural Unemployment occurs because of structural changes within the economy caused by changes in technology or the pattern of demand for goods and services. It results from a mismatch of labour skills with the job vacancies offered structural change in manufacturing may lead to the introduction of new technology making some jobs obsolete, whilst new jobs may be created in expanding industries such as catering and hospitality. Excessive increases in labour costs may prompt employers to replace labour with capital, which often occurs when real wages increase quicker than productivity. Most of Australia’s persistent, long-term unemployment problem is attributed to structural unemployment. 2. Cyclical Unemployment (also known as ‘Keynesian Unemployment’) occurs because of the variations in the level of economic activity over time and is due to a temporary deficiency in the level of aggregate demand which leads to falling employment opportunities. It often rises during a recession as firms are forced to downsize their workforces or cease hiring new workers. Cyclical unemployment has risen in recent years as a result of deteriorating economic conditions, and is the major contributor to the rise in unemployment since late 2008. 3. Frictional unemployment is inevitable as it represents the people who are temporarily unemployed as they change jobs – they have finished one job, but have not started a new one, and since it takes time to move from one job to another, individuals are classified as ‘frictionally unemployed’ during the change-over period. Improving the efficiency of job matching services through job and skills databases can help to reduce frictional unemployment. 4. Hidden unemployment refers to a situation of unemployment where people have given up looking for a job but would, under better economic circumstances, actively seek employment. They are not counted as part of official unemployment statistics because they are not actively seeking work and therefore are not included in the labour force. The ABS estimates that there are as many as 1.3 million unemployed people in Australia. 5. Seasonal Unemployment occurs at predictable and regular times throughout the year, resulting from the seasonal nature of production of some goods, usually for jobs dealing with primary production such as fruit pickers. Unemployment figures are usually ‘seasonally adjusted’ in order to account for these fluctuations. 6. Long-term Unemployment refers to people who are enduring a period of more than 12 months of unemployment , putting them at a severe disadvantage due to the potential loss of skills over that time (and hence they often face ‘structural unemployment’ too). Once a pool of long-term unemployed people exists, it is very difficult to reduce it; however, high economic growth can stop the number from rising. This was a large problem during the 1990s, up at 34% of all unemployed people – however, it has since fallen to 15%. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 7. Hardcore Unemployment refers to long-term unemployed people who may be considered unemployable and unable to perform work effectively because of their personal circumstances – this is often due to physical/mental/social incapacities. 8. Underemployment refers to those people who are working part-time (therefore they are NOT unemployed), but would like to work more hours, or people who are full-time employees but would like to work a second job/over-time. These people are classified as ‘underemployed’ because they are not working to their full potential. Causes of Unemployment Unemployment arises as a consequence of a number of factors in the economy, including: The level of economic growth The demand for labour is a derived demand – it is derived from the demand for the goods and services that labour helps to produce. If there is a downturn in the level of aggregate demand in the economy (due to an economic downturn with lower domestic consumption and investment spending; contractionary fiscal/monetary policies; or decrease in demand for Australian exports due to slower trading partner growth/reduced international competitiveness of Australian firms), this may be reflected in a downturn in the demand for labour and an increase in the level of unemployment. The GFC in late 2008 led to a fall in aggregate spending and economic activity in Australia. Unemployment is closely correlated with the overall level of economic growth – as a general trend, unemployment starts to rise when economic growth is below 3% of GDP; unemployment falls when economic growth is greater than 3.5% of GDP. There is usually a time-lag of 6 months between a change in the level of economic growth and a change in unemployment (cyclical unemployment is primarily affected by changes in economic growth). Following the -0.9% growth in the December quarter of 2008, unemployment rose to 5.8% by mid-2008, up from 4.2%. The sustained high growth performance of the Australian economy in recent years pushed unemployment to 4% in 2008, from highs of 7% earlier in the decade –initial Treasury forecasts predicted the economy to experience a contraction in economic growth of 0.5% in 2009-10 and a subsequent rise in unemployment to 8% by mid-2010, further highlighting the connection between economic growth and unemployment rates. The Keynesian Deflationary or Unemployment Gap: A theoretical explanation for cyclical unemployment was proposed by Keynes in 1936. In the diagram, the equilibrium level of national income is YE, determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. Keynes suggested that the equilibrium level of national income in an economy may not necessarily coincide with the full employment level of income, denoted by YF. If total spending was insufficient to guarantee full employment of the economy’s resources, a deflationary gap or unemployment gap of AB would arise, causing cyclical unemployment to increase. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Constraints on Economic Growth In the long-term, unemployment is influenced by the level of sustained economic growth achieved by the economy – if there are significant constraints on economic growth, the economy will struggle to create enough jobs to reduce unemployment. During the 1980s, Australia’s inflationary concerns and CAD issues were significant constraints on economic growth and therefore contributed to the unemployment problem – although inflation proved to be less of a constraint on growth in the 1990s, the CAD emerged as a problem during the strong growth phases in the mid 1990s and the late 1990s, however, it did not seem to substantially impact on Australia’s growth rates considering Australia still delivered 17 years of consecutive growth (links with Pitchford Thesis) . The Stance of Macroeconomic Policies The Australian Government’s macroeconomic policy settings can influence the level of cyclical unemployment in the short to medium-term through their influence on the business cycle. Expansionary/contractionary stances affect economic growth through changes in leakages/injections or changes in the cash rate – this ultimately affects AD and output and flows on to the demand for labour and unemployment levels change accordingly. Macroeconomic policies such as raising interest rates or running budget surpluses would restrict economic growth, thus causing an increase in unemployment in the medium-term. For example, to emphasise the correlation between contractionary/expansionary policies and impacts on unemployment: o 1992-1994: expansionary fiscal + monetary policy (large budget deficits/low interest rates) – unemployment fell from 11% to 8.5% o 1996-1997: shift towards tighter monetary policy and fiscal consolidation = slower growth and a slight increase in unemployment to 9%. o 2005-2008: mildly expansionary fiscal policy alongside a major resources boom helped to sustain further reductions in unemployment to around 4%. o 2008-2009: unemployment levels increased as the GFC impacted on the Australian economy – a shift to highly expansionary monetary policies implemented from late 2008 helped abate the sudden spike in unemployment, but could not fully offset falling business confidence + decline in demand. Rising Participation Rates An increase in the labour force participation rate will tend to cause an increase in unemployment in the short-term. This is because more people who previously were not looking for work (and hence were not classified as ‘unemployed’) start actively seeking employment – this usually occurs during an economic recovery where discouraged job seekers, observing the improvement in employment prospects, start looking for work. They enter the labour market and unless they find a job immediately, they became a part of the unemployment statistic. This means that the level of unemployment may only be reduced slowly, even when economic growth and employment growth are strong, because more individuals are looking for jobs. Structural Change Structural change (such as reductions in protection levels through huge tariff cuts) involves the loss of jobs in less efficient industries/areas undergoing major reforms (e.g. privatisation and loss of jobs in manufacturing industries). This often leads to a rise in structural unemployment. Uncompetitive industries such as textiles, clothing and footwear, steel and passenger HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] motor vehicles were also forced to reduce their workforces in the face of tariff and quotas cuts introduced by the government between 1988 and 2005. In the long-term, the contraction of some industries (in manufacturing for instance) due to structural change has allowed for the growth of more efficient industries, resulting in net benefits for the labour market – more employment opportunities should arise and more jobs should be created to offset the losses. Technological Change Rapid technological change can cause unemployment in the short-term – new and improved production methods will often result in capital replacing labour and a subsequent change in work skills required, leading to redundancies and higher structural unemployment. Many economists argue that in the long-term, technological change may create more jobs than they eliminate – displaced workers may be re-employed in the future, provided that they have suitable opportunities to be retrained – therefore their redundancies may be only temporary. Productivity A slow-down in productivity growth will tend to result in lower unemployment in the short-term but higher unemployment in the long-term since an economy with lower productivity growth will be less competitive and slower growing and therefore employers may use capital instead of labour in production. Higher productivity growth will tend to slow employment growth (or increase unemployment) in the short-term, because less employees are required per unit of output – however, in the long-term, higher productivity contributes to greater economic growth and will therefore lower unemployment. Rapid Increases in Labour Costs Unemployment may rise because of a sudden rise in labour costs (wages). The circumstances under which this may occur: o When nominal wage rates rise faster than inflation and productivity increases, they cut into business profit levels - this encourages firms to replace labour with capital, therefore resulting in wage-induced unemployment. o When there is a substantial rise in labour on-costs – these include the additional costs of employing labour, such as superannuation, sick leave, holiday pay and workers’ compensation. If governments raise these too high, it can cause a decline in the demand for labour, resulting in higher unemployment. o A decision by Fair Work Australia to increase award wages substantially in its Minimum Wage Decision (to improve the living standards of lower paid workers) may make it too expensive for employers to keep all of their workers employed and reduce their wage costs by making some labour redundant – hence, in 2009, the Australian Fair Pay Commission (predecessor of (FWA) decided not to increase the minimum wage, citing the risk of increasing unemployment levels in an already strained jobs market. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Inflexibility in the Labour Market The inflexibility of the labour market (due to its regulation) has led to higher wage costs – some economists argue that Australia’s relatively high minimum wage rates make it less attractive for employers to hire less skilled workers, contributing to a higher level of unemployment and that deregulation of the labour market may lead to lower minimum wages and a lower rate of unemployment. If a minimum wage is established above the market equilibrium by government regulation, unemployment rises because the derived demand for labour becomes less than the supply of labour. This diagram shows that if a minimum wage of W 2 is established above the market equilibrium wage rate of W 1 by wage-fixing tribunals or trade union bargaining power raising wages above equilibrium, unemployment of Q3 – Q2 will occur since the demand for labour (Q2) is less than the supply of labour (Q3) at wage rate W 2. Inadequate Levels of Training and Investment By the early 2000s, major skills shortages had emerged in areas of the economy for occupational groups such as tradespeople, health professionals & trained chefs – in 2008, 60 occupational groups were experiencing a shortage of skilled labour. The skilled labour shortage is a significant supply constraint on the Australian economy, and is regarded to be a result of huge weaknesses in Australia’s education and training system – the gaps in education and training may be related to shortages in the provision of training opportunities/people entering the workforce without undertaking sufficient education or training. See ‘Policies of Unemployment’ for the various labour market programs Australian governments have implemented to address the issue of improving education, training and skills of the labour force – these have been designed to increase the role of apprenticeships in developing the skills of young people (15 to 19 years) who have a higher incidence of unemployment than mature age workers. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Natural Rate of Unemployment The natural rate of unemployment or NAIRU (Non-Accelerating Inflation Rate of Unemployment) refers to the level of unemployment at which there is no cyclical unemployment, i.e. where the economy is at a state of equilibrium (quantity of labour supplied = quantity of labour demanded) or when the unemployment rate is consistent with full employment in the labour market. The natural rate of unemployment consists of frictional unemployment, seasonal unemployment, hardcore unemployment and structural unemployment, but does NOT include cyclical unemployment (which is the main contributor to the gap between the official unemployment rate and the NAIRU). 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. Once the natural rate is reached, any further cuts in wages or stimulus or aggregate demand will not lead to permanent reductions in the rate of unemployment – therefore, making the economy grow faster by increasing the level of demand through macroeconomic policies is futile once the economy is at the natural rate of unemployment, and it will only lead to higher inflation as wages growth accelerates (hence the alternative name of NAIRU). The NAIRU is the lowest possible level of unemployment that can be achieved without causing inflation to accelerate/causing inflationary pressures in the economy and it attempts to remove cyclical influences even though the levels of unemployment and inflation are heavily influenced by cyclical factors. The Australian Treasury estimated the NAIRU in 2009 was 5% - a lower NAIRU increases the economy’s capacity to grow without increasing inflation. It has always been difficult for the government to achieve low unemployment, particularly in conjunction with low inflation – this is illustrated by the Phillips Curve where a tradeoff between low unemployment and low inflation was seen to exist, i.e. an improvement in one cannot be achieved without leading to deterioration in the other. During the global resources boom, Australia’s unemployment rate fell below the Treasury’s NAIRU estimate. With inflation average 2.5% between 1998 and 2009, the NAIRU was estimated at between 4-6% in 2009. The Natural Rate of Unemployment – this diagram illustrates the concept of the natural rate of unemployment. The real wage rate is measured on the vertical axis and the quantity of labour on the horizontal axis. The labour force is denoted by the vertical line LF. Full employment is where equilibrium (E) occurs in the labour market at real wage W and labour quantity QL. The distance EU (QN – QL) is equivalent to the natural rate of unemployment. Some workers are unemployed (due to frictional and structural factors) because they are unable to find work at the equilibrium real wage rate of W. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Main Groups Affected by Unemployment The unemployment problem is more severe for some groups in Australia than for others and the incidence of unemployment varies between demographic and skill groups in the labour force. The persistently higher rates for some groups in society may reflect the persistence of discrimination and unequal employment opportunities in the Australian labour markets. The main groups affected by unemployment in Australia are: 1. Young workers – the youngest group in the workforce (aged 15-19) can often experience levels of unemployment up to 3 times the rate of the general population. A recent report released by the OECD suggested that any deterioration in labour market conditions is disproportionately felt by young people. It is a particular issue for the youth because employees seek workers with greater skills and experience, which young unskilled workers lack – this explains the increasing school retention rate (at the beginning of the 1980s only about 35% of students completed Year 12, but it has now stabilised at around 75%) and the longterm rise in participation in tertiary education in Australia, which will ultimately lead to a more skilled and competitive workforce in the future. Government policies such as replacing unemployment benefits/other social security payments with the Youth Allowance and study allowances has helped to increase school retention rates, ultimately reducing youth unemployment. Workers with low levels of educational attainment tend to experience higher rates of unemployment than those with higher levels of educational qualifications. For males and females who had not completed high school, the rates of unemployment were 16.3% and 14.6% in the 1990s and 2000s – in contrast, for workers who had degrees, diplomas, a vocational qualification or had completed high school, the rate of unemployment varied between 6% and 8.5% in the 1990s and 2000s. Workers in semi-skilled or un-skilled occupations (labourers, factory workers) had unemployment rates of 7-10% during the 1990s and 200s, compared to rates of 1-5% for managers and professionals. 2. Indigenous Australians have high levels of unemployment due to a lack of skills and education and particularly due to their often sparse regional locations (disadvantaged by their geographic proximity to work). A 2007 Study by the Productivity Commission found that the unemployment rate among Indigenous Australia was 13%, compared to the 4% for non-Indigenous people. Indigenous Australians also have a much lower labour force participation rate. 3. Older workers have greater difficulty in finding work once they have lost a job – although the overall rate of unemployment falls as workers get older, the actual experience of unemployment for older workers can actually be more severe than young workers looking for their first job. For example, in August 2009, the average duration of unemployment for 15-19 year olds was 20.3 weeks, while it was 86.7 weeks for those aged 55 and over, well above the youth unemployment average. 4. Migrants often face higher unemployment levels than people born in Australia, which may be due to the language barriers faced by people of non-English speaking backgrounds or the fact that international qualifications are often not recognised domestically in Australia. The unemployment rate for people born outside of Australia was 5% in 2007, compared to 4% for Australian-born residents – this problem was most acute for women + younger non-English speakers. 5. Workers from specific regions – some regions suffer higher unemployment rates than others, and unemployment tends to be higher in non-metropolitan and rural areas – in 2006, the unemployment rate in Australian capital cities was 4.6%, while the nonmetropolitan areas suffered unemployment rates of 5.6%. Regional unemployment is of particular significance to these workers. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Effects of Unemployment – Economic & Social Costs Consistently high unemployment has serious negative consequences (economic and social) on the Australian economy and individuals. This explains why the lowering of unemployment is a major goal of economic management. The consequences of high unemployment include: Economic Costs 1. Opportunity cost - Unemployment means that the economy’s resources are not being used to their full potential/capacity, and hence the economy is operating below its production possibility frontier – total output is lower than potential production, which lowers household incomes and expenditure, thus lowering business sales/profits. Higher unemployment levels may also therefore lead to reduced business investment, production and employment, and in some cases business failure. 2. Lower living standards - While unemployed people continue to consume resources (by relying heavily on income support payments/other social welfare benefits), they are not able to contribute to the production process – this reduces living standards because fewer consumer goods (which are necessary to satisfy wants/needs) and capital goods (which are needed to increase the long-term productive capacity of the economy in order to aid in economic growth and development) are being produced. Ultimately, reduced production leads to a fall in the rate of economic growth and living standards. 3. Decline in labour market skills for the long-term unemployed because unemployment leads to a loss of skills among existing workers who find themselves without work for extended periods of time – human capital virtually ‘depreciates’ or loses its value as workers are now out of touch with new developments in certain industries, and as a result, these people lose their skills, self-esteem and experience, becoming even less employable or even unemployable in the future. In this way, cyclical or short0term unemployment can turn into long-term structural unemployment, a process known as hysteresis (a process whereby unemployment in the current period leads to the persistence of unemployment in future periods as unemployed people can lose their skills, job contracts and motivation to work and hence employers find them less attractive as potential employees). Also, new members of the labour force (such as young people or university graduates) will not develop labour skills if they do not obtain jobs soon after leaving educational institutions. 4. Lower Wage Growth – higher levels of unemployment mean that there is an excess supply of labour in the economy, which should lead to a fall in the equilibrium level of wages –however as there are regulations restricting the downward flexibility of wages (e.g. high minimum award wages), higher unemployment is more likely to lead to slower wage growth rather than wage reductions. 