Topic Two

Question 1

What is the Balance of Payments?

Answer 1

the balance of payments records the transactions between Australia and the rest of the world. It consists of the current account (usually in deficit) and the capital & financial account (usually in surplus)

Question 2

What is the Current Account?

Answer 2

The current account shows the money flow from all exports and imports of goods services, income flows and non-market transfers for a period of a year. Transactions are non-reversible.

Question 3

What is the formula used to calculate the current account balance?

Answer 3

CAB = BOGS + net primary income + net secondary income

Question 4

What are net goods on the current account?

Answer 4

This refers to the difference between what Australia receives for its export of goods and pays out for its import of goods.

Question 5

What is net secondary income on the current account?

Answer 5

This refers to non-market transfers, meaning income not earned through a factor of production. These occur when products or financial resources are provided without a return. An example includes funds taken out of Australia in the form of unconditional aid to developing nations.

Question 6

What is the capital and financial account?

Answer 6

Records the borrowing, lending, sales and purchases of assets between Australia and the world. They are reversible transactions.

Question 7

What is the capital account?

Answer 7

A country’s capital account refers to any and all international capital transfers. This account captures the inflow or outflow of money once the initial investment has taken place. The capital account has two components, they are:

Capital transfers - conditional foreign aid grants, debt forgiveness and debt cancellation.
Purchase and sale of non-produced, non-financial assets - intellectual property rights such as patents, copyrights, trademarks and franchises.

Question 8

What are some links between key BOP categories?

Answer 8

The deficit on the current account is equal to the surplus on the capital and financial account.
An increase in the current account deficit (CAD) will result in a rise in the capital and financial account surplus.
In the longer term, a capital and financial account surplus will result in a larger deficit on the net primary income account. This is because any foreign financial flow that comes into Australia must earn some kind of return for its owner, and these earnings are a debit recorded on the net primary income account.
The sum of all transactions recorded in the balance of payments must be zero. The reason is, every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa.

Question 9

What are the cyclical factors that affect the trends in the balance on goods and services?

Answer 9

Exchange rate - Movements in the exchange rate affect the international competitiveness of Australia’s exports and the relative price of the goods and services that Australia imports. Depreciation decreases the foreign currency price of Australia’s exports, increasing the international competitiveness of Australian exports in the world market.
Terms of trade - The terms of trade shows the relationship between the prices Australia receives for its exports and the prices it pays for its imports. An improvement in the terms of trade means that the same volume of exports can buy more imports.
Domestic economic growth - The level of domestic economic growth also influences the BOGS balance by affecting demand for imports. An upturn in the domestic business cycle results in increased business investment and higher disposable income, leading to higher consumption.
The international business cycle - Changes in the international business cycle impact on the BOGS by affecting the demand for Australia’s exports. A slow down in global economic growth and weaker growth in Australia’s key regional trading partners both reduce growth in demand for Australia’s exports, worsening the BOGS.

Question 10

What are the structural factors that affect the trends in the balance on goods and services?

Answer 10

Narrow export base - Australia has a narrow export base, exports are heavily weighted towards primary commodities - their comparative advantage lies within low value-added products. BOGS has tended to be in a deficit rather than surplus as import payments very often outweigh export revenues

Question 11

What are the consequences of a high CAD?

Answer 11

The growth of foreign liabilities - A CAD implies financial inflow on the cap/fin account, either in the form of foreign debt or equity. This will mean lenders become reluctant to lend to or invest in Australia.
Increased servicing costs - Increased servicing costs associated with high levels of foreign liabilities lead to larger outflows on the net primary income account, worsening the CAD. Foreign debt must be serviced through interest repayments that vary according to the level of domestic/overseas interest rates, and profits must be returned on foreign equity investment.
Increased volatility for exchange rates - High CAD may undermine the confidence of overseas investors in the Australian economy and in turn, reducing demand for Australia’s currency may result in a depreciation of $AU.

Question 12

What happened to Australia’s exchange rate system in 1983?

Answer 12

In Dec 1983 Australia switched from a managed flexible peg to a floating exchange rate system.

Question 13

What is the Trade Weighted Index?

Answer 13

The Trade Weighted Index (TWI) gives an indication of how the value of A$ is moving against all currencies in general. The TWI is a measure of the value of the Aus dollar against a basket of foreign currencies of major trading partners. These currencies are weighted according to their significance to Aus trade flows.

Question 14

What are some factors affecting the demand for Aus $?

Answer 14

Level of Aus interest rates relative to those overseas; higher domestic interest rates makes Aus a more attractive location for foreign investment, increasing demand for A$.

Future expectations of an appreciation of AUD will increase current demand for A$ by speculators, thus contributing to the expected appreciation.

The demand for Aus exports, determined by international competitiveness, global economic conditions as well as tastes and preferences of overseas consumers. E.g if China experiences strong economic growth their demand for Aus exports increase. They must convert their currency to AUD in order to pay Aus exporters, increasing demand for A$.

Question 15

What are some factors affecting the supply for Aus $?

