In the long term, the growth of Australia’s foreign debt can lead to debt sustainability problem. This means that it becomes increasingly difficult for Australia to service its foreign debts, and if the size of the debt rises faster than GDP, the interest payments on the debt will progressively take up a greater proportion of our GDP. This reduces both Australia’s overall standard of living and the economic growth potential of the economy. Further, international financial markets generally consider that a high foreign debt can become a significant risk to an economy’s future performance. If market suspect the level of debt may become unsustainable for the debtor country, they may reduce the country’s international credit rating (which reflects confidence that world financial markets have in that country). 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.
The CAD is further worsened as a result of Australia’s low rate of savings. To make of for this lack of savings, Australia borrows from overseas and utilised foreign savings to fund projects. This implies that the CAD is not so much of a problem if revenue from these developments can service the debt in the future. The Pitchford thesis argues that is the CAD and foreign liabilities are caused mainly by the private sector then there is no need for concern.
Achieving external stability has times been the most important objective of economic policy in Australia. On some occasions policy settings have been changed primary with the objective of restraining the growth of the current account and foreign liabilities.
The tightening of both fiscal and monetary policy in the late 1980s was implemented with the aim of reducing consumption and investment; reducing the CAD and also putting downward pressure on the relatively high inflation that was hurting international competitiveness of Australia products.
The implementation of microeconomic reform policies from the late 1980s was aimed at lifting the efficiency and international competitiveness of Australian producers in order to improve their performance on world markets.
However, in more recent years, external stability has not been a major objective of macroeconomic policy. While both the commonwealth treasury and the Reserve Bank continue to monitor the level of the current account deficit, the foreign debt, and 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 economists and policy makers, that CAD’s and foreign debt reflects the decision of the private sector and do not require policy change by government. The declining importance of external stability issues has also occurred because Australia 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 past targeted external stability, they have generally been ineffective.
External stability issues are now addressed through the general framework, which is designed to promote the international competitiveness of the Australian economy, to increase exports; to encourage savings by households and businesses, to contain the growth of foreign debt and maintaining international investor confidence in the Australian economy and its financial institutions, to reduce fluctuations in the value of the exchange rate.
Maintaining low inflation is major objective of economic policy because the benefits of lower inflation provides to the economy in the long term. Australia has enjoyed relatively low levels of inflation since the early 1990s because inflation overseas has been lower and economic policies have placed a high priority on the objective of low inflation.
The annual rate of inflation is calculated by the percentage change in CPI over the year.
Inflation rate (%) = CPIcy – CPIpy x 100
CPIpy 1
Consumer Price Index is the movement in prices of goods and services according to their significance for the average Australian household.
Economist generally recognise four main causes of inflation
-Demand pull: In a market economy, prices are determined by the interaction of demand and supply in the market place. When aggregate demand or spending exceeds the productive capacity of the economy, prices rise as output cannot expand any further in the short term. Consumers then force up prices by bidding against each other for the limited goods and services available.
Cost push inflation is caused by an increase in the cost of the factors of productions. When production cost rise, firms attempts to pass them to consumers by raising the prices of their products in order to maintain their profit margins.
Inflationary expectations arise when individuals in the economy expect higher inflation in the future, and act in a way that causes an increase in inflation.
Imported inflation is the type of inflation transferred to Australia through international transactions. The most obvious cause of imported inflation is rising import prices. AN increase in the price of imported goods will increased the inflation rate as it cost more for producers to purchase these goods and survives and they may attempt to pass on prices to consumers to maintain profits.
The higher the level of inflation the more severe the consequences. As a result, government around the world have placed a strong emphasis on sustaining low inflation in recent years to avoid the negative consequences which high inflation brings. Inflation is the main constraint on economic growth as excessive economic growth tends to raise inflationary pressures through increased wage demands and through strong consumer demand, bidding up price levels. In overall terms, higher inflation distorts economic decisions since producers and consumers change their spending and investment decisions in order to minimise the effect of inflation on themselves such as spending their disposable income in period of high inflation, because the purchasing power of their money is reduce over time.
The level of inflation is major influence on nominal wage demands as during periods of high inflation, employees will seek larger wages increases in order to be compensated for the erosion in the purchasing power of their nominal wages. This can lead to the emergence of wage price inflationary spiral that is very difficult to break where higher wages lead to higher prices, which lead to higher wage demands and so on.
Income distribution have tended to be negatively affected by high inflation as lower incomes earners often find that their incomes do not rise as quickly as prices. In addition, lower income earners may face higher interest rates on their borrowing if inflation rises. In general, high rates of inflation hurt those individuals who are on fixed incomes or whose incomes are not indexed to the rate of inflation. Higher inflation rates can also erode the value of existing savings so individuals who do not have the means of protecting their savings from the impact of inflation will see their net wealth decline.
High inflation results in increased prices for Australia’s exports, reducing international competitiveness and quantity exports. As the prices domestic goods increase, consumers will also be more likely to switch to import substitutes, worsening the deficit. By contrast, low inflation will improve international competitiveness, as well as making it more attractive for other countries to purchase Australia’s goods and services.
In the short term, high inflation may result in an appreciation of the exchange rate as spectators expect the Reserve Bank to raise interest rates in response, attracting greater financial flows. However, high inflation may be expected to cause the currency to depreciate overtime. In general, economies with high inflation levels experience a decline in the value of their currency. Over the long term, sustained low inflation may foster greater international confidence on the Australian economy, strengthening the value of the dollar.
Lower inflation normally brings about reductions in nominal interest rates, since nominal interest rates are based on a real rate if return (or real interest rate) plus inflation. Higher inflation usually results in higher interest rates, as the Reserve back tries to reduce demand pressures in the economy and avoid the negative consequences of a high inflation.
Monetary policy has been the main tool used to achieve low inflation, but occasionally other parts of the policy mix are used to address price pressures in the economy. In the short to medium term, monetary policy is the major tool used to reduce inflation and it attempts to sustain growth at a level that does not create excessive inflationary pressures. If inflation starts to rise, the RBA is able to increase interest rate throughout the economy by tightening monetary policy. This has the effect of dampening consumer and investment spending, resulting in a lower level of economic activity and therefore, lowering inflation.
The RBA has also used pre emptive monetary policy by taking action against inflation before it emerges as a problem. The RBA generally aims to increase interest rates before inflationary reaches to the top of the target band. The Reserve has also attempted to make use of monetary policy predictable by emphasising consistently its intention to use monetary policy predictable by emphasising consistently its intention to use monetary policy primarily to ensure that inflation remains within the target band, effectively lowering inflationary expectations and thus further reducing inflation an s problem in the economy.
Fiscal policy can also play a role in maintaining low inflation. If the government increases revenue and decreases spending, this reduces demand pressures in the economy and can reduce demand pull inflation. Fiscal policy settings that support low inflation objective may also reduce the need for higher interest rates to combat an inflation challenge.
Reduced protection is a microeconomic policy which has helped reduce inflation over the years, as it lowers the price of imports and increases the competition faced by domestic producers from both overseas competitors and from new entrants into domestic markets. This makes it more difficult for domestic producers to raise their prices. In addition, reforms to the labour market attempt to ensure that wage increases are linked to productivity improvements. Of productivity rises, the economy will be able to afford real wage increases without inflationary pressures. Finally, government has argued that its greater spending on economic infrastructure such a roads, railways and ports in coming years is necessary to reduce to capacity constraints faced by business that increase production costs and contribute to inflation.