5. Costs to the Government – high levels of unemployment have a significant influence on the government’s revenue and expenditure and particularly on the Federal Budget. Falling incomes associated with unemployment will generate less taxation revenue, and at the same time, governments will be forced to pay out more transfer payments (unemployment benefits) to the unemployed, as well as funding training and other labour market programs. The decrease in revenue and increase in cyclical expenditure will deteriorate the government’s budget balance (rising deficit or falling surplus). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Social Costs The social costs of unemployment are difficult to quantify but researchers have linked them to undesirable social trends such as: 1. Negative social trends and severe personal and social problems arise in the long-term due to unemployment, such as severe financial hardship and poverty; increased levels of debt; homelessness; family tensions/breakdowns; boredom; increased social isolation and levels of crime; erosion of confidence/self-esteem; deteriorating psychological state (depression/suicide). These social problems have an economic cost for the community as a whole since more resources must be directed towards dealing with them – e.g. more public funds must be spent on health and welfare services rather than being used to satisfy collective community wants. This means the government will face an erosion of its tax base and a rise in cyclical expenditure on welfare – this will increase a budget deficit or reduce a budget surplus. 2. Increased inequality as unemployment tends to occur more frequently among lower income earners in the economy, such as the young and the unskilled. Because unemployment means a further loss of income for these people, they become relatively worse off compared to higher income earners, contributing to poverty and overall inequality in income distribution. This increased income inequality then creates a trap of welfare dependency, further adding to government expenditure. Trends in Unemployment in Australia For the past three decades, unemployment has been a significant policy challenge in Australia. Australia began experiencing high unemployment rates in the mid-1970s after recording very low unemployment rates of 2-3% in the 1960s and early 1970s. The level of unemployment peaked in the early 1990s – the 10.7% unemployment rate (up from 6.1% just before the recession hit) recorded in 1991-92 was at its highest level since the Great Depression of the 1930s. This increase in unemployment was due to 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 hence an increase in unemployment. Australia had two severe recessions over the period from 1970-2002 (1982 and 1991) when the unemployment rate reached over 10% on both occasions – this highlights the relationship between falling economic growth and rising unemployment in Australia. Unemployment peaked AFTER the worst of each recession was over, however – this is because unemployment is a lagging economic indicator – at the onset of a recession, firms hang on to workers until they are certain there is a recession, and as the economy recovers, firms hold off employing more until they are certain the economy is recovering. The unemployment problems experienced over this period was worsened by extensive structural change and microeconomic reform – many people who lost their jobs in declining industries during the recessions were unable to obtain new jobs created in growing industries because the job vacancies often required higher or different skills – structural unemployment. As new technologies and production techniques changed the structure of businesses, Australia’s unemployment problem became one of the major structural issues facing the Australian economy. After the 1991 recession and particularly since 2002, the unemployment rate has steadily edged downwards, reaching 3.9% in February 2008 – the lowest unemployment level in Australia in 34 years. Much of the fall in the unemployment rate can be attributed to the 17 years of consecutive economic growth in Australia from 1991 to 2008. This downward trend in unemployment was only achieved after successive Australian Governments for three decades struggled with the challenge of achieving a sustained reduction in unemployment. Recent years have shown that sustained economic growth is the best way to achieve a lasting fall in unemployment – however, during this era of sustained low unemployment, shortages of skilled workers became a significant economic problem facing Australia, highlighting that unemployment can still be a problem in some parts of the labour market even when unemployment is low overall. With the onset of the GFC in 2008-2009, Australia’s unemployment rate rose, reversing some of the gains of previous years. Australia’s economic slowdown reduced demand for labour. Unemployment in Australia peaked at 5.8%, far lower than the projected highs of 8.5% in 2009-10 – economists argue that because Australia was able to weather the downturn HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] more effectively than many other economies and was therefore not as severely affected by the global recession as some of its OECD counterparts, unemployment did not reach the initially projected levels. Unemployment has since fallen back down to 5.3% (as of April 2010). The extent of the fall in labour demand due to the GFC was not fully captured by the official unemployment statistics – this is due to an increase in the rate of underemployment. The decline in full-time jobs was partially offset by a similar rise in parttime jobs – there were 52800 fewer people in full-time employment in 2008-09 than in 2007-08, but part-time employment rose by 99500 over the same period - industry evidence suggests that many firms, in response to the downturn, chose to avoid laying off employees and instead encouraged workers to share jobs, shift to part-time work, or take unpaid leave. This response reflects the fact that after many years of experiencing skills shortages, businesses may be reluctant to retrench workers, fearing that they will again have difficulty in attracting skilled labour in future years and after the GFC. However, there were still major retrenchments in industries affected by the global crisis such as mining, manufacturing and finance. Another feature of the recent recessions has been the growth of long-term unemployment in Australia – these are people who have been out of work for longer than 12 months. As a recession hits, long-term unemployment rises rapidly as those already unemployed before the recession have very little chance of finding employment – and then after a recession, the long-term employed are further disadvantaged by their length of unemployment. o The distribution of unemployment between Australian states changed markedly between 2006 and 2008 as the labour market reached full employment – most states experienced falls in their unemployment rates, with the resource rich states benefiting from the global resources boom (e.g. WA [3%] and QLD [3.8%]) recorded the lowest unemployment rates of any states in 2008. All states experienced strong employment growth in 2008, with the national average being 2.3% in the year to September 2008. The global resources boom and the large rise in Australia’s terms of trade since 2003 led to a reallocation of the economy’s resources (including labour and capital) away from non-resource rich states such as NSW, Victoria and South Australia, to the resource-rich states of WA and QLD, where mining accounts for a large proportion of their state product. These resource rich states recorded higher economic and employment growth and lower levels of unemployment than the non-resource rich states between 2003 and 2008. o As of August 2009, the long-term unemployed comprised 15.3% of the unemployed – however, some economists cast doubt on the likelihood of this improving much even after this GFC, pointing to the sharp rise of those on disability pensions since the early 1990s. This rate of long-term unemployment has fallen significantly though since 1993-94 when it was at 34.6% of the total number of unemployed people. However, the impact of the global financial crisis and recession in the second half of 2008 led to negative employment growth and rising unemployment rates in all states in 2009. Employment growth fell by -0.4% in Australia in the year to July 2009 and the unemployment rate rose to 5.8% in 2009. Large rises in unemployment in WA and QLD reflected a contraction in mining output, whilst rising unemployment in the larger states of NSW and Victoria was caused by a fall in manufacturing and the financial sector. Australia needs economic growth rates of 3.5% or higher in order to make progress on reducing unemployment. The relationship between economic growth and unemployment is explained by Okun’s Law – this law suggests that “to reduce unemployment, the annual rate of economic growth must exceed productivity growth + labour force growth in any year.” o Part of the reason for Australia’s slow progress on unemployment during the 1990s was the strength of labour productivity growth, which meant that businesses were able to increase their output without hiring more workers. Since the early 2000s, productivity growth has been much slower, which has meant that the unemployment rate has continued falling even though economic growth has only averaged around 3%. o In the long-run, a higher level of productivity growth should lead to stronger economic growth and more job creation, but in the shorter-term, more jobs are likely to be created during a period of lower productivity growth because employers will be forced to hire more workers if they want to increase production. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Policies to Reduce Unemployment Reducing unemployment is one of the most difficult tasks of economic management. Sustained reductions in unemployment take time to achieve and are dependent on sustaining economic growth over a long period of time. In periods of rising unemployment, such as the period following the GFC, the challenge for governments is to minimise the short-term increase in unemployment in order to achieve the fastest possible return to low unemployment. Australia now faces the immediate short-term challenge of avoiding a rise in cyclical unemployment, and reducing the gap between the demand and supply for labour. Policy action must also be taken to reduce long-term, structural unemployment that limits the growth potential of the Australian economy. The main policies available to the federal government to reduce unemployment are: o Stimulatory monetary policy through cuts to interest rates. o Expansionary fiscal policy through an increase in government spending and/or tax cuts. o Prices and incomes policy or wages policy to contain the growth in aggregate wages. o Microeconomic reform policies to improve the economy’s resource allocation and productivity. Governments choose policies to reduce unemployment based on what they see as the main causes of unemployment. Cyclical Unemployment Measures The most important government strategy to reduce unemployment is the use of macroeconomic policies to sustain economic growth and avoid a recession – the experience of recessions since the 1970s is that unemployment rises quickly during a recession but can take many years to fall afterwards. Avoiding sharp downturns in economic activity can therefore minimise any increase in cyclical unemployment. The downturn following the GFC forced a dramatic shift towards expansionary fiscal policy, with government spending playing the lead role in stimulating economic activity in Australia and supporting jobs – the Australian Government, along with many other governments of developed economies, intervened in the economy to make up for the sharp fall in aggregate demand. In Australia, the cash rate was cut to 4.25% by the RBA between September 2008 and April 2009, and the Australian Government increased the size of the budget deficit to -$53bn (-4.5% of GDP) with new discretionary spending on cash payments to households ($10.4bn) and infrastructure projects through the Nation Building and Jobs Plan ($42bn). o The Treasury estimated in 2009 that the forecast peak rate of 8.5% would have been 1.5% higher if the government had not intervened in the economy, and the effectiveness of the Australian Government’s intervention is highlighted in that unemployment peaked at 5.9%, significantly lower than the initial projections. Structural and Frictional Unemployment Measures Australia faces an ongoing problem with structural unemployment – experience in economies such as Australia over the last few decades has shown that monetary policy and fiscal policies are relatively ineffective in terms of reducing STRUCTUAL unemployment. Thus, a key focus of policies has been microeconomic reform, particularly labour market reform. o The global downturn placed renewed attention on labour market policies – spending measures in the 2009-10 Budget were designed to support aggregate demand and employment (up to 210,000 jobs) to reduce the expected unemployment increase. By lifting the economy’s efficiency, competitiveness and productivity, microeconomic reforms in Australia have aimed to increase economic growth and job creation over the long-term. o Australia’s microeconomic reforms have included tariff reductions, deregulation, national competition policy, privatisation and tax reforms. In particular, policies relating to the labour market have pertained to industrial relations, HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] education and training and welfare to work initiatives which are intended to foster a higher level of employment growth over time. Labour market policies have played an important role in reducing unemployment – they have the aim of increasing flexibility in the labour market, removing regulations that might discourage employers from hiring new workers, introducing programs to help the unemployed build up their skills and training and improving the efficiency with which workers can find work. o Under the Howard Government, Howard attempted to make labour markets more flexible by reducing regulations to provide incentives to employers to hire more workers through the Work Choices Legislation – e.g. in 2006 the Government exempted businesses with less than 100 employees from unfair dismissal laws, arguing that laws prohibiting unfair dismissals discouraged employers from hiring new works because of their concern that employees might take legal action against them if they are dismissed. The Rudd Government abolished this exemption in 2009. o The ‘Job Network’ policy, a collection of competing employment agencies that enter into contracts with the Federal Government for successfully placing unemployed people into jobs. This was overhauled by the Rudd Government in 2009 and made into Job Services Australia – it is similar to the Job Network, however it is more strongly focused on assisting people suffering from long-term obstacles to employment. o Another priority was to improve incentives for unemployed individuals to move off welfare and into employment, to encourage higher levels of workforce participation – in 2006, a package of ‘Welfare to Work’ policies came into effect, which imposed stricter eligibility requirements for income support payments. By making it more difficult to access income support payments if out of work, these changes were designed to encourage unemployed individuals to actively seek work or participate in skills training programs that would enable them to re-enter the labour force. st st In the 2008-09 Budget the Government announced personal income tax cuts between July 1 2008 and July 1 2010 – these tax cuts are designed to provide further incentives for individuals, including part-time workers, to participate in the workforce. The government also announced the Henry Review of the Australian Taxation System in the 2008 Budget with a view to ensuring that the tax system and transfer system of welfare payments did not reduce work incentives. Successive governments have also sought to increase the tax-free threshold, particularly through the Low Income Earners’ Tax Offset that was increased in the 2009-10 Budget. The marginal rates of income tax have been reduced to minimise the incidence of poverty traps, benefitting lower income earners. o The move towards decentralized wage determination where firms/employers can negotiate wage increases on the basis of improved productivity has been a central component of Australia’s recent labour market reform agenda. o The implementation of policies for increasing workforce training and education since a major reason for unemployment is a lack of education, training and skills that are demanded by employers for the jobs available (particularly in young people) – the Australian Government has introduced: New apprenticeship centres to promote skills formation of apprentices by employers. Funding for vocational and school education including the National Education Framework for Schools to raise literacy and numeracy standards. The Australian National Training Authority to improve the skill development of Australian workers through ongoing training, development and education. The Job and Training Compact in the 2009-10 Budget at a cost of $1.5bn over 5 years in response to the rise in unemployment caused by the impact of the GFC on the Australian labour market – it was designed to assist workers whose job prospects were severely affected by the recession. The main measures in this compact included a guaranteed education or training place for young Australians under 25 who wanted to up-skill or undertake additional training; support to retrenched workers who were provided with immediate employment assistance through the Job Services Australia program; and assistance to regions and communities directly affected by the GFC through the funding of local job projects. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] o The Fair Work Act 2009 was passed to strengthen the safety net of the workplace relations system – this included the introduction of a new No Disadvantage Test to ensure minimum wages and conditions for all workers under a variety of workplace agreements. It placed more emphasis on collective bargaining and phased out the use of individual workplace agreements such as AWAs. o Addressing the skills shortage – the government can increase the labour force participation rate by retaining older workers with specific skills and encouraging other workers such as younger workers and females to acquire higher levels of education and training + increasing the supply of skilled labour through an intake of skilled migrants in specific occupations and industries (immigration will increase aggregate demand and hence the demand for labour). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.3 Inflation Inflation occurs when there is a g eneral or overall sustained rise in the prices of goods and services in an economy or a declining purchasing power of money. It is an economic problem that can have negative impacts on many economic outcomes, including economic growth, international competitiveness, exports and income inequality. Maintaining low inflation is a major objective of economic policy in Australia because of the benefits that lower inflation brings to the economy in the long-run. Australia has enjoyed relatively low levels of inflation since the early 1990s in line with the global trend of low inflation rates and economic policies that have placed a greater emphasis on the objective of low inflation. Measurement of Inflation – Current ABS Measures The Consumer Price Index (CPI) summarises the movement in the prices of a basket of goods and services according to their significance for the average Australian household. It is used to measure the headline rate of inflation. INFLATION RATE (%) = CPICY – CPIPY CPIPY x 100 1 Where CPICY = the value of the CPI in the current year. Where CPIPY = the value of the CPI in the previous year (which is given a base index of 100). The measure of CPI is not entirely accurate because it does not indicate all household items or all goods and services available in the economy – instead, it covers a wide selection that reflects average household spending patterns. As such, it gives a good overall indication of the movement in the prices of consumer goods and generally reflects changes in the cost of living (i.e. how much consumers have to pay for the goods and services they buy). Also, the CPI lags behind changes in spending patterns, is perfectly accurate for the statistically “average” households and covers only metropolitan households. While the RBA still uses the CPI as its primary guide for the administration of monetary policy (aiming to keep inflation in the target zone of 2-3% CPI inflation), other methods exist to calculate inflation in order to overcome the somewhat misleading nature of the CPI as a measurement of inflation rates in Australia. This is the level of underlying inflation or core inflation. o Underlying inflation – this measure of inflation removes the effects of one-off or volatile price movements such as seasonal factors (adverse climatic conditions can, for example, cause a one-off increase in the price of fruit and vegetables which will soon be reversed). It is designed to reveal the underlying relationship between aggregate demand and aggregate supply in the economy. o Most economists focus on TWO measures of the ‘underlying inflation rate’ published by the RBA, both of which attempt to give less weight to “outliers” (i.e. very large rises/falls in prices of particular goods or services): Trimmed mean inflation - determined by calculating the average inflation rate after excluding the 15% of items with the largest price increases + 15% of items with 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. Recent highlight the greater volatility of the headline measure of inflation. The annual CPI measure of inflation fluctuated from 4% in June 2006, down to 1.9% in September 2007, up to 5% in September 2008 and then down to 1.5% in June 2009. Over the same period, by contrast, underlying inflation gradually increased from 2.6% in June 2006 to 4.4% in December 2008, before beginning a gradual decline. While headline inflation would give the impression that the nation’s inflationary problems HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] vanish and reappear every 12 months, the underlying inflation measure suggested Australia’s price pressures were slowly building until the onset of the GFC in 2008. Causes of Inflation – demand, cost and imported inflation + inflationary expectations Economists generally recognise FOUR main causes of inflation that may come from the demand or supply side of the economy: 1. Demand-pull inflation occurs when aggregate demand or spending is growing while the economy is nearing its supply capacity – the economy therefore has insufficient factors of production available to produce the goods and services required as all factors of production may already be fully employed in production (FULL EMPLOYMENT). Therefore, aggregate demand exceeds aggregate supply and higher demand results in rising prices (due to consumers bidding against each other for the limited goods and services available) rather than rising output (since the economy has reached its maximum productive capacity). The main causes of demand-pull inflation are excessive growth in any of the major components of aggregate demand (increased consumption, investment spending, government expenditure or export income). This situation was reached in Australia in 200708 as full employment occurred, and demand pressures led to higher inflation. This diagram reflects demand-pull inflation. Aggregate demand increased from AD1 to AD2. Consumers are willing to pay a higher price for any given level of supply. Prices will therefore increase from P1 to P2 (causing an expansion in supply). The price increase that results from higher aggregate demand is known as demand-pull inflation. 