Answer 15

Level of Aus interest rates relative to those overseas; lower domestic interest rates discourage foreign investment and therefore contribute to a lack of demand for A$.

Future expectations of a depreciation of AUD; speculators in the FOREX market who expect the value of A$ to go down will sell it, increasing the supply and thus contributing to the anticipated depreciation.

Question 16

What are the main factors that cause an appreciation in AUD?

Answer 16

Increased demand for australian exports due to stringer world economic growth
An increase in Aus interest rates or decrease in overseas interest rates
Future expectations of a currency appreciation

Question 17

What are the main factors that cause a depreciation in AUD?

Answer 17

A decrease in Aus interest rate or increase in overseas interest rate
Deterioration in investment opportunities in Aus or improvement in foreign investment opportunities
A deterioration in Aus international competitiveness
Increased demand for imported goods and services
Future expectations of a currency (depreciation)

Question 18

What is a fixed exchange rate?

Answer 18

Under a fixed exchange rate system, the Gov or RBA officially set the exchange rate - that is, it would not be left up to the forces of supply and demand. The Gov/RBA can attempt to maintain a fixed exchange rate by either buying or sell foreign currency in exchange for A$.

Question 19

What is a managed flexible peg exchange rate?

Answer 19

Under this system, the RBA would “peg” the value of the A$ at 9am each day and that price would operate throughout that day. A flexible peg system provides more flexibility than the fully fixed rate, but it can still allow the official rate to drift away from that which would exist under pure market forces. Large degree of speculation

Question 20

How does the RBA may influence the exchange rate

Answer 20

When the RBA feels a significant short-term change in the exchange rate - often due to excessive speculation - it may decide to step into the FOREX market, as either a buyer or seller in order to stabilise the AUD. The RBA’s ability to directly intervene through buying A$ is limited to the size of its foreign currency holdings.

Question 21

What are the positive effects of an appreciation in A$?

Answer 21

Australian consumers enjoy increase ‘purchasing power’ - they can buy more overseas produced goods with the same quantity of A$.
An appreciation decreases the interest servicing costs on foreign debt. This would reduce outflow on the net prim income component of the CA in future years and help reduce the CAD.
An appreciation will reduce the $A value of foreign debt that has been borrowed in foreign currency - valuation effect
Inflationary pressures in Aus will be reduced as imports become cheaper. This is likely to reduce pressure on the RBA to raise the interest rate to defend its inflation target.

Question 22

What are the negative effects of an appreciation in A$?

Answer 22

By increasing the value of $A in terms of other currencies, Aus exports become more expensive on world markets and therefore more difficult to sell, leading to a decrease in export income and deterioration in the CAD.
Imports will be less expensive, encouraging import spending and worsening the CAD.
Foreign investors will find it more expensive to invest in Aus, leading to lower financial inflows.
An appreciation reduces the $A value of foreign income earned on Aus investments abroad and would cause a deterioration in the net prim income component of the CA.
An appreciation will reduce the value of foreign assets in Aus dollar terms - valuation effect

Question 23

What are the positive effects of a depreciation in A$?

Answer 23

by decreasing the value of A$ in terms of other currencies, Aus exports become cheaper on world markets and therefore easier to sell, leading to an increase in export income and an improvement in CAD.
Imports will be more expensive, discouraging import spending and potentially improving CAD.
Lower import spending and greater export revenue will increase Aus growth rate but this may not happen if Aus is unable to replace its imports with domestically produced goods.
A depreciation will increase the value of foreign assets in Aus dollar terms - valuation effect
Foreigners will find it less expensive to invest in Aus, generally leading to greater financial inflows.

Question 24

What are the negative effects of a depreciation in A$?

Answer 24

Aus consumers suffer reduced ‘purchasing power’ - they can buy fewer overseas produced goods with the same quantity of A$.
A depreciation increases the interest servicing costs on Aus foreign debt, as less overseas dollars can be bought with domestic currency. This increases income outflow on the net income component on the current account and thus increases the CAD - foreign equity
A depreciation will also raise the A$ level of foreign debt that has been borrowed in foreign currency as expressed in Aus dollar terms - valuation effect
Inflationary pressure in Aus will increase as imports would now be more expensive. This may increase pressure on the RBA to raise interest rates to defend its inflation target.

Question 25

NSY (Net secondary income)

Answer 25

refers to non market tranfers (i.e. when financial resources are provided without returning a good or service)

Question 26

Capital account

Answer 26

consists of two main componets:

a) purchase and ale of non financial assets (intellectual property, rights (i.e. patients, copyrights)
b) capital transfers (conditional foreign aid, debt forgiveness)

Question 27

Australia has a comparative advantage in:

Answer 27

• commodities (e.g: iron ore, coal, natural gas, and gold, which make up approximately 30% of exports).
• Agricultural products (e.g: wheat, beef and wool)
• Services (e.g. tertiary education and inbound tourism)
• Australia also manufactures some niche, sophisticated products including medical equipment, pharmaceuticals, processed food.
• Australia is sometimes criticised for having a narrow export base.

