Download economics notes – topic 3: economic issues

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[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
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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
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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).
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 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.
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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.
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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).
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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.
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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.
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 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.
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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.
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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.
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 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
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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
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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.
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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.
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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.
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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
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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%.
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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.
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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
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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.
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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.
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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.
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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.
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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).
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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
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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.
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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,
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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.
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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).
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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
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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.
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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’).
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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.
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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
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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.
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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
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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
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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.
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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
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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
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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.
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 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.
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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.
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 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.
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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
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[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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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-
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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.
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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.
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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.
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(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.
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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.
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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.
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 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.
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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.
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 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.
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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).
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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.
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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
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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.