2. Cost-push Inflation (from the supply side) occurs when there is an increase in production costs (such as oil price increases/wage increases) which means that in order to maintain profits, producers must raise prices for consumers, thus raising the rate of inflation. This often occurs when there are large increases in wages relative to productivity, and since wages account for around 60% of a firm’s costs, consumers will ultimately pay higher prices so businesses can sustain their profit margins. This diagram reflects how cost-push inflation can arise in an economy. The initial equilibrium for the economy is at price level P and a real GDP of real GDP1. A decrease in aggregate supply from AS (e.g. caused by an ‘across the board’ wage increase or an increase in the price of oil) will shift the aggregate supply curve to the left to AS1. This will cause a new equilibrium to be established at a higher price level of P1 and a lower level output at real GDP2. The economy experiences both a contraction in real GDP (less economic growth) and a rise in inflation as the price level has increased. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3. Imported inflation is transferred to Australia through international transactions – the most obvious cause of imported inflation is higher import prices, which will increase the inflation rate in the same way an increase in the price of a domestically-produced good/service would. A depreciating $A will also lead to an increase in the price of imports, increasing inflation, and market conditions will determine the extent to which an increase in import prices will see consumers pay more for goods and services. A major course of inflation in the world economy which affected Australia in 1973-74 and 1979-80 was imported inflation – when the price of imports rises as did the price of oil in 1973-74 and again in 1979-80 due to OPEC restrictions on oil supplies, not only did energy prices rise, but also the final prices of goods and services dependent on oil inputs such as the price of petrol and transport services in distributing final goods and services to consumers. 4. Inflationary expectations cause further inflation, as if individuals or firms in an economy expect higher future inflation, they will act in a way that causes an increase in inflation in the present. For individuals, if prices are expected to rise, consumers will attempt to purchase products before prices increases – however, as consumers bring forward their planned purchases, this will cause an increase in consumption (rise in aggregate demand) and hence resulting in greater demand-pull inflation. Similarly, if firms expect that demand for their product will increase, the firm may raise prices in order to maximise profits, causing an increase in inflation and encouraging a wage-price inflation spiral. If employees expect inflation to increase, they will take this into account when negotiating their wage increases and attempt to gain higher nominal wages to preserve their real wages– workplace contracts are typically negotiated in advance, and so an employee who expects higher inflationary pressures over the next few years will ask for a higher wage to preserve the purchasing power of their wage. Higher wage increases may be passed on by firms, which may lead to a fall in aggregate supply and further price rises, leading to greater cost-pull inflation. If aggregate demand continues to increase, further price and wage increases may occur, leading to accelerating inflation. This situation is known as runaway or galloping inflation. There are TWO other possible causes of inflation: 1. Government policies may influence the level of inflation. By increasing indirect taxes, the government can have a significant impact on the general level of prices – the introduction of the GST in 2000 is an example of a government policy that temporarily raised the rate of inflation. Other measures that may influence prices include the deregulating of an industry, changing tariff rates, imposing price controls/price monitoring and increasing charges for goods/services provided by the Australian Government. 2. Excessive increases in the money supply can also lead to an increase in inflation. When the increase in the money supply outstrips the growth rate of the economy, an increased volume of money chases the same amount of goods and services and prices are likely to rise. Therefore, increasing money supply without an increase in real production simply causes inflation (sometimes called ‘monetary inflation’). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Effects of Inflation Inflation has significant impacts on the economy in both the short-term and long-term – in general, the higher the level of inflation, the more severe the consequences. As a result, governments all around the world have placed a strong emphasis on sustaining low inflation in recent years in order to avoid the negative consequences which high inflation brings. According to the Statement on the Conduct of Monetary Policy (December 2007): “Both the Reserve Bank and the Government agree on the importance of low inflation and low inflation expectations. These assist businesses in making sound investment decisions, underpin the creation of jobs, protect the savings of Australians and preserve the value of the currency.” The impacts of high and low inflation on the Australian economy include: Economic Growth and Uncertainty Inflation is an important constraint on economic growth – excessive economic growth tends to raise inflationary pressures through increased wage demands and through strong consumer demand bidding up price levels, and this tends to force governments to use contractionary economic policy to curb economic growth so inflation can fall. On the other hand, a sustained lower inflation rate allows moderate economic growth to be maintained without it becoming necessary to curtail growth through higher interest rates. Sustained low inflation since the early 1990s has allowed for a long period of relatively high economic growth in Australia. Higher inflation distorts economic decision-making since producers and consumers change their spending and investment decisions in order to minimise the effects of inflation on themselves, such as through buying assets rather than investing in income-producing activities – thus, inflation distorts the pattern of resource allocation in an economy by encouraging investment in speculative and relatively unproductive activities such as gold and real estate. Low inflation has a beneficial impact on the level of economic growth because it removes the distortion to investment and savings decisions which high inflation causes. High inflation discourages business investment because it makes producers uncertain about future prices and costs, and therefore future profit levels. Low inflation positively impacts on business investment, restoring the incentive to invest in long-term productive assets rather than short-term speculative investments, which a high inflation environment encourages. Higher inflation will distort consumers’ decisions to spend or save disposable income – consumers are more likely to spend and not save during periods of high inflation, because the purchasing power of their money reduces over time. Sustained low inflation is likely to encourage consumers to save a higher proportion of their disposable income. However, Australia’s experience since the early 1990s has not been consistent with this general principle, with sustained low inflation failing to reverse the long-term decline in the household savings ratio. Wages The level of inflation is a major influence on nominal wage demands (a nominal wage is the pay received by employees in dollar terms for their contribution to the production process, not adjusted for inflation). During periods of higher inflation, employees will seek larger wage increases in order to be compensated for the erosion in the purchasing power of their nominal wages –this can lead to the emergence of a wage-price inflationary spiral that is very difficult to break, where wage increases lead to higher prices, which lead to higher wage demands and so on. While rising inflation in 2007 and early 2008 caused higher wage demands by employees, as inflation receded in 2009, employee wage demands also fell. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Income Distribution High inflation tends to have a negative impact on the distribution of income and particularly on lower-income earners because lower-income earners have a lower MPC and often find that their incomes do not rise as quickly as prices – lower-income earners may face higher interest rates on their borrowings if interest rates rise as a part of the government’s contractionary monetary policy framework. High inflation means that consumers suffer a loss in purchasing power and real income, in that unless consumer incomes keep pace with inflation, the cost of living continues to rise, reducing real incomes and living standards – higher inflation hurts those individuals who are on fixed incomes or whose incomes are not indexed to (rise as fast as) the rate of inflation). Higher inflation also erodes the value of existing savings so that individuals who do not have a means of protecting their savings from the impact of inflation will see their net wealth decline, adding further economic pressure to lower income earners. International Competitiveness (External Stability Issues) High inflation results in increased prices for Australia’s exports because higher inflation is also associated with rising production costs (cost-push inflation), reducing international competitiveness and the quantity of exports – foreigners’ costs of production become lower than Australian costs of production, giving them a competitive advantage in both overseas markets AND in domestic Australian markets (this is because as the price of domestic goods increase due to higher inflation, consumers will also be more likely to switch to import substitutes, worsening the BOGS and the CAD). Australia’s inflation rate has been worse than its main trading partners since 1999, which has been a force weakening our international competitiveness. Low inflation should improve Australia’s international competitiveness, making it more attractive for other countries to purchase Australian goods and services, as well as making local goods more competitive with imports. This should lead to an expansion of exports and the replacement of imports with domestic substitutes, thus improving the BOGS and the CAD. Exchange Rate Impacts (External Stability Issues) In the short term, higher inflation may result in an appreciation of the exchange rate, as speculators expect the RBA to raise interest rates in response, attracting greater financial flows to Australia and thus raising the value of the $A. However, in the long-run, higher inflation will result in depreciation of the $A – this is because as prices rise, the purchasing power of the currency will decline. Sustained low inflation may also, in the long-term, foster greater international investor confidence in the Australian economy, strengthening the value of the dollar and also reducing exchange rate volatility. Interest Rates Lower inflation normally brings about reductions in nominal interest rates, since nominal interest rates are based on a real rate of return plus inflation. The reduction in inflation since the early 1990s has led to much lower nominal interest rates than in the preceding decades – higher inflation usually results in higher interest rates, as the RBA tries to reduce demand pressures in the economy and avoid the negative consequences of high inflation. Unemployment The levels of unemployment and inflation are often closely related, especially in the short-term. Higher levels of inflation will usually result in more contractionary fiscal and monetary policies, resulting in slower economic growth and higher unemployment in the SHORT TO MEDIUM TERM. However, generally, periods characterised by high levels of unemployment often also have low inflation rates, while low levels of unemployment are often associated with rising HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] inflation. During the 1970s and 1980s, governments generally chose between the priority of low inflation (and slower growth) or lower unemployment (at the risk of higher inflation) – but this inverse relationship breaks down over the long-term, with a problem called stagflation arising in the mid-1970s whereby the rate of inflation and the rate of unemployment were rising simultaneously. For most of the 1990s and 2000s, Australia has experienced the opposite – a combination of LOW inflation and FALLING unemployment (only reversed during the GFC). The Inflation and Unemployment Trade-Off >> The Phillips Curve The Phillips Curve shows the trade-off governments face in trying to simultaneously achieve the economic objectives of low inflation AND low unemployment. While higher economic growth creates jobs and reduces unemployment, it can also lead to excessive demand in the goods market, pushing up prices – it can also create extra labour market demand, causing an increase in wages which will add to inflation as businesses raise prices to protect profit margins. In the economy shown here, expansionary government policies could reduce the unemployment rate from 6% to 3% but only at the cost of increasing inflation from 2% to 4% (i.e. moving from Point A to Point B). In the 1970s, this relationship between unemployment and inflation as shown in the diagram above broke down – in Australia and many other industrialised nations, inflation levels increased and remained high even when the economy was stagnating and unemployment was high – a situation called stagflation. High unemployment AND high inflation rates prompted an entire rethink of the relationship between unemployment and inflation. The outcome of this rethink was the Long-Run Phillips Curve (also called the Friedman-Phelps Expectations Augmented Phillips Curve). This new curve was based on the inclusion of two long-term economic principles in the explanation of the relationship between unemployment and inflation – the natural rate of unemployment and inflationary expectations. o The natural rate theory suggests that there will always be some level of frictional, seasonal, structural and hard-core unemployment that cannot be addressed through demand-management or macroeconomic policies. If a government uses expansionary macroeconomic policies to lift demand reduce and unemployment, it will result in an increase in wage levels and inflation. As workers become used to the higher levels of inflation, they will begin to demand even higher wages, which if granted, will see unemployment return to its natural level. Their inflationary expectations, however, will remain high – as a result, in the long-term, expansionary macroeconomic policies are not effective in reducing unemployment because unemployment is locked-in at the natural rate. The only long-term impact of expansionary policy is a permanently higher level of inflation. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] This diagram shows the Long-Run Phillips Curve – it is a vertical line at the natural rate of unemployment, U n, which is equal to 5% in this hypothetical economy. The economy starts on the Short-Run Phillips Curve P1 at point A, with an unemployment rate of 5% and 0% inflation. If the government operates expansionary macroeconomic policy, (increasing government spending), the economy will move to point B, with a lower rate of unemployment (3%) but a higher rate of inflation (2%). However, when workers realise inflation is now 2%, they will demand higher wages to offset the increase in the cost of living. Businesses, realising that the prices of others goods have also rise by 2%, and facing higher wage costs, are likely to cut back production and reduce their demand for labour – hence, unemployment will slowly creep back up to the natural rate, but inflationary expectations will remain high. The economy jumps from one short-run Phillips Curve to another – from P1 to P2. In the long-term, the expansionary policies have simply raised inflation to 2% with the same level of unemployment – i.e. the economy will be at point C. Hence, Philips argued that there was no trade-off between inflation and unemployment in the long-run, as the economy would always return to its natural rate of unemployment. They argued that government attempts to reduce unemployment by using expansionary macroeconomic policies would only lead to higher inflation. Trends in Inflation in Australia Australia’s inflation record has indicated low inflation in the 1950s and 1960s, much higher inflation in the 1970s and 1980s and a return to low inflation in the 1990s and the 2000s. During the mid-1970s and mid-1980s, inflationary expectations and cost-push inflation were more prominent. Australia’s inflation record was poor in the 1970s and 1980s because of oil price shocks which saw oil prices rise by 2000% between 1973 and 1983 as a result of supplier-created shortages in production. The late 1980s saw demand-pull inflation as the main factor behind inflation (reduced demand = fall in demand-pull inflation). One of the most significant macroeconomic policy achievements of recent times was that Australia achieved a sustained reduction in inflation rates from the early 1990s after experiencing relatively high inflation rates since the mid 1970s. The main development that drove down inflation was the recession of the early 1990s – in 1993, the RBA began to target an average inflation rate of 2-3% over the course of the economic cycle as a guide to determine interest rate levels, and this created an anchor for inflationary expectations by making the conduct of monetary policy more predictable, credible and effective in controlling inflation in the Australian economy. This has meant that whenever inflationary pressures have emerged since then – such as in 1994, 1999, 2003 and between 2005 and 2008 - the Reserve Bank has tightened monetary HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] policy to slow down growth in demand and essentially curb inflationary expectations. Since then, inflation has generally stayed within the target band of 2-3%, although in 2000, the introduction of the GST caused a one-off increase in the headline inflation rate to 6% before recovering in subsequent years – ultimately, both the headline and underlying inflation rates have averaged 2.7% between 1996 and 2009 in Australia. Global factors such as lower worldwide inflation and increased competition from imported goods have also assisted in containing inflationary pressures in Australia. In the late 2000s, the economic downturn had effects on several types of inflation – reduced demand caused a fall in demandpull inflation, and slower growth in wages reduced cost-push inflation. Lower household and business confidence in the strength of the Australian economy saw inflationary expectations fall. While lower global demand for commodities like food and oil reduced imported inflation pressures, the depreciation of the exchange rate in late 2008 saw the prices of many imported goods increase. Since the mid 2000s, the inflation rate has been more volatile as commodity prices and health/education prices in particular emerged as important drivers of prices and the economy approached many estimates of the natural rate of unemployment. The period when inflationary pressures were strongest came between 2005 and 2008 – underlying inflation peaked at 4.7% because of a combination of these higher global prices (commodities, food and energy) and the strength of economic activity. With the Australian economy at close to ‘full capacity’, production costs such as labour, transport and materials were rising across the economy and feeding through to higher consumer prices. However, a rapid collapse in economic growth led to the CPI only rising 1.5% in the year to June 2009, the lowest CPI outcome in a decade – this eased inflationary pressures significantly during 2008 due to the onset of the global recession. The broadbased easing in price pressures in 2008-09 in Australia reflected the falling demand pressures in both the global and Australian economies due to the GFC and slower economic activity in Australia as well as lower global commodity prices (including oil and food). Slower world economic growth and incomes growth reduced the ability of businesses to increase consumer prices, while lower demand for labour and materials reduced pressures on business costs, exerting downward pressure on inflation and inflationary expectations in the global economy. By 2009, both headline and underlying inflation were falling back to the lower-end of the RBA’s inflation target band – the most recent inflation figure released for April 2010 is 2.9% CPI (3.1% weighed mean and 3.0% trimmed mean), rising back towards the upper end of the RBA’s target zone of inflation due to the strength of the Australian economy. Policies to Sustain Low Inflation Since the large fall in inflation during the recession of the early 1990s, the government and the RBA have sought to maintain a low level of inflation in the Australian economy. Inflation control has been given a higher priority in the economic objectives of government policy by means of a general agreement among economic advisers that INFLATION CONTROL should be given priority OVER unemployment control – for instance, the Australian Government approved the very high interest rate policy of the RBA at the end of the 1980s to slow the economy and discourage wage rises (which could trigger cost-push inflation). The surprising feature of the relatively long cycle of economic growth of the 1990s and 2000s is that inflation pressures remained relatively constrained, and monetary policy was quite successful in addressing inflation pressures when they did emerge. Many economists attributed these lower inflation rates to the impact of structural changes during the 1980s and 1990s – microeconomic reform increased the intensity of competition within Australia and from overseas, while productivity growth also improved in the 1990s, contributing to sustained low inflation. This made it possible for Australia to achieve low inflation while simultaneously enjoying strong economic growth and falling cyclical unemployment. Monetary policy has been the main tool used to achieve low inflation and has played a major role in achieving price stability, but occasionally other parts of the policy mix are used to address price pressures. Monetary policy in controlling inflation attempts to sustain growth at a level that does not create excessive inflationary pressures – if inflation starts rising, the RBA is able to use contractionary monetary policy to increase interest rates throughout the economy by tightening monetary policy. This has the effect of dampening aggregate demand, specifically consumer and investment spending, resulting in a lower level of economic activity and thus lower inflation. Increased interest rates also provide a greater incentive for households to save HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] rather than spend and borrow (and in the same way reduce business investment and spending) - the resulting decline in aggregate demand will help to reduce demand-pull inflationary pressures. The effects of the higher interest rates appeared in mid to late 2008, with slower growth in retail spending, a reduction in debt levels and falling demand for credit from financial institutions. The RBA aims to keep inflation within a target band of 2-3% over the business cycle, emphasising inflation as a major policy priority over maintaining low unemployment. The RBA uses pre-emptive monetary policy by taking action against inflation before it emerges as a problem – for instance, the RBA increased interest rates eight times between 2005 and mid-2008 in response to continued economic growth and concerns about demand-pull inflationary pressures, with a rise from 6.25% in August 2007 to 7.25% in March 2008. o The RBA generally aims to increase interest rates before inflation reaches the top of the target band. Therefore, the RBA has attempted to make its use of monetary policy predictable by emphasising consistently its intention to use monetary policy primarily to ensure that inflation remains within its target band. This has had the effect of lowering inflationary expectations and thus further reducing inflation as a problem in the Australian economy. Fiscal policy can also play a supporting role in maintain low inflation. If the government increases revenue and decreases spending, this reduces demand pressures in the economy and can reduce demand-pull inflation. For instance, in the 2008-09 Budget, the Government increased the size of its Budget surplus with the objective of minimising inflationary pressures in the economy by reducing public demand. In 2009-10, the Budget strategy had completely changed, with the Government increasing spending to stimulate the economy, and inflation being a much smaller priority. Fiscal policy settings that support the low-inflation objective may also reduce the need for higher interest rates to combat an inflation challenge. Microeconomic reform policies of the Government have also contributed to Australia’s generally low inflation environment and can be used to help achieve price stability in the economy in the longer term. The microeconomic policies are designed to foster structural changes in product and factor markets that lead to higher levels of productivity, efficiency and competitiveness, all of which contribute to price stability and lower inflationary expectations. MER is most effective in containing cost-inflationary pressures such as rises in wages not based on productivity improvements or rises in the price of raw materials and other productive inputs due to a lack of competition and efficiency in markets. Examples of MER implemented to support the objective of price stability in Australia include: o Reduced protection has lowered the price of Australia’s imports and has increased the competition faced by domestic producers from both overseas competitors and new entrants to domestic markets – this makes it more difficult for domestic producers to increase their prices and thus contains inflation. o Reforms to the labour market - labour market deregulation has reduced the problem of cost-push inflation and these reforms have ensured that wage increases are linked to productivity increases. If productivity rises, the economy will be able to afford real wage increases without inflationary pressures, and this has meant that the principle of productivity bargaining now underpins workplace agreements (reducing cost-push inflation). o The Government has argued that its greater spending on economic infrastructure (such as roads/railways/ports) in coming years is necessary to reduce the capacity constraints faced by businesses that increase production costs and contribute to inflation. o Taxation reform to remove indirect taxes such as the sales tax which distorted prices and raised cost structures for firms. The RBA’s continued commitment to maintaining low inflation and the heightened level of competition in the economy suggest that, at least in the foreseeable future, the high levels of inflation experienced in the 1970s and 1980s are unlikely to return. In the long-term, inflation is likely to be increasingly influenced by global factors rather than by government policies. Just as the rise of China as a producer of low cost manufactured goods helped to reduce global inflationary pressures in recent years, the increasing demand of China and other industrialising nations for limited energy/mineral goods may result in greater global inflationary pressures in the coming decades. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.4 External Stability External stability is an aim of government policy that seeks to promote sustainability on the external accounts so that Australia can service its foreign liabilities in the medium to long-term and avoid currency volatility. External stability exists when Australia’s trade and financial dealings with the rest of the world do not created significant foreign concerns. Achieving external stability is an important objective of economic policy – it involves monitoring the size of the current account deficit (CAD) and the sustainability of the level of foreign debt and equity (net foreign liabilities). It also involves ensuring that the economy is able to service its foreign liabilities, and stabilising any dramatic movements in the exchange rate. Australia has experienced times when overseas investors decided that the economy’s external position was not sustainable – if this occurs, it can have serious consequences including a depreciation of the currency, withdrawal of investment funds, higher interest rates on overseas borrowing and slower economic growth. Measuring External Stability – CAD, net foreign liabilities & foreign debt (as % of GDP) The measurement of external stability is done as a percentage of a nation’s real GDP, as it is a more accurate indication of a country’s ability to service or sustain its debts/liabilities rather than raw figures which vary between countries of different sizes. Australia’s external problems are among the potentially more serious structural problems facing the domestic economy. Amongst industrialised economies, Australia has consistently had among the highest CAD and foreign liabilities and among the lowest national savings. This has not stopped the Australian economy from sustaining a long period of economic growth since the early 1990s. However, it makes Australia vulnerable when global economic conditions become more unstable – for instance, the high reliance of the Australian financial system on an ongoing inflow of foreign capital was a major reason why the Government considered it necessary to provide a blanket guarantee for all overseas loans of banks and financial institutions after the GFC in 2008. The Government argued that without the government guarantee, banks would not have been able to obtain overseas loans and the financial system would have faced a major crisis. This demonstrates the extent to which a consistently high level of external imbalance increases the vulnerability of the Australian economy to adverse economic developments overseas. Current Account Deficit - Measurement as a % of GDP, Trends, Causes and Effects (The CAD as an imbalance in domestic savings and investment) Measurement as a % of GDP + Trends A current account deficit is recorded when the debits in the current account (imports, income payments to overseas, interest servicing costs on foreign debt) exceed credits (export income, income payments from overseas). For the last 37 years, Australia has experienced a deficit on the current account that is highest in booms (when imports of goods and services are strongest) and more subdued in recessions (when import consumption falls). The current account deficit has varied from -2.6% of GDP over 2000-02 to a high of $72.5 billion or -6.4% of GDP in 2007-08, before falling to $39.5 billion or -3.2% of GDP in 2008-09 due to the GFC – as the Australian economy recovers, the CAD has again started to rise, expanding to -5.4% of GDP by the December quarter of 2009. The net income deficit of around 3-4.5% of GDP has been rarely offset to any significant extent by a BOGS surplus – suggesting long-term problems in our export mix and international competitiveness. Australia’s BOGS performance over most of the late 2000s was particularly disappointing, remaining in deficit despite seemingly favourable global economic conditions. In 2008-09 the BOGS reached its highest surplus since the dollar was floated, at +0.5% of GDP before worsening to -1.9% of GDP by the December quarter of 2009 since economic activity picked up again globally and import consumption was again on the rise in Australia. Between 2004-06 and 2008-09 the CAD was affected positively by Australia’s rising terms of trade – the BOGS balance improved because of the increased volume HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] and value of mineral and resource exports, although the net income deficit continued to widen, reflecting robust growth in the remittance of mining profits and rising net interest payments because of a rising stock of net foreign debt. Overall, the CAD was relatively stable at -5% of GDP, reflecting some improvements in the BOGS but continued growth in the net income deficit. 2010 should see the BOGS stabilise as commodity prices improve and growth picks up globally. However, Australia has had difficulties in sustaining any improvements in the BOGS because of its unusual reliance on commodity exports and its dependence on rural/mining export prices which fluctuate greatly from year to year – however, Australian firms have diversified and have adopted a far more global approach to trade, with an increase in manufacturing and service exports. Causes of the Current Account Deficit When the CAD first emerged as a major problem in the 1980s, economists mainly saw it as a product of Australia’s trade problems – i.e. Australia’s lack of export competitiveness/reliance on imports. While this view still holds to some extent, in the 1990s, many economists came to view the CAD as a result of an excess of domestic investment over domestic savings. In Australia, the shortfall in domestic savings means foreign borrowings are used to finance domestic investment. The two main accounts of the CAD are the balance on goods and services and the net primary income account. The balance on goods and services (BOGS) is influenced by cyclical and structural factors, although cyclical factors have played a more prominent role in recent years. The four main cyclical factors that affect the BOGS are: o Exchange rate: the major cause of the recent fluctuations in the BOGS balance has been changes in the exchange rate – over the late 2000s, the Australian dollar experienced a substantial appreciation due to the rising terms of trade and high interest rate differential which encouraged positive speculation on the Australian dollar – the Australian dollar peaked at $US0.97 in July 2008. However, as the GFC began to take shape with the first signs of collapsing financial institutions, investors globally started to withdraw funds from higher risk economies such as Australia and consequently demand for the Australian dollar fell, causing a rapid depreciation with the Australian dollar falling to $US0.61 by October 2008 (a fall of 38% in 3 months). The dollar remained stable over late 2008 and early 2009. The depreciation of the Australian dollar led to improved international competitiveness of Australian exporters on world markets, increasing exports – and as a result, Australia’s export volumes rose from 19.8% of GDP in 2007-08 to 22.6% of GDP in 2008-09, their highest ever level. At the same time, the low Australian dollar also increased the price of imports, slowing import consumption with Australia’s import volumes rising slower from 21.8% of GDP in 2007-08 to 22.2% of GDP in 2008-09. This rise in export volumes and rallying commodity prices at the time and the falling import consumption helped to improve the BOGS and bring it to its highest ever surplus of +0.5% of GDP in 2008-09. However, over 2009-10, the Australian dollar appreciated significantly, rising from $US0.63 in March 2009 to almost $US0.93 in April 2010, remaining around $US0.90 since – this has harmed the international competitiveness of Australia’s exports, resulting in a decline in exports which fell to 18.2% of GDP in the December quarter of 2009, forcing the BOGS back into deficit (-1.9% of GDP). o Terms of trade: over the 2000s, Australia experienced a substantial increase in its terms of trade. Between 2002-03 and 2008-09, Australia’s terms of trade increased from 67.9 to 109.6, before peaking at 118.3 in September 2008. As newly industrialising economies such as China and Indian experienced rapid growth fuelled by their booming manufacturing industries, the demand for commodities globally increased dramatically, driving up global commodity prices. Since Australia’s main export is commodity goods, this resulted in a significant increase in the prices received for Australia’s exports, increasing export revenue (and even when the GFC hit, Australia was still able to receive great prices for its exports because the commodity contracts locking in prices were still running at the time). Ordinarily this would be expected to improve the BOGS – however, the rising terms of trade actually led to an Australian dollar appreciation (reducing export competitiveness of Australia’s non-commodity exports) – this resulted in a phenomenon known as the ‘Dutch Disease’ whereby growth in one export industry tends to cause harm to others. The increase in income levels across the Australian economy due to higher export revenue increased import expenditure which, combined with lower non-commodity exporting, undercut the benefits of a rising terms of trade. The terms of trade fell over 2009-10 as a result of falling commodity prices and lower demand from China and India (due to the GFC) and by mid-2009 the terms of trade had fallen back to 97.7. As the global economy HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] recovers, the IMF predicts that China will return to growth rates of 10% and consequently Australia is likely to once again see record high terms of trade over the medium-term – in the December quarter of 2009 the terms of trade had already risen to 102.5. o International business cycle/demand for exports: The demand for Australia’s exports is affected by changes in the international business cycle – strong global growth increases demand, improving the BOGS. Over the 2000s, the booming Chinese economy provided a significant boost to Australia’s export demand. As global economic growth picks up over 2010 following the contraction in economic activity due to the GFC, demand for Australia’s exports is likely to increase further, improving the BOGS balance. o Domestic business cycle/demand for imports: demand for imports is also affected by the domestic business cycle. High growth in household disposable income levels due to the commodities boom was one of the factors behind the poor BOGS performance, as increases in household income results in increased import spending. The onset of the GFC led to a slowdown in the growth of import spending over 2009. In the June quarter of 2009, imports fell to 20% of GDP, compared with 23.8% of GDP in the December 2008 quarter. However, as the domestic rate of economic growth improves, import expenditure is also expected to rise. In early 2010 the trade deficit has continued to widen due to an increase in import spending – this is likely to continue over 2010-11 as domestic incomes increase. The failure of recent favourable global economic conditions to translate into an enduring improvement in the BOGS is largely due to persistent structural factors – Australia has a narrow export base with a comparative advantage in low value-added products such as commodities, whilst tending to import high value-added products. Additionally, over the late 2000s, Australia saw the emergence of capacity constraints caused by poor infrastructure, which limited export volume growth. Between 2003 and 2008, export volumes increase on average by 3% per annum, whereas import volumes increased by 8% - this comparatively higher growth in imports offset any gains from higher export prices, perpetuating the BOGS deficit and CAD. In February 2010, new investment plans for road and rail links were called by the Australian Government to improve Australia’s export capacity – this, coupled with recent new government spending on infrastructure, is likely to improve Australia’s ability to increase export volumes over the next few years. The net primary income account is the ongoing structural cause of Australia’s continuing CAD – however, cyclical factors have also influenced its performance in recent years. In 2006-07 and 2007-08 the NPY deficit widened to a record high of over -4% of GDP before falling to -3.4% of GDP in 2008-09 – this recent volatility is due to the increasing importance of cyclical factors in influencing the NPY deficit. The main cyclical factors influencing NPY are: o Australia’s interest payments (debt servicing costs) are affected by the level of domestic and global interest rates and the exchange rate: when the GFC hit in 2008, central banks worldwide responded by cutting official interest rates to close to zero – therefore, global interest rates fell, reducing the interest repayments on Australia’s foreign debt obligations. Also, changes in the exchange rate may affect the value of Australia’s debt servicing costs – a depreciating Australian dollar will increase the Australian dollar value of debt denominated in foreign currencies which will increase debt servicing costs (however, in practice the valuation effect is very small as most financial institutions hedge to reduce the risk of large exchange rate fluctuations). o The performance of the domestic business cycle through its influence on equity servicing costs: when the domestic economy experiences strong growth, domestic company profits rise, and these profits are distributed to shareholders as dividends – as approximately 40% of the Australian share market is foreign-owned, a large proportion of dividends flow out of Australia as payments to overseas shareholders, which is recorded as a debit (outflow of funds) on the NPY account. Between 2003 and 2008 the commodities boom lifted profits in the domestic resources sector, which allowed mining companies to declare large dividends – this increase in dividend payments was reflected in the surge in the NPY deficit over the mid 2000s. However, the GFC saw commodity prices fall over 2008-09, reducing the flow of large special dividends and returning the NPY deficit to -3.4% of GDP. In 2010, as NIEs such as China return to high manufacturing-driven growth, Australia is again likely to experience a boom in profits in the resources sector, leading to another surge in the NPY deficit. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] The main underlying factor affecting the NPY account is structural – Australia’s savings and investment gap. o The underlying structural problem in the Australian economy causing the persistent current account deficits is Australia’s savings and investment gap, i.e. our lack of national savings – it is claimed that we are spending far beyond our means (therefore our consumption and investment is far too high and savings is too low) – hence, we must increase savings at the expense of consumption (but not investment as it is regarded as too important to be restricted). Using this savings-investment analysis, Australia’s persistent CADs and need for capital inflow can be explained as a natural consequence of specific features of the economy – Australia is a young country with a small population but a large land mass and extensive natural resources that offer significant investment opportunities. Australia has therefore historically relied on overseas capital in order to develop its economy and fill the gap between domestic savings and investment. Ultimately, provided that the investment that is being funded by overseas capital inflow generates sufficient returns to pay for future servicing costs, the increase in foreign liabilities can be viewed as sustainable in the longer term. National savings (comprising private saving + public saving) declined from nearly 30% of GDP in the mid 1960s to about 20% of GDP by the late 1990s and mid 2000s, while national investment fluctuated between 30% and 25% of GDP over the same period. This has led to Australia’s increasing reliance on foreign savings to finance that part of national investment that cannot be financed by national saving. Public savings deteriorated in the recession of the early 1990s to less than 5% of GDP, whilst private savings fell from 20% of GDP in the 1970s to 15% by the late 1990s. The government used fiscal policy in the late 1980s to try to achieve budget surpluses, because it was argued by many economists that a rise in public sector savings by cutting back government spending (running budget surpluses rather than budget deficits) could have a substantial impact in reducing the CAD and level of foreign debt as the economy would not be over-spending as much. This was known as the twin deficits hypothesis. However, this theory is limited in that the elimination of the Government’s deficit in past budgets has not reduced the CAD (e.g. 1999-2000 Budget was in surplus by 1.9% of GDP yet the CAD was not resolved since savings and investment also changed over this period – household savings ratio slumped from 2.5% to 2%, and hence the CAD stayed at over 5% of GDP despite the increase in the Budget surplus). In the period of 2002-03 to 2007-08 household savings were again weak (-3.1% to 2%, investment was strong and the Budget was in surplus throughout this period – the CAD fluctuated between 5% and 6.4% of GDP). In 2008-09, the CAD was much lower at 3.2% of GDP due to the GFC as household savings increased and investment weakened sharply - and the budget outcome shifted from a surplus to a sizeable deficit. In terms of Australia’s net lending position (difference between national gross saving and investment), changes have occurred in various sectors of the economy – households have historically been net lenders, but between the 1980s and 2000s shifted to a net borrowing position, particularly to fund spending on housing. However, with higher domestic interest rates, households reduced their borrowing over 2003-08 and increased savings. The government has increasingly become a net lender, with rising general government saving due to the accumulation of budget surpluses, more than offsetting government investment. However, the return to budget deficits in 2008-09 and 2009-10 reversed this trend as the government sector became a net borrower of funds in financial markets. Other factors that have contributed to and caused the rise in Australia’s CAD during the 1980s, 1990s and 2000s include: o The growth in foreign borrowings (both public and private) during the 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. o The lowering of protection (removal of protectionist barriers such as tariffs and quotas) in the 1980s, 1990s and even the mid-2000s, coupled with the growth of domestic demand, led to increased import volumes and import penetration in the domestic Australian economy. This has led to increased import spending relative to the growth in export earnings, worsening the deficit in the BOGS balance. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Consequences of the Current Account Deficit Growth of Net Foreign Liabilities + Increased Servicing Costs - the problem with generating persistent current account deficits (and thus surpluses on the capital and financial account) is that it causes the kind of increase in net foreign liabilities that Australia has experienced over the last couple of decades. To finance the growth in the CAD, net foreign liabilities grew from 13% of GDP in 1980-81 to 60.6% of GDP by 2008-09. Since these liabilities have servicing costs (whether in the form of interest or dividends on debt or equity), they create an additional burden on the current account in the future and the current account-foreign debt cycle may become self-perpetuating. Only successive reductions in or stabilisation of the CAD and the retirement (repayment) of foreign debt obligations can correct this cycle. This is why Australia cannot sustain a rate of economic growth in excess of 5% if the CAD rises to over -5% of GDP, since the debt servicing obligation becomes greater than the capacity of the economy to increase its income without increasing import spending and deteriorating the CAD. If the CAD reaches an unsustainable level, Australia’s credit rating will fall as domestic firms are unable to service the debt/borrowing costs, and this will decrease foreign investment. The increased servicing costs associated with a higher level of foreign liabilities (particularly foreign debt used to finance the CAD) will be reflected in the net income deficit which will continue to grow – higher levels of foreign debt can lead to lenders demanding a ‘risk premium’ on loans, forcing up interest rates and contributing to the ‘debt trap scenario’ in which Australia is borrowing money to service its existing foreign liabilities. This occurred in the late 1980s after Australia’s CAD increased dramatically (as did the level of foreign borrowings) – it became more difficult and expensive for Australian firms to borrow funds in overseas financial markets. The response to this was a shift back to equity financing in the 1990s from the trend towards debt financing in the 1980s. Foreign equity investment has been actively encouraged in Australia by governments in the 1990s and 2000s and has led to an upgrading of Australia’s international credit rating. Loss of international investor confidence - A persistent CAD and large foreign debt increases the exposure of the Australian economy to external shocks which may reduce export income and increase the debt servicing ratio due to greater servicing costs as a proportion of total export revenue. It also increases the possibility of capital outflows if foreign investors/lenders lose confidence in the economy’s ability to sustain the high CADs (as seen with the Asian Financial Crisis in 1997 when there were concerns over Thailand’s high CAD). Countries with high CADs are generally most vulnerable to shifts in investor sentiment. High CADs may also result in greater exchange rate volatility, which can also undermine investor confidence in the Australian economy – they can reduce demand for the Australian dollar, prompting depreciation. This will generally worsen the CAD problem in the short-term because the price of imports will rise, and this can contribute to higher domestic inflation too. The settings of macroeconomic and microeconomic policies had to be changed in the 1980s and 1990s to promote structural adjustment in response to growing external imbalances. Governments will generally use more contractionary economic policy (tighter monetary and fiscal policies) – fiscal policy was directed at raising national savings through balancing the federal budget and paying off public debt (to improve the net income deficit); monetary policy was conducted through the use of an inflation target to maintain Australia’s international competitiveness (and help to improve the BOGS balance). Various microeconomic reforms also need to be implemented to promote competitiveness and help to solve the structural problems behind the CAD, such as tariff reform and the introduction of enterprise agreements in the labour market to link age outcomes to improvements in labour productivity. In the short to medium-term, tighter macroeconomic policies and accelerated microeconomic reform is likely to lead to slower economic growth and higher unemployment. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] In the long-term, the CAD limits economic growth as high levels of growth generally involve an increase in imports and a subsequent decline in the BOGS balance. Therefore the CAD represents a ‘speed limit’ to growth – the balance of payments constraint is the extent to which an economy’s capacity to grow is constrained by the need to keep the CAD at a sustainable level. The government aims to maintain growth between 3-4% of GDP to avoid blow outs in the CAD and inflation. The Pitchford Thesis – this thesis, presented by economist John Pitchford, argues that Australia’s current account problem differs from that of many Latin American countries, which have periodically experienced financial/economic crises arising from external imbalances in recent decades because most of their foreign debt was accumulated by governments in order to cover day-to-day government expenditure. However, Pitchford noted that Australia’s CAD and foreign liabilities are almost entirely generated by the private sector (which accounted for 99% of Australia’s net foreign debt in 2008 and 95% of Australia’s net foreign debt in 2009, with the increase in government debt attributed to the expansionary fiscal stance which caused a deficit in the 2009-10 Budget) to fund private investment projects. Ultimately, Pitchford assets that the Australian Government does not need to be too concerned about the level of foreign liabilities any more than it is concerned with the level of the domestic liabilities of private firms. Further, even if some private sector projects are not successful, the private sector would go bankrupt and there would be no need to repay this part of the debt as this was a risk that was assumed by overseas lenders. The CAD debate: (AGAINST THE CAD) The chief concern was that such current account deficits raised the prospects of default and/or sharp reversals in capital flows – i.e. it was feared that the deficits were not sustainable and that they left the country more vulnerable to adverse external shocks (such as a change in sentiment of foreign creditors). Hence it was argued that all arms of policy, in both macroeconomic and microeconomic spheres, should and could attempt to reduce the CAD. The CAD debate: (FOR THE CAD) The view of the CAD as threat to Australia’s external stability was challenged by those that argued the current account merely reflected the optimal decisions of private agents and as a result, concerns about sustainability were misplaced and there was certainly no role for macroeconomic policy to intervene. This view was influenced by the fact that despite widespread reforms (such as the substantial fiscal consolidation which led to ultimately no public debt), the CAD had remained stable, averaging 4.5% of GDP between 1980 and the present. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Net Foreign Debt and Net Foreign Liabilities – Measurement as a % of GDP, Trends, Causes and Effects Measurement as a % of GDP + Trends Australia’s net foreign debt rose significantly especially in the period 1982-83 – 1992/93 as the private sector in particular borrowed heavily to finance investment both within Australia and offshore. While the 1990s saw debt financing fade away following some massive corporate crashes at the end of the 1980s/early 1990s (e.g. Bond Corporation), net foreign debt stabilised between 37-42% of GDP. In the 2000s, very low interest rates have encouraged a switch back to borrowing foreign savings and as a result, net foreign debt has risen above 50% of GDP – in the December quarter of 2009, foreign debt was at 51.4% of GDP ($633 billion) compared to 56.2% in December of 2008, a result of the GFC which saw financial flows fall dramatically. Between 1998 and 2009, net foreign debt averaged 48.2% of GDP. One of the most reliable economic measures of a country’s capacity to service its foreign debt is the debt servicing ratio – this figure indicates the proportion of export revenue that can be used to make interest repayments on overseas debt and is a common indicator of debt sustainability. The debt servicing ratio peaked at just under 20% in 1990, but has since fallen back due to lower worldwide interest rates as well as Australia’s continued export growth and global demand for commodities which has helped to increase Australia’s export revenue – by 2008-09, the debt servicing ratio was at 10.1%, reflecting the ability of Australia’s export growth (due to higher export prices and an improved terms of trade) to grow at the same rate of Australia’s mounting borrowing requirements. The servicing cost of net foreign debt requires interest payments abroad which are recorded as income debits in the current account. Since the 1980s, Australia’s private foreign debt has risen at an unprecedented rate. This trend was accentuated by the ‘debt for equity swap’ that was prevalent during the 1980s when private sector businesses preferred to borrow overseas (because of lower interest rates and the tax deductibility of interest payments) rather than using equity borrowings. The escalation of net income payments overseas during this time was a reflection of the rising debt servicing burden on Australia. There has been also been a tremendous rise in Australian investment overseas – hence there has been an overall growth of other countries’ liabilities to Australia. In the decade to 2008-09, Australia’s gross level of foreign assets increased from $325 billion to $1051 billion. Australian ownership of equity overseas rose from $196 billion to $495 billion during this period, while Australian loans to overseas countries grew from $129 billion to $557 billion. On the other hand, our liabilities are still much larger – growing from $647 billion to $1777 billion. This is a result of foreign-owned equity in Australia soaring from $287 billion to $588 billion, while gross foreign debt increased from $360 billion to $1190 billion. The increasing net foreign liabilities and net foreign debt (both in terms of what Australia owes to other countries and what other countries owe to Australia) reflect the idea that Australia is becoming increasingly integrated in the global economy as a consequence of globalisation. Net foreign liabilities averaged 55.5% of GDP between 1998 and 2009. More Australian companies are investing overseas, just as Australian financial institutions are lending more and more money to other countries. In overall terms, however, foreigners are lending and investing in Australia more than Australia is lending or investing overseas – Australia is a NET CAPITAL IMPORTER. Causes and Effects Persistent and increasing XADs throughout the 1980s, 1990s and 2000s required financing through higher levels of overseas debt and equity borrowings. The lack of domestic savings (public and private) has led to an increased reliance on foreign savings (mainly through overseas debt borrowing) to finance domestic investment. In the long-term, the growth in Australia’s foreign debt can lead to a debt sustainability problem – this means that it becomes increasingly difficult for Australia to serve its debts. If the size of the debt is increasing at a faster rate than the increase in GDP, as it has down for most years between 1980 and the present, the interest payments on the debt will progressively take HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] up a greater proportion of our GDP. This will ultimately reduce Australia’s overall standard of living and the economic growth potential of the Australian economy. International financial markets also generally consider that a high net foreign debt can become a significant risk to Australia’s future economic performance. If markets suspect the level of debt may become unsustainable for the debtor country, they may reduce the economy’s credit rating (which reflects the declining confidence of world financial markets in that economy). A downgrading in Australia’s credit rating would make it more difficult to borrow funds internationally and would increase the cost of borrowing by forcing up interest rates on loans. External imbalances caused by a high level of foreign debt make it more difficult to retain the confidence of international investors and financial markets – financial markets are often characterised by herd behaviour and sentiment can change quickly. If just a few major investors decide to withdraw their investments from an economy, many more can follow, creating a stampede and resulting in falling capital inflow + depreciation of the Australian dollar. If the RBA was forced to raise interest rates in order to attract foreign funds and increase demand for Australian dollars, it would reduce consumption and investment in Australia, potentially causing a recession. Australia clearly wants to avoid the risk of this kind of ‘herd mentality’ and the Government must therefore continually monitor the perceptions of foreign investors and sustain their confidence in the Australian economy’s ability to service its liabilities. As a small economy with a relatively narrow export base and a high level of net external liabilities, Australia is vulnerable to these changes in overseas perception of its economic performance/prospects. There is the argument about which is a better way of financing a CAD – debt or equity. o Equity is generally preferable. In future years, Australia must pay interest on its foreign debt and returns on its foreign equity, both of which constitute an outflow of funds on the net income component of the current account – however, because with foreign equity there is only a servicing cost while the equity asset is generating profits, there is the argument that the outflow of dividends from equity financing may constitute less of an income drain on the current account than the interest payments on foreign debt. This is why Australia tends to focus its concerns on net foreign debt (rather than net foreign liabilities which also includes net foreign equity). Large current account deficits and foreign indebtedness can imply some degree of vulnerability for a small open economy subject to large external shocks. However, in Australia’s case, a high debt level may be less of a signal of vulnerability and more a reflection of resilience which attracts foreign capital and keeps it in place. External Stability and the Exchange Rate The exchange rate provides a direct link between Australia and the rest of the world – all trade/financial relationships between Australia and other countries are mediated through the exchange rate. The exchange rate therefore has a significant impact on Australia’s international competitiveness and external stability. The Australian dollar is subject to large fluctuations, as seen in recent history – much of this volatility can be attributed to the extensive speculation that occurs in Australian dollars (speculation accounts for 95% of FOREX market transactions). Approximately 6.7% of world FOREX transactions involve Australian dollars, making it the sixth most traded currency. The Trade Weighted Index (TWI) of the value of the Australian dollar has shown a tendency to fluctuate greatly – for example, in the 2000s, the Australian dollar has moved in a TWI range of 49-70 points (more than a 40% fluctuation). Australian dollar volatility has significant influences on Australia’s external stability – a change in the exchange rate affects the balance of payments by affecting Australia’s international competitiveness and the size and servicing costs of our foreign debt. Therefore, if the value of the dollar is continually subject to change, Australia’s CAD and net foreign debt (two important indicators of Australia’s external stability) will also be affected and volatile. A depreciation of the Australian dollar due to a fall in the confidence of foreign investors can create a vicious cycle – a low and depreciating dollar may lead investors to conclude that the Australian economy is unstable and may therefore undermine confidence for other investors – this may result in rapid withdrawal of foreign investment, leading to further currency depreciation until investors begin to think that the currency is undervalued and demand more Australian dollars. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] o The most famous example of the wide-reaching influence that a volatile currency can have on economies was seen during the Asian Financial Crisis of 1997 – an initial loss of investor confidence in Thailand led to rapid withdrawals of foreign capital from Thailand and the collapse of the Thai baht triggered a change in sentiment for currencies across East Asia, resulting in large depreciations and the most severe economic downturn in the region. The global financial crisis also contributed to increased volatility across currency markets in 2008. Policies to Achieve External Stability Australian Governments now run policies with objectives of restraining growth in the CAD and foreign debt/liabilities. Macroeconomic policies (fiscal/monetary) and microeconomic reforms play a role in achieving sustainability in the growth of our CAD or foreign debt and maintaining external stability in Australia. For example: o The Australian Government has primarily used FISCAL POLICY to reduce the size of the CAD in Australia – fiscal policy has had a medium-term focus of raising public savings through the accumulation of underlying budget surpluses between 1998 and 2008 which have eliminated the public sector’s call on national savings. Therefore the Australian Government has a fiscal policy goal of maintaining fiscal balance in the medium term – this was adopted to ensure that the public sector did not draw on savings that could otherwise be used to fund domestic investment. Traditionally, economists have explained the negative effect of budget deficits on investment through the ‘crowdingout theory’ – if governments continue to run budget deficits and borrow from the domestic public in order to finance the deficit, it will soak up the available domestic funds and therefore crowd out domestic private sector investment, as there are no funds available for firms to borrow for investment purposes. o The following are ways that national savings can be increased: Policy action that will break consumer confidence in the economy and lead to greater savings – higher interest rates could be a suitable measure; however, a severe recession will lead to a fall in national savings. Run budget surpluses to gain more public sector savings. Increase taxes on consumption – prior to 2000, only Australia (of all OECD nations) had no broadbased consumption tax- the absence of such a tax on consumption was argued to encourage consumption at the expense of savings. The imposition of the GST represented the Government’s main policy attempt to increase national savings. Stricter asset and income testing on pensions to encourage more private savings for retirement purposes as well as making employer superannuation contributions compulsory from July 1992 – compulsory superannuation was the main arm of Government efforts to raise national savings over the 1990s, however, the Howard Government reduced the target level of this initiative from 15% to 9%. o The tightening of fiscal and monetary policy in the late 1980s was implemented with the aim of reducing investment and consumption, reducing the CAD and also putting downward pressure on our relatively high inflation rate that was hurting the international competitiveness of Australian products. Keeping inflation within the target band of 23% CPI is important for maintaining the competitiveness of Australia’s export and import competing industries, which are vital for reducing the size of the CAD. However, the consequence of such contractionary economic policy could ultimately be slower economic growth and higher unemployment despite the reduction in import spending that these policies could achieve in stabilising the CAD. o The implementation of microeconomic reforms from the late 1980s was aimed at improving the economy’s level of efficiency, productivity and international competitiveness of Australian producers in order to improve their performance on world markets in the long-term – MER has aimed to broaden Australia’s export base and improve the level of national savings. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] An example of MER to help solve the structural problems of the CAD and maintain external stability - industrial relations policy is important in linking wage movements to improvements in productivity in the workplace – this helps to contain inflationary expectations and encourages firms to adopt more competitive labour and management practices which are essential for firms exporting to the global market. Other important MERs for maintaining external stability are the application of national competition policy to market sand the continuing cuts to protection, which increase the level of competition from inside and outside the Australian economy. More competitive domestic industries will help to boost exports as a share of GDP, thereby reducing the BOGS deficit and the size of the CAD. Industry policy also has a role to play in encouraging innovation, risk-taking and investment in research and development which the government believes are essential for building world competitive firms. The Howard Government implemented a number of the recommendations proposed in the Fitzgerald Report on National Saving (1993) as a means of increasing savings to reduce the savings-investment gap. The government eliminated the Budget deficit and returned the budget to surplus, lifting public savings and reducing the public sector’s call on private savings. Howard also reduced the Commonwealth Government’s net debt to GDP ratio from 20% in 1995-96 to 1.3% by 2004-05 through the proceeds from the privatisation of a number of PTEs and accumulated budget surpluses. Measures were also introduced to increase private savings such as tax reforms in budgets from 2000 to 2007 and the elimination of taxation on superannuation in the 2006 Budget for retirees reaching 60. In more recent years, external stability has not been a major objective of macroeconomic policy – while both the Commonwealth Treasury and the RBA continue to monitor the CAD, foreign debt and the exchange rate, improving external stability is not used to guide fiscal or monetary policy settings. In part, this change reflects a widespread acceptance of the ‘consenting adults’ view of the current account among policy markets and economists, that the CADs and the foreign debt reflect the decisions of the private sector and do not require policy change by the Government. Despite the acceptance of the ‘consenting adults’ view of the CAD, the severity of the GFC has made financial markets much more concerned about the risks of high and unsustainable debt levels, as well as making it more difficult to borrow funds. The GFC demonstrates that the collapse or rescue of any major financial institution can quickly lead to panic across an entire financial system – i.e. economies cannot afford to allow substantial borrowers to default on their loans. This to some extent undermines the Pitchford Thesis that private sector borrowings do not matter, since the experiences of the GFC suggest that in a crisis, the public sector will be forced to step in to rescue a major financial institution, even at the cost of billions of dollars. Thus, the GFC has contributed to greater concern about the risk of large external imbalances. The declining importance of external stability issues has also occurred because Australia’s economic prospects have improved with its much higher terms of trade and the medium term prospect that China’s hunger for resources will see further increases in Australia’s resource exports. In addition, even those economists who remain concerned about Australia’s external imbalance accept that when macroeconomic policies have in the past targeted external stability, they have generally been ineffective. In July 2006, Commonwealth Treasury Secretary, Dr Ken Henry, stated: “…in a world of more or less floating exchange rates and international capital mobility, we can’t be confident that macroeconomic policy can be used to reduce the current account deficit without it also producing a significant slow-down in the economy, and quite possibly a recession. That provides a reasonably compelling reason for policy makers being a bit wary of targeting the current account.” This change does not mean that external stability is unimportant or of no interest o economic policy markets – it means that achieving sustainable external stability outcomes on the current account and foreign debt and a stable value of the currency are now treated as more long-term objectives of economic policies. External stability issues are now addressed through the general economic framework, which is designed to promote the international competitiveness of the Australian economy, increase exports, encourage household and business savings, contain the growth of foreign debt, and to maintain international investor confidence in the Australian economy and its financial institutions in order to reduce exchange rate fluctuations. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.5 Income Distribution and Wealth While inequality is a feature of all market economies, the degree of income inequality increases if nations make their taxation systems more regressive, reduce welfare payments, cut back government services and deregulate their labour markets. Essentially, the distribution of income and wealth reflects how the benefits of economic growth are shared amongst the population as a whole. Australia has traditionally considered itself a country offering people a ‘fair go’ with relatively low levels of inequality – economic evidence suggests that inequality in Australia is about the same as in other developed nations. During the late 1990s and mid-2000s, the level of inequality in Australia’s income distribution became more unequal, though there was an improvement during the early 2000s. The GFC may also be expected to result in greater inequality as a result of higher unemployment. Measurement of Income Distribution and Wealth – Lorenz Curve and Gini Co-Efficient Income inequality refers to the degree to which income is unevenly distributed among individuals in the economy – the degree of inequality can range from a high level of equality where people receive a similar share of income, to a high level of inequality where there is a large gap between high and low income earners. Income inequality is measured using TWO main indicators: A. The Lorenz Curve (diagram below) is a graphical representation of income distribution, plotting the cumulative increase in population against the cumulative increase in income. If income were distributed evenly across the entire population, the Lorenz Curve would be the diagonal line through the origin of the graph – the line of equality. The further the Lorenz Curve is away from this line, the greater the degree of income inequality in society. B. The Gini Co-Efficient is a single statistic that summarises the distribution of income across the population. It is calculated as the ratio of the area between the actual Lorenz curve and the line of equality (area A) and the total area under the line of equality (A + B). GINI CO-EFFICIENT = A A+B The Gini Co-efficient ranges from 0 (when all incomes are equal) to 1 (when a single household receives all the income) – the smaller the number, the more even the distribution of income. The Australian Gini Co-Efficient increased from 0.292 in 1996 to 0.331 in 2008, suggesting rising income inequality in the last decade. A survey of th OECD nations in 2008 ranked Australia 16 in the OECD for its Gini-Coefficient, with a Gini Co-Efficient just below (i.e. more equal) than the OECD average. Sources of Income as a % of Household Income Personal income = the money and value of benefits in any kind received by individuals during a period of time in return for their factors of production (land, labour, capital and enterprise) or as government transfer payments such as pensions, jobs search allowances and other forms of welfare. Personal wealth = the net value of real assets (property, consumer durables) and financial assets (shares, bonds) owned by individuals at a particular point in time – the ‘net value of assets’ is calculated by subtracting any debts (financial liabilities). Wealth is a stock concept in economics since it is the amount of a person’s net assets at a given point in time. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Mean income = the average level of income – calculated by dividing the total income of a group by the number of income recipients in that group. Median income = the level of income that divides the income recipients in a group into two halves, one half having incomes above the median and the other half having incomes below the median (therefore, median income = the ‘middle’ income). For household income, the main sources of income can be divided into primary income and secondary income sources. Primary income represents income from markets, such as: o Wages from the sale of labour: this is the main source of income for consumers – it comes in the form of wage or salary payments for labour when consumers participate in the labour market – it may also include non-wage income such as fringe benefits, superannuation payments and workers’ compensation payments. In 2008-09, 55.3% of household income was in the form of wages and salaries. o Rent from land: many consumers own land that becomes a source of income when it is rented – investment properties that generate rental income may be owned. o Earnings from capital: returns from the ownership of capital are a significant source of income – people with greater wealth tend to enjoy a much higher income because wealth creates ongoing income through returns from owning the factors of production. For most consumers, their ownership of capital occurs indirectly through superannuation and other investment funds or through the ownership of shares (which now generate dividends for many consumers). They may earn interest on savings held in cash management accounts or bonds. In 2008-09, 12.4% of household income was in the form of rent, interest and dividends. o Profit from the sale of entrepreneurial skills: a substantial number of Australians are involved in operating small businesses – if the business makes a profit, this income is considered a return for their use of entrepreneurial skill. In 2008-09, 18.9% of household income was in the form of profits. Secondary income includes: o Social welfare: a significant portion of household income is received by way of social security or welfare payments or government benefits. This is income collected through taxation and then transferred from governments to households – over 1/3 of the total income tax that is collected is used to pay unemployment and sickness benefits, age and disability pensions, family allowances and similar social security payments. Sources of Wealth Household net work is the measure used by the ABS to measure private sector wealth in Australia – net worth is the extent to which the value of household assets such as households and savings (i.e. the things they own) exceeds the value of their liabilities such as loans (i.e. the things they owe). Aside from debts, the types of wealth include: Physical assets such as land, buildings, contents of buildings (plant and equipment, inventory etc.) and vehicles. Intangible assets such as goodwill, trademarks, copyrights and patents. In 2006, the average household at assets worth $655,000, liabilities worth $92,000 and a resulting average net worth of $563000. Superannuation was the largest financial household asset while property was the main non-financial asset – both these assets have increased in importance in recent decades, while savings and ownership of business assets have declined in comparison. Loans taken out to purchase property were the most significant household liabilities, accounting for 85.5% of household liabilities in Australia – other liabilities are loans for vehicles, other investments and credit card debts. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] The Reserve Bank has estimated the household wealth grew by 7% on average in 2007 and then fell by 14% over 2008, with most of the fall occurring in the wealthiest one-fifth of households in Australia. Wealth Accumulation (factors that increase the wealth of nations and individuals) 1. Nation Wealth Accumulation Increases in quantity and quality of the factors of production. Increases in capital production (higher levels of investment) – associated with higher economic growth. Willingness and ability of domestic entrepreneurs to seize opportunities in the foreign sector (whether it be by tapping into export markets and thus adding to domestic economic growth OR gain and make good use of foreign savings). Inflation rate will influence the measurement of total wealth – higher inflation tends to slow the rate of economic growth by making private investment more risky, thus higher inflation may reduce the real wealth of a nation. 2. Personal Wealth Accumulation A flow of income that is surplus to immediate consumption requirements, i.e. savings. Existing wealth – owners of assets have a strong likelihood of gaining additional income from these assets and hence the ability to purchase more assets (wealth produces more wealth). Inheritance of wealth boosts wealth accumulation for individuals. Personal qualities such as skills, inventiveness, willingness to innovate. Choice of assets especially in inflationary periods – some assets gain value faster than others in times of inflation (real estate). The interrelationship between Income and Wealth Although the distribution of wealth is far more unequal than the distribution of income, wealth and income are closely related – individuals with higher incomes tend to also enjoy greater levels of wealth compared to low income earners. Household income can be used to purchase goods and services, service debts and acquire assets – the more income a household has left over after covering living expenses, the greater the capacity to build wealth. Also, the more wealth a household has, the greater its capacity to generate income – a household can generate higher income in the form of rent from a property investment or dividends from a share portfolio, but these assets may not be affordable until income levels reach a certain threshold. Therefore, an increase in income inequality can result in a widening of wealth inequality, and an increase in wealth inequality can result in an increase in income inequality. Because wealth is a STOCK and income is a FLOW, it is possible to be asset rich but income poor – however, very wealthy people tend to hold more of their wealth in income-generating forms such as shares and investment property – it is therefore not surprising that the high concentration of wealth is a major element in intensifying the inequality of income distribution. There is a strong correlation between income and wealth – people with little wealth tend to have lower incomes, while people with substantial wealth tend to have higher incomes. This is because wealth generates income and in many cases, high incomes can generate increasing levels of wealth. People with a substantial stock of wealth have the ability to derive unearned income such a rent, interest, profits and dividends in addition to earned sources of income such as wages and salaries. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Economic and Social Costs and Benefits of Inequality BENEFITS OF INEQUALITY Some economists argue that inequality is a natural consequence of the free market functioning effectively since each individual receives a share of income according to their marginal productivity. To gain the best efficiency and economic growth, it is argued that we must accept some degree of inequality in the distribution of income. Economic Benefits of Inequality (INCENTIVE EFFECTS OF INEQUALITY) Income inequality creates and strengthens an individual’s incentives (incentive effect) – employees will work harder to achieve higher wages and other rewards if these can be attained through higher levels of education, training, skill acquisition and productivity. People may be willing to work longer hours and sacrifice more leisure time for additional income and in order to change their position in the distribution of income if inequality exists. Income inequality can lead to an increase in the productive capacity of resources and thus an increase in real GDP per capita – it raises the efficiency with which the economy satisfies its wants and speeds up economic growth, which contributes ultimately to improve standards of living in the future. Inequality encourages the labour force to increase education/skill levels – if those with higher qualifications and skills reap higher income rewards, new entrants and existing participants in the labour force will be encouraged to improve their education and skill levels. Therefore, so long as low income recipients can afford to pay for education and training, income inequality may encourage an increase in the quality of the labour force. Inequality encourages the labour force to work longer and harder –the potential to earn higher incomes produces an incentive for workers to work longer hours or to work overtime and encourages greater productive effort from employees, which may enhance economic growth. However, workers will only be willing to give up leisure in order to work longer hours when they feel the extra income is more valuable than their leisure time. Additionally, if increased output is rewarded through higher pay, this encourages improved labour productivity. Inequality makes the labour force more mobile – the use of higher incomes can act as an incentive to encourage labour to move to where it is most needed. A more mobile labour force will lead to a more efficient allocation of resources and a higher rate of economic growth. Inequality encourages entrepreneurs to accept risks more readily – the prospect of considerable income rewards accruing to entrepreneurs may be necessary to encourage them to take risks associated with business. If entrepreneurs received no extra reward for risk-taking, there would be fewer entrepreneurs and businesses, a lower rate of economic growth, fewer jobs and a reduced productive capacity in the economy. Inequality creates the potential for higher savings and capital formation – there is a strong relationship between income and savings levels. The higher the income an individual earns, the greater the proportion of income that will be saved. In theory, greater income inequality should encourage increased savings in the economy because of the greater number of higher income earners. Increased savings should reduce Australia’s reliance upon foreign capital by providing domestic funds for investment, which can improve our external stability through improvements in the CAD. Inequality makes technological change more rapid – the presence of high incomes can contribute to more rapid technological change in two main ways: (a) through higher savings and thus investment, the capital stock of the nation is increased and likely to be replaced more frequently (and replacement capital will probably incorporate the latest technological advances) – an economy will gain more frequent and widespread injections of technology which assists, through higher productivity, in the satisfaction of more wants. (b) due to the incentive effects of higher incomes, the labour force will be encouraged to be available to implement the technology and have the skills to further advance/speed up technological change. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Social Benefits of Inequality The potential economic benefits of inequality may stem towards creating social benefits – economic benefits such as higher levels of saving or productivity could produce a ‘larger pie’ from which all members of society could be advantaged, and that social benefits may also arise from an economic system that encourages hard work, risk-taking and social mobility. However, since the economic system that determines the distribution of income does not give everyone the same opportunity to pursue their income and wealth goals, income inequality has very few social benefits. Inequality of opportunity exists in Australia for several reasons: o Existing inequality in the distribution of income and wealth tends to perpetuate inequality of opportunity – higher income earners have better access to education opportunities, making it more likely that they will gain admission to university courses, allowing them to take up higher-paid occupations. o Not everyone has the same mental and physical attributes and the same potential with regard to the acquisition of income and wealth. Some people are more talented at manual work, which tends to lead to lower paying jobs than jobs that require analytical skills. o People who acquire wealth through inheritance have a much greater opportunity to build up their wealth through investments, as opposed to those that start with no wealth. o People may not have access to the same networks of people that may lead to new opportunities – for example, new migrants will struggle to access social and business networks. Often this inequality is difficult to overcome because many of the barriers to opportunity are informal barriers (business people may prefer to do business with people who speak the same language or have a similar social background, informally excluding others). COSTS OF INEQUALITY Economic Costs of Inequality Inequality reduces overall utility or satisfaction in society – this is because people on higher incomes gain less utility from an increase in income than people on lower incomes, explained by the principle of diminishing marginal utility – as more of a good is consumed, it will provide progressively less utility to the consumer, meaning that an extra $1 of income is worth more to a lower income earner than it is to a higher income earner. A more equitable distribution of income would therefore increase total utility – however, it is difficult to measure relative utilities accurately. Inequality can reduce economic growth – low income earners spend a higher proportion of their income than higher income earners, since the cost of basic essentials such as housing and food take up a greater proportion of their income. In economic terms, lower income earners have a higher MPC (they spend more of each additional dollar they earn than high income earners) – this means that in an economy with a high level of income inequality, there will be a lower level of consumption and a higher level of savings, ultimately leading to lower economic activity, employment, investment and living standards. Inequality creates conspicuous consumption – some economists argue that inequality in the distribution of income creates a ‘leisure class’ consisting of the higher income earners in society. The leisure class puts a large proportion of their income towards ‘conspicuous consumption’, which is the consumption of expensive goods and services such as designer label clothes, purely for the purpose of displaying wealth. This can contribute towards a culture where individuals’ sense of their own worth depends on their relative position in the wealth and income hierarchy. Inequality increases government spending on welfare support and social welfare payments – governments provide safety net income support for people out of work, the aged and people with disabilities, which places demands on government revenue as a large number of people on low incomes may require government assistance. In macroeconomic terms, Keynes argued that this type of government expenditure would stimulate aggregate demand and help lead to economic growth. However, increased government expenditure on welfare payments can lead to a higher tax burden on taxpayers and deterioration in the federal government’s fiscal position through a higher budget deficit or a smaller budget surplus. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Social Costs of Inequality At a household level: Poverty – Australia does not suffer from high levels of absolute poverty, but it does have a large existence of relative poverty – many sections of the community have income levels and lifestyles that are not meeting the expectations they have as part of a modern Australian society. According to the 2008 Human Development Report, 12.2% of Australians live below the poverty line, defined as receiving an income below 50% of the median income level – this is a higher level of relative poverty than most developed economies. Poverty tends to trap families in a vicious cycle of low incomes and limited economic opportunities (to health and education) – they tend to be associated with increased levels of crime, suicide (due to a sense of isolation and exclusion), disease, and reduced life expectancy. At a national level: Social class divisions – the distribution of income and wealth creates class distinctions in modern economies, as the system of free market capitalism tends to divide society into different classes (working class, middle class, upper class) – these class divisions tend to entrench higher levels of inequality and poverty, creating tensions between people and regions often through wage disputes between employers and employees in which workers attempt to improve their income level. These divisions can lead to social and economic instability as parts of society/individuals may be intolerant of the distribution or degree of inequality and use violence in an attempt to change the situation. Social tensions can be raised especially when certain groups in society (Indigenous Australians, the unemployed, non-English speaking migrants, single parents, low income families and aged pensioners) are perceived to be the major recipients of government welfare payments. These groups may feel alienated from market opportunities and some taxpayers may also resent contributing taxes to support welfare recipients. Dimensions and Trends in the Distribution of Income and Wealth in Australia (according to gender, age, occupation, ethnic background and family structure) Despite a long period of economic growth during the 1990s and 2000s, Australia has not substantially reduced overall levels of inequality – often some groups in society are more affected by inequality than others. Like most market economies, there is a high degree of income inequality in Australia. As of 2008, weekly incomes ranged from about $150 per week to $1400 per week for the majority of people, highlighting the extent of income inequality in Australia – over 50% of the population earn less than the mean income of $811 per week, indicating that income distribution is asymmetric – a relatively small number of households have relatively high incomes and a large number of households have relatively low incomes. The lowest quintile or 20% of households received 7.9% of total equivalised disposable household income in 2005-06, whereas the highest quintile or 20% received 38.5% of total equivalised disposable household income. The middle three quintiles (60% of the population) received 53.7% of total equivalised disposable household income in 2005-06. Between 1997-98 and 2005-06, the lowest quintile’s share of income fell by 0.1% while the highest quintile’s share rose by 0.6%. The Gini Co-Efficient of 0.303 in 1997-98 rose to 0.310 in 1999-00 before falling back to 0.307 in 2005-06. The ABS attributed this reduction in income inequality over this period to the introduction of new welfare payments to families and carers and modest income tax cuts in the 2004-05 Budget. However, in 2008-09, the Gini Co-efficient rose to 0.330, suggesting that income inequality has again risen in recent years Wealth is more unevenly distributed than income in Australia – in 2006, over 65% of households had a net worth of less than $500,000 and higher wealth brackets have fewer households than previous ones – this indicates a high level of wealth inequality and an even greater concentration of wealth at the ‘top end’ compared with the distribution of income. As with income distribution, wealth distribution is also asymmetric – a relatively small proportion of households have a relatively high net work and a large number of households have a relatively low net worth. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Characteristics that add to income and wealth inequality in Australia (Dimensions in the Distribution of Income) 1. Age and education: Income varies over the course of a person’s life, although it tends to remain highest between the ages of 25 and 64, the main years of a person’s working life. In 2008, the 35-44 year-old age bracket earned the highest mean income per week ($1124), while those aged 15-19 years-old earned the lowest ($278), followed by 20-24 year olds ($657) – this suggests that income levels are lowest in the earlier years of working life since people have less education/experience and hold lowerpaying/part-time jobs. Similarly, income levels decline as people get older and need to rely on aged pensions or other forms of retirement income. Those with higher qualifications (e.g. tertiary degrees/diplomas) enjoy higher income levels than those with vocational training or no qualifications beyond high school. Wealth distribution 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. 2. Gender and occupation: in 2009, the average weekly earnings of women were only 2/3 of those of males (males AWE were $1331 per week compared to $1080 per week for females) – there seems to have been very little change in wage relativities of males and females in recent decades. This can be explained by human capital factors – due to past attitudes concerning the role of women in society, females had fewer opportunities to acquire education, skills and qualifications – this suggests labour market discrimination, which is highlighted by the observation of average earnings of males and females working full-time in the same occupation group – females still earn less than their male counterparts regardless of whether they have the same qualifications and experience as men. The gap in earnings between males and females in ‘Generation Y’ workers has increased in recent years according to a 2008 report by the National Centre of Social and Economic Modelling. There is also inequality between different occupations, particularly highly-skilled jobs versus low-skilled jobs– jobs requiring higher levels of education, training and experience (managerial positions/professional occupations) tend to enjoy higher incomes than those that do not. Managers, administrators and professionals earned an average of $1700 per week in 2009 compared to labourers, clerks and salespersons whose average weekly wage varied between $718 and $983 in2009. 3. Ethnic and cultural background: those born overseas tend to receive higher weekly incomes than those born in Australia – however, income distribution is strongly influenced by the length of time that migrants have been in Australia and the countries from which they have migrated. Recent migrants from mainly English speaking countries (such as the UK, New Zealand, the US, Canada, Ireland and South Africa) tend to have higher income levels than those born in Australia – income distribution is also more unequal, with a greater proportion of migrants earning very high incomes and no incomes compared to those born in Australia. Long-standing migrants from mainly English speaking countries have similar income trends to Australian born people – i.e. their income levels are lower and more evenly spread compared with recent migrants. For RECENT non-English speaking background migrants, their income levels are much lower than Australian born people – this reflects the fact that even if non-English speaking migrants have the equivalent skills and experience of their Australian-born counterparts, they may not be able to obtain better paid jobs if they do not have a good command of the English language. However, long-standing migrants from non-English speaking backgrounds have a very similar income distribution to Australianborn people. This suggests that compared with Australian-born people, recent migrants from English-speaking (and richer) countries are relatively advantaged, while those from non-English speaking (and poorer) countries are relatively disadvantaged. Over time, however, income distribution among all migrant groups slowly conforms to the Australian average. Indigenous Australians experience greater levels of disadvantage than other groups in Australia – household income for Indigenous Australians is only 65% of non-Indigenous people ($398 per week) – household income growth for Indigenous Australians between 2001 and 2006 was the same as for non-Indigenous Australians, suggesting no improvement or deterioration in income relativities in recent years. Indigenous Australians are almost twice as likely as non-Indigenous Australians to be in the lowest income quintile (20% of the population with the lowest incomes) – approximately 37% of them are in the lowest quintile and 8% in the top quintile, compared with 19% of non-Indigenous Australians in the lowest quintile and 20% in the top quintile. Indigenous Australian incomes are lowest in remote areas. Australia’s most disadvantaged socio-economic group is therefore Indigenous Australians, as they face significant challenges in attaining the standards of living enjoyed by non- HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Indigenous Australians. This is a result of lower levels of education, fewer opportunities, remote locations and continued reliance on government welfare payments. Indigenous Australians rely heavily on government welfare payments. 4. Family structure: there are great disparities in family income and wealth levels – single-parent households were the worst off and received weekly incomes significantly below the median of $692 per week, earning weekly incomes over 1/3 below the average for all family structures. Couples (without dependent children) were the highest income family structure, receiving $730 per person per week – though they have a lower proportion of household members in the workforce, couples with children are more likely to be older and hence the adults in the household are more likely to have higher individual incomes even if they need to share it among more household members. The distribution of WEALTH by family type shows a similar pattern to income distribution, with couple-households enjoying significantly higher wealth levels compared with single parent and single-person households. The main difference is that singleperson households have much more wealth than single-parent households despite their similar weekly incomes – this reflects the influence of ‘income-poor and asset-rich’ elderly people in the single-person category who have paid off their mortgages and now live off modest government pensions/other retirement incomes. 5. Geography: at one level, inequality exists between different states in Australia, but there is also inequality between major cities and regional areas and between better-off and less well-off suburbs in major cities. The ACT enjoys the highest average weekly income of $1143 and Tasmania suffers the lowest income of $789 per week – WA and the NT, jurisdictions with the largest shares of economic activity in mining, have clearly benefitted from the commodities boom and now have incomes above all jurisdictions other than the ACT. Younger jurisdictions such as the ACT and NSW have people earning higher incomes than states with older populations like Tasmania – however, this assumption does not account for the differences in the cost of living between states (e.g. in 2009, renting an average 3 bedroom house cost $370 per week in Perth but only $300 per week in Adelaide – therefore, while Western Australians earned a higher income, they may not enjoy as high a standard of living as the cost of living is greater). Inequality exists within states, particularly between the MAJOR CITIES and the REST of the state – for instance, in NSW, 72.4% of the population living in major cities like Sydney, Newcastle and Wollongong, earned 8% more than the state median income level – by contrast, outer regional areas were much worse off, earning 34% less than the state median weekly income level. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Policies for Addressing Income Inequality Government policies can influence inequality throughout society in direct and indirect ways. It is FISCAL and LABOUR MARKET policies that generally have the most direct impact through changing the levels of government benefits, taxation and wages and salaries. However, indirectly, MICROECONOMIC REFORM policies pursued for other purposes can affect the distribution of income and inequality in Australia. There are FOUR major policy influences on the distribution of income: 1. General developments in the economy: (a) The persistence of high unemployment in Australia between the 1970s and late 1990s was perhaps the most significant factor contributing to a widening gap between the rich and the poor – unemployed people rely on government benefits which are significantly lower than the average incomes earned by people in employment – therefore, low and falling unemployment rates tend to reduce the gap between the rich and the poor. In the past decade, the downward trend in unemployment boosted the income of poorer households and helped reduce the level of income inequality – but the recent rise in unemployment due to the GFC in late 2008 will increase the disparities between the rich and the poor. (b) The emergence of long-term unemployment has also contributed to inequality in income and wealth distribution in Australia – those people who have been out of work for extended periods of time find it very difficult to find employment again, but these levels dropped in the early 2000s which helped to reduce the level of income inequality between households. A key focus of government policies in response to the GFC has been to prevent workers who lose their jobs from becoming long-term unemployed in future years. (c) The integration of the Australian economy with the global economy has exposed Australia to the fluctuations of the international business cycle – the downturn in Australia after the GFC highlighted how Australia is affected by conditions in other economies, with implications for economic growth, unemployment and income and wealth distribution. The process of increasing Australia’s integration with the global economy required structural changes that had the greatest negative impacts on low-income earners, but in the long-run, Australia’s economic integration has helped to create a more competitive and prosperous economy that has seen incomes rising across all income-earning categories, reducing the gap between the rich and the poor. 2. Changes in the Labour Market: (a) Changes in the pattern of employment has seen more casual or part-time jobs created than full-time jobs, which has caused the problem of underemployment to arise (where people working part-time want to work longer hours but can’t find more work). Underemployed people tend to hold casual/part-time jobs that are low paid, with work hours changing from week-to-week – therefore, they tend to have lower incomes and suffer greater fluctuations in their income levels. The number of underemployed people jumped sharply following the GFC, as businesses cut costs by converting full-time jobs into part-time jobs. (b) The decentralisation of the labour market has widened inequality between wage earners – under enterprise agreements, workers with greater skills and bargaining power have achieved greater average wage increases than less-skilled workers who rely on industrial rewards for wage rises. Jobs have become more highly-skilled and highly specialised, widening the gap between pay for high-skilled and unskilled work. The problem of increased ‘wage dispersion’ was recognised in the Fair Work Act 2009, which includes special provisions to help low paid workers engage in enterprise bargaining. The minimum wage decisions of Fair Work Australia can also impact on income inequality because they set wage levels for millions of employees covered by awards and agreements based on awards – the final decision of the Australian Fair Pay Commission in July 2009 (before it was replaced by Fair Work Australia) awarded no wage increase to workers, who wages are dependent on award minimum. Once inflation is taken into account, workers covered by the minimum wage took a cut to their real incomes – this decision was criticised by unions as causing an increase to income inequality, but supported by business groups who argued it would help employers to retain staff and thus avoid a higher level of unemployment. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3. Government policies to reduce inequality: Changes in government spending and taxation policies have the most direct impact on inequality in Australia – overall, government intervention tends to reduce income inequality by taxing the wealthiest groups more heavily and redistributing income to lower socio-economic groups. The final income of households is more evenly distributed than income from private sources – as a result of government policies the share of final income received by the lowest 40% of income earners is increased from 9.7% to 28.2%. As income rises, so too does the level of taxation – Australia has a progressive taxation system with higher marginal tax rates for higher income levels – however, the lowest 40% of income earners have a proportionately larger tax burden due to the impact of indirect consumption taxes that are not related to income, earning only 9.7% of total private income but paying 14.6% of total taxes. The progressive tax system provides revenue to the government to redistribute income from higher income earners to lower income earners (assisting those in the bottom 3 quintiles) in the form of transfer payments which are designed to help to create a more equitable income distribution. These social welfare payments are often received by the unemployed, low income earners and the elderly and the government aims to provide services such as health, education and housing. These are the primary mechanisms for reducing disadvantage/helping to address income inequality in Australia. The 2009-10 Budget included a range of decisions that may redistribute income from higher to lower income earners – on the revenue side of the Budget, the changes to the income tax system, including the expansion of the Low Income Tax Offset, might reduce the tax burden on low income groups. In the 2008-09 Budget, the Australian government raised the income tax thresholds for the second, third, fourth and fifth tax brackets which gave relief to low, middle and high income earners. On the expenditure side, the large boost in pension entitlements provides a permanent increase in income levels to some of the lowest income earners in the economy. Also, the means-testing of family payments and the reduction of the private health insurance rebate for higher income earners may also contribute to reducing income inequality. In 2009-10, $110.9 billion was allocated for expenditure on social security and welfare and in Australia it represents about 33% of total budgetary expenditure. Compulsory superannuation has greatly improved the distribution of wealth in Australia since its introduction in 1992 – under current rules, employers must contribute a minimum of 9% of an employee’s wage to a superannuation fund which they cannot access until retirement. Since the mid 1980s, the proportion of employees covered by superannuation has risen from 42% to 94%. While superannuation assets boost the wealth of ALL wealth quintiles, they are especially important for the poorest 20% of households – in 2008, the ABS calculated that the wealth of the lowest quintile would be 22% lower in the absence of superannuation. Although compulsory superannuation has reduced wealth inequality, the tax concessions given to voluntary superannuation contributions mainly benefit high income earners who can afford to set aside extra income at reduced tax rates–the 2009-10 Budget imposed lower limits on the amount of voluntary contributions that can be contributed to superannuation at a reduced tax rate, reducing the extent to which tax benefits are used to advantage higher income earners. 4. Indirect impacts of government policies: The impact of government policies aimed at creating a more equitable distribution of income can be outweighed by the consequences of other government policies that tend to widen the gap between higher and lower income earners in Australia. (a) The use of monetary policy to slow the rate of economic growth can affect the distribution of income and wealth – when interest rates increase, this often results in a transfer of wealth from low to high income earners because most low income earners are borrowers (they have a mortgage or personal debts) and must pay the higher interest rates. High income earners, on the other hand, often have net savings so that high interest rates increase their income. This is an unintended side-effect of a policy that is used for other purposes such as maintaining a low inflation rate or moderating the pace of economic growth. However, during the GFC, the government shifted to an expansionary stance on monetary and fiscal policies to support aggregate demand – main priorities were to support economic growth, household incomes and living standards in the short-term, to minimise the increasing rate of unemployment in the labour market in the medium-term, and to increase public investment in economic and social infrastructure to increase Australia’s productive capacity in the medium to long-term. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] (b) Microeconomic reform initiatives sometimes require economic restructuring that can create unemployment in the short-term, or may result in the closure of some industries – privatisation of formerly government-owned businesses for instance is often followed by price increases and ‘downsizing’ of the workforce to improve profitability for shareholders. In general, microeconomic reform is intended to improve efficiency and increase the returns on investments to owners of assets – this means that its benefits tend to flow to wealthier asset owners, while its costs tend to be felt most by lower income earners. One of the challenges for governments that undertake microeconomic reform is to implement in such a way that they do not increase inequality – microeconomic reforms are often accompanied by structural adjustment packages to compensate for the hardship that lower income groups may experience as a result of the reforms – e.g. welfare recipients received a compensation package after the introduction of the GST in 2000, while lower income earners are expected to receive compensation for higher energy costs following the introduction of the planned emissions trading scheme scheduled to commence in 2011. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3.6 Environmental Management In recent decades, environmental issues have assumed greater prominence within the study of economics and have had greater influence on policy decisions by governments and international organisations. While in the past, economics and economic policy have concentrated on traditional issues such as output, employment and prices, consideration of the environmental consequences of economic development is now of central concern to many individuals, businesses and governments. Economic growth and development have led both to higher standards of living and increasing concerns about the impact of humans on the environment they live in. While prioritising environmental concerns can involve economic costs, sustainable economic growth in the longer term depends on a healthy environment, and in recent decades, environmental issues have been incorporated into economic theory with the emergence of environmental economics which is based on the argument that there are ecological limits to economic activity. Ecologically Sustainable Development Ecologically sustainable development involves conserving and enhancing the community’s resources so that ecological processes and quality of life are maintained. It is a level of economic activity which is compatible with the long-term preservation of the environment, rather than merely the maximum level of growth possible in the short-term. Key principles of ecologically sustainable development are: o Intergenerational equity – using resources in a way that will not compromise the ability of future generations to meet their own needs and that will not limit their quality of life – this involves preserving renewable resources and rationing non-renewable resources. o The need to protect biodiversity – a precautionary approach is required where the environmental effects of an activity are uncertain but potentially very large and irreversible. DIAGRAM - The long-term impact of resource overuse on the possibility production frontier. Environmental concerns provide an additional dimension to the concept of sustainable economic growth overuse or exploitation of natural resources to achieve short-term growth can deplete these resources and permanently damage the environment, reducing the productivity of affected sectors of the economy. Achieving growth which is inconsistent with maintaining natural resources will thus lead to a fall in future potential output, especially in primary industries. The benefit of satisfying a greater number of material wants is diminished if it is accompanied by damage to the natural environment and depletion of natural resources – it also reduces the future economic growth potential of an economy by limiting its natural resources. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] DIAGRAM – The Trade-Off between Economic Growth and Environmental Quality This diagram illustrates how a trade-off may arise between economic growth and environmental quality by using a model of production possibility curves A and B, showing a combination of economic growth and environmental quality. Points 1 and 2 are feasible on Curve A: Point 1 yields a higher rate of economic growth (and current living standards) than Point 2, but at the expense of less environmental quality. If instead a society chose Point 2 instead of Point 1 on curve A, it would involve an opportunity cost of lower living standards in the present, by the enjoyment of higher levels of environmental quality. If there was an improvement in technology or higher productivity of existing resource use, the PPC would shift outwards from A to B and result in new combinations of economic growth and environmental quality. If society was able to move from Point 1 to Point 3, it could enjoy the same level of economic growth and living standards but more environmental quality (e.g. by preserving biodiversity and having cleaner air through less pollution by greenhouse gases). This would represent more ecologically sustainable development without a reduction in the rate of economic growth. On the other hand, if society chose to move from Point 1 to Point 4, a higher rate of economic growth could be experienced, but there would be no change in environmental quality. If the environment became more degraded because less resources were being devoted to environmental protection, the PPC A would shift to the left to curve C, as more natural resources are degraded, thereby limiting society’s future choices. This would represent ecologically unsustainable development. Private and Social Costs and Benefits – Market Failure Private costs are the costs of production paid by the firm involved in producing the product or the costs incurred by consumers in using part of their income to buy goods and services. Producing more of the product will see the firm’s total costs of production rise – the extra cost incurred to produce another product unit is the marginal cost. Private benefits include the profits made by producers in selling goods and services and the utility (satisfaction) gained by consumers from consuming goods and services to satisfy their own needs and wants. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Social costs refer to the costs imposed on or borne by society as a result of private actions – e.g. the externality caused by private production such as industrial output may be borne by the surrounding community as higher pollution. In a modern market economy, decisions about what good swill be produced, in what quantities and the prices at which they will be sold are determined by the price mechanism, involving the interactions between supply and demand to reach an equilibrium price and quantity of production. Thus, market outcomes reflect a balance between consumer preferences (as represented by consumer DEMAND) and the costs of producing output (as represented by the firm’s SUPPLY schedule). However, market failure occurs when the price mechanism takes into account the private benefits and costs of production to consumers and producers but fails to take into account indirect or external costs called social costs which are borne by the entire society such as damage to the environment and are not included in the price decision of the free market. One of the main economic problems that lies behind the market’s failure to account for the environmental impacts of production is that in an economic system based on private property ownership, there is a lack of well-defined property rights associated with environmental resources such as oceans and the atmosphere – the price mechanism cannot determine a price or value for these resources, and they may be freely used without regard to their depletion. Therefore, the environment and other common resources can be destroyed through overuse, a market failure that is referred to as the tragedy of the commons (a situation where the failure of the market to assign costs to individuals leads to an overuse of resources such as the natural environment, which have no single owner). The price mechanism plays a limited role in protecting the environment by limiting the sales of depleted resources which do have a price – when environmental resources become scarce, the cost of natural resources increases, reducing the number of resources consumed. Therefore, if a large number of trees are cut down to be sold on the market, it will eventually become more expensive to supply them. However, this can only protect those resources which are sold in markets (such as minerals and timber) – the price mechanism plays no part in allocating environmental resources which can be used for free such as the use of the atmosphere to dispose of gases during the production process. DIAGRAM – Market failure The problem of market failure is illustrated by this demand and supply graph which shows the price mechanism, the interaction between supply and demand which determines the market price and quantity levels. Society’s supply curve, however, which takes into account all costs of production (including environmental and social costs) lies above the producer’s supply curve (which only considers private costs). 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, if social costs were accounted for, there would be a higher price and a lower quantity produced. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Public and Private Goods Private goods are goods that must be purchased by a person if the benefits from consuming this product are to be gained – private goods are therefore EXCLUDABLE as any individual not willing to or able to pay for the good is excluded from enjoying the benefits of the good or service and are excluded from the market. The consumption of a private good is also RIVAL, because it is no longer available for consumption once consumed by one person in the market – e.g. if a cake is purchased from a supermarket and eaten by one person, it cannot be consumed by another. Public goods are non-excludable (once public goods are provided, the producer cannot exclude consumers from enjoying the benefit of that good even if they are unwilling to pay) and non-rival (consumption of the good by one consumer does not reduce the quantity of the good available for other consumers to enjoy). Some public goods and services cannot be withheld from consumption due to the nature of their supply – e.g. if the government reduces pollution, there is no way of preventing people from enjoying the benefits of cleaner air. Examples of pure public goods include defence and public order (education, health services, transport and electricity are still excludable and rival and are therefore not pure public goods as there may be some private provision of these goods and services). Examples of impure public goods (the use of which is usually subject to congestion as only a limited number of consumers can enjoy the commodity before consumption possibilities begin to deteriorate) include beaches and national parks. These characteristics of public goods create the opportunity for free-riding behaviour – this occurs when consumers or businesses benefit from a good or service without having to pay for its production or maintenance and consequently, the good/service is likely to be under-supplied in relation to the total demand (e.g. a fishing company that benefits from clean oceans without paying the cost of cleaning up ocean pollution is free-riding behaviour). This free-rider problem can be regarded as market failure since free-riding prevents allocative efficiency and can lead to a less than optimum level of supply – it can be overcome by governments by introducing licensing and policing regulations. Due to this problem of free-riding, public goods tend to be provided by the government (public sector goods such as hospitals and train services). Not all public sector goods are public goods – train services for instance are provided by the government but they are not public goods because they are excludable (train guards can prevent you from rising for free). Major Environmental Issues 1. Preserving Natural Environments In the long-run, the economy cannot keep growing if the environment is degraded – environmental damage affects human health (higher levels of pollution) and restricts the availability of resources. The aim of taking active measures to preserve the natural environment is to avoid the social and economic problems that arise when the environment is not actively preserved. The preservation of the natural environment may include measures such as : o Restrictions on development in environmentally-sensitive areas (e.g. mining in national parks) – impose regulations on the use of these areas. o Requiring new plantation in areas where logging has occurred – state governments have needed to increase the priority given to preserving forests and ecosystems that support endangered species. o Controls over emissions of waste products – pollution of air and water are increasingly subject to controls which may be regulatory limits on waste disposal and charges for waste disposal. Awareness of the importance of environmental issues has been slow to develop in Australia and throughout the industrialised world – Australia protects about 10% of its total land area in the form of national parks compared with around 15% in the US and 24% in New Zealand. Australia has a poor record of preserving biodiversity despite being one of the six most biodiverse nations on the planet – in the past 200 years, 27 mammals have become extinct in Australia, one-third of the global total. The World Development Indicators 2009 publication reported that of surviving species in Australia, 623 animals and plants are listed as threatened with extinction. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Australia faces a number of specific problems that threaten the preservation of Australia’s natural environments: o Land and soil degradation – problems such as soil erosion, acidity and salinity have occurred particularly in farming areas which have been subject to overuse or mise – e.g. in the Murray-Darling Basin, water flows have been reduced to such an extent by agriculture and drought that the entire catchment is under threat. o Over-exploitation of resources by commercial development has led to a decline in some renewable and non-renewable stocks and environmental quality – e.g. logging in native forests and mining in national parks. This is known as resource depletion which can cause a reduction in the extent of biodiversity in some ecosystems. Governments often face significant problems in attempting to preserve the natural environment: o In the short-term, intervention is likely to result in reduced economic growth and an intervention in the price mechanism, that may cause higher prices or reduced supply. o Industries will face higher costs if they have to comply with rigorous environmental standards – in a highly competitive global economy, our environmental standards may make us less competitive as a place to do business compared with other countries with weaker environmental safeguards. As a result, Australia may miss out on opportunities that would lift economic growth and exports – in addition, groups that represent affected industries (such as farming, mining and construction) may try to lobby governments to prevent strict environmental protection policies. o The cost of repairing damage to the environment is often borne by tax payers rather than those who have caused the environmental damage – e.g. the 2008-09 Budget introduced a number of policies and additional funding for preserving the natural environments such as the $2.6 billion “Caring for Our Country” package – this policy aims to protect the Great Barrier Reef, protect fragile ecosystems and fight the spread of cane toads. 2. Depletion of Renewable and Non-Renewable Resources The depletion of natural resources is an environmental and economic problem – without intervention, the market is likely to fail in this area and allow important resources to be overused. o Renewable resources can naturally regenerate or replace themselves in a relatively short period of time – however, the main issue that arises with the exploitation of renewable resources is that they may be depleted to the point where they become non-renewable and are lost forever (e.g. overfishing of a species of fish may cause the numbers to fall to a level at which the species cannot reproduce and become extinct). o Non-renewable resources are those natural resources that are limited in supply because they can only be replenished over a long period of time, or cannot be replenished at all – these include fossil fuels such as petroleum and coal and minerals such as copper/iron ore. The existing supply of these resources can be exhausted but not added to, so the consumption of non-renewable resources needs to be carefully managed so as to minimise waste – improvements in technology may lead to more efficient usage. The impact of natural resource depletion is greatest on future generations – the aim of sustainable resource management is to ensure that the present generation does not over-consume the stocks of renewable resources and minimises depletion of nonrenewable resources, or at least ensures that new technology makes alternative resource use possible. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 3. Controlling Pollution Pollution occurs when the natural environment is degraded in some way such as by harmful chemical substances, noise and untreated rubbish – it imposes costs on society including health costs, loss of value to the environment and a loss of recreational facilities. Firms essentially pollute because in doing so, they are able to pass on some of their production costs to others – if a chemical plant disposes of its waste products by dumping them into a river, the firm is in effect transferring part of its costs of production onto others who will bear the ill-effects of the pollution. One of the best known global pollution problems is the depletion of the ozone layer – to reduce this problem, an international agreement was finalised in 1987, committing all nations to the goal of reversing the depletion of the ozone layer (the Montreal Protocol of 1987) committed members to phasing out production of ozone depleting substances. The problem seems to be coming under control through collective efforts, as data from the World Meteorological Organisation shows that the hole in the ozone layer has shrunk by 15% in recent years. It has been estimated the ozone layer will recover to its 1980 levels by 2068. Within individual countries, governments can also implement policies to reduce pollution – they can introduce laws banning environmentally damaging production techniques, quotas to restrict the emission of harmful pollutants, subsidies to encourage environmentally friendly practices and taxes to discourage some forms of economic activity. Taxes are particularly favourable to governments because they reduce production and consumption and raise government revenue that can be used to cover the costs of repairing environmental damage. One method of reducing pollution is the use of a tax on pollution – economists argued that the divergence between social and private costs could be corrected by a tax on pollution to achieve an optimum allocation of resources and maximise society’s welfare. If a tax is imposed on a polluting firm (the vertical distance between the MPC and MSC curves) this will raise the firm’s costs of production and lead to a higher equilibrium price (P 1) and a lower quantity of output (Q1). HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] 4. Externalities Externalities are the social and environmental costs associated with economic activity which are not reflected in the private costs of production – they represent the costs and benefits that affect society as a whole, but that are not accounted for by the price mechanism. They are generally not dealt with by those responsible for them, but passed on to other members of society. Negative externalities are unintended negative outcomes or adverse spillover effects of an economic activity whose cost is not reflected in the operation of the price mechanism – goods and services that have negative externalities are demerit goods. Positive externalities are unintended positive outcomes or beneficial spillover effects of an economic activity whose value is not reflected in the operation of the price mechanism – goods and services that have positive externalities are merit goods. Although production does not usually generate positive environmental outcomes, it can create other beneficial spillover effects for society. Example: A company may decide to reduce its freight costs by transporting its goods by road rather than by rail. The use of semitrailer trucks may result in substantial damage to roads in that area and also add to noise and air pollution. This may cause damage to cars because of pot holes, loose stones and increased risk of accidents, discomfort through noise levels of trucks, and respiratory problems from worsened air quality. In this situation, the company generates a negative externality because society bears the cost of the damage to the roads, the noise and the air pollution. However, although the use of the truck will create negative externalities, they may also provide new job opportunities for small business people operating trucks as well as increasing demand for food from roadside diners, which are positive externalities. Negative externalities – in this diagram, the costs of production are borne by the producer and are represented by the producer’s supply curve. Negative externalities that are borne by the whole society, however, are an additional cost on top of the producer’s costs. If we add the producer costs (private costs) and social costs together for each level of output, we can plot the supply curve for the WHOLE of society – S (social cost) which lies above the normal supply curve. The vertical distance between the two supply curves is the size of the negative externality. Positive externalities – in this diagram, the consumers’ demand curve is based on the individual benefits of consumption. If we add the social benefits, we can plot the demand curve for the WHOLE of society – D (social benefit), which lies above the normal demand curve. The vertical distance between the two demand curves is the size of the positive externality. The market will only take into account private costs and benefits of production, resulting in a price of pm and an output level of qs, highlighting that goods and services with negative externalities tend to be overproduced. The market will only take into account private costs and benefits of production, resulting in a price of pm and an output level of qm. if the positive externality were enjoyed by the producer of consumer, however, price would rise to ps, reflecting the higher value of the good’s production – output would rise to qs, showing that goods and services with positive externalities tend to be under-produced. Positive externalities are the opposite of negative externalities in that they are benefits of production not enjoyed by individual consumers. For example, while buying an efficient refrigerator will reduce a household’s energy bill, it will also reduce energy consumption and the emissions of carbon dioxide – a benefit for the whole society. HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] Government Policies and Environmental Management In recent years, environmental management has emerged as an increasingly important issue for policymakers worldwide – however, environmental issues have tended to play a secondary role to economic objectives such as increased economic growth and higher living standards. The benefits of long-term environmental policies are less apparent than the benefits of higher living standards. Government policies can influence environmental management by discouraging environmentally harmful activities, and providing incentives for firms and individuals to act in an environmentally responsible manner. Governments will often use a combination of regulatory or command/control regimes (legislation, zoning and licensing, pollution laws and standards for individuals and firms to comply with), as well as market-based economic instruments (including taxes, pricing policies, taxation incentives and trade pollution permits). The Australian Government is a signatory to global environmental conventions such as the Montreal Protocol to limit CFC emissions and the Kyoto Protocol to limit CO2 emissions. In recent budgets, the Rudd Government has announced a number of initiatives to manage climate change – a renewable energy target was devised in 2008, a target which attempts to ensure that 20% of Australia’s electricity supply is generated from renewable sources by 2020. A national water policy framework was introduced in the 2008-09 Budget, recognising the significant urban and rural water challenges facing Australia with a desalination plan to invest in water recycling and initiatives to encourage household water saving measures. The Rudd Government had announced an Emissions Trading Scheme as a key mechanism for achieving a reduction in carbon emissions in a cost-effective and flexible way. The Carbon Pollution Reduction Scheme under which this ETS was suggested was seen as the most efficient method of reducing carbon emissions, as alternative non-market based approaches such as regulation or command/control policies would impose higher costs on the community because they would not utilise market mechanisms to encourage low cost technologies to reduce carbon pollution. However, the Rudd Government recently announced that the ETS and CPRS would be delayed until at least 2013. A ban on the production of a particular good or service is the most extreme action a government can take to achieve improved environmental management – for example, since 2002 it has been illegal to sell leaded petrol in Australia, and motorists who formerly used leaded petrol must use lead replacement petrol instead. o Banning a product will eliminate all externalities associated with its use, to the extent that its use can be stopped – however, it can also impose significant costs on firms and individuals, particularly those whose EMPLOYMENT depends on the production of this product. Consequently, governments generally only consider this option of banning a product if this product is causing severe environmental or social damage or where a suitable substitute product exists – for instance, to help reduce energy consumption, the Federal Government introduced new standards for lighting in 2007 that will see incandescent light bulbs gradually phased out and eventually replaced by more energy-efficient fluorescent light-bulbs. The imposition of a tax on the production or use of a particular product is a less extreme government measure to reduce the consumption of a particular good or service – for example, the Commonwealth Government imposes a tax on petrol of 38 cents per litre. These taxes aim to internalise the externalities associated with a particular economic activity, i.e. they require firms and individuals that cause the externality to pay for some, or all, of its costs – for instance, a tax on petrol forces the owners of motor vehicles to pay some of the costs associated with air pollution and road maintenance. Market mechanisms such as issuing permits for an activity and allowing those permits to be bought and sold in open markets is another measure governments can take to control the consumption of natural resources or restrict environmentally harmful activities in Australia. Policies to encourage firms and individuals to use more environmentally-friendly goods and services can be introduced – for example, State Governments in Australia provide subsidized public transport services such as buses, trains and ferries to offer individuals an alternative to motor vehicles. Government funding is also used to accelerate the introduction HSC 2010 [ECONOMICS NOTES – TOPIC 3: ECONOMIC ISSUES ] of new technologies that have environmental benefits but high establishment costs – for instance, in the 2009-10 Budget the Government announced subsidies for installation of home insulation that aimed to reach 2.2 million homes. In recent years, governments have shifted towards solutions that use market mechanisms to address environmental issues – they have attempted to use taxes and subsidies rather than outright bans or the provision of public goods to achieve environmental objectives. However, just as most environmental problems take years, or even decades, to emerge, most solutions to those problems also take many years to have their impact – this can result in governments putting off dealing with environmental problems in favour of shorter term priorities.