Question 28

Direct investment

Answer 28

> (greater than) 10% long term ownership of Australian assets (shares). It also includes setting up of new companies.

Question 29

portfolio investment

Answer 29

< (less than ) 10% ownership of Australian assets- smaller shareholdings in companies. Also include loans to companies. (more speculative and volatile)

Question 30

Cyclical factors affecting BOGS

Answer 30

The volatility of the exchange rate impacts domestic and international demand levels, both affecting trade and investment (BOGS and primary income (NPY)

The terms of trade directly affect the BOGS. For example, an improved TOT may improve the trade balance and CA.

Favourable economic conditions domestically affect foreign investment (KAFA surplus) and may cause an increase in foreign liabilities (CA deficit). The opposite is true for economic downturns)

Favourable global conditions and confidence will generally be reflected by an increase in export volumes and foreign investment into Australia which may cause an increased CAD, due to increased credits in the KAFA. The opposite is true for a downturn in the international business cycle. For example, this was seen in early 2020 where the international business cycle was negatively affected by the COVID-19 pandemic and foreign liabilities in Australia decreased.

Question 31

structural factors affecting BOP

Answer 31

Australia is an attractive, open and safe economy: This is a major factor that affects the general trend of Australia’s persistent CADs, as Australia is a recipient of high volumes of FDI, which is recorded as a credit on the KAFA and debit on the CA.

Dependence on low-value exports: Such as mining products (e.g. iron ore). This impacts the BOGS, as exports are subject to changes in commodity prices, which can cause volatility in Australia’s balance and the BOGS.

Dependence on high-value imports; This impacts the BOGS, as high-value imports (e.g. electrical goods, technology) are subject to changes in domestic consumer confidence. Hence, in times of strong domestic. Growth, these imports may increase in volume and worsen the trade balance and BOGS. The opposite is true for economic downturns domestically.

Cuts in protection: Such as tariffs for local industries over the last 30. Years have allowed for greater volumes of trade and has increased the size of BOP.

Low rate of domestic savings: Savings are sourced from overseas to fund the level of investment (saving-investment gap). This is recorded as a credit on the KAFA, and a debit in the CA (outflow from the NPY, in the form of interest repayments). The household savings ratio in Australia averages about 3-4%. However, in early 2020 this ratio increased to 5.5% due to anticipated contractions in the economy and decreased consumer confidence.

Question 32

Easings of MP stance

Answer 32

Prior 2020, there were 8 easings (also of -0.25%) in the stance of monetary policy between November 2011 and May 2014. This gives a total of 18 easing’s (-0.25% or less ) cuts in the cash rate during the current monetary policy easing cycle (November 2011 – November 2020).

Question 33

Depreciation and appreciation of the AUD during 2020

Answer 33

After falling to a 17-year low on March 20 of US55.10c (TWI 54.7), the Australian dollar had recovered to US63.14c (TWI 56.2) by April 22. The renewed strength of the AUD was largely sourced to continued strong iron ore prices due to China’s sustained demand following its economic recovery. Iron ore has been trading above $US 100 a tonne since May and reached a 12 year high (in Australian dollar terms) in December. Also, the continued weakness in Brazilian output since the COVID 19 pandemic hit its economy was a contributing factor here. The strengthening balance of payments position for the Australian economy was another critical factor behind the underlying strength of the AUD despite the global shock created by the COVID 19 pandemic.

Question 34

export growth from mining

Answer 34

From 2005 to 2011 the Australian mining industry (gross value added) grew by about 85%. This was by value measured in Australian Dollars. During the same period the value of Australian GDP grew 41%. Exports of the mining industry’s products – principally iron ore and coal – grew by 100% in value.

Question 35

Protection definition

Answer 35

Protection refers to any type of government action that has the effect of giving domestic producers an artificial advantage over foreign competitors.

Question 36

Change in protection in 1973

Answer 36

Over the past 30 years, the Australian government has removed many protective barriers on various industries such as manufacturing. In 1973 there was a 25% unilateral reduction of protectionist policies by the Whitlam Government. This aimed to promote structural change to increase efficiency, productivity, and competition in the Australian government.

Question 37

Average tariff levels

Answer 37

From 1995-2019, there has been a decrease in the average tariff level in Australia from 9% to 0.8%. The volume of exports has increased by 8.6% and has increased Australia’s GDP by approximately $4 billion, according to the productivity commission in 2015.

Question 38

What protection still remains in Australia

Answer 38

Some subsidies remain. For example, the Australian government subsidises farmers to increase international competitiveness as food prices can be volatile, especially after natural disasters.

Question 39

Bilateral agreements: ChAFTA

Answer 39

a. Aims to increase tariff free exports from 86% to 98%
b. Significant as China is the world’s second largest economy and will continue to be one of the greatest drivers of global economic growth in the future
c. Aus has been granted increased access to financial, professional and educational service providers.
d. This is significant as China is Australia’s largest market for education exports
e. However, some critics have argued this FTA may result in an inflow of Chinese workers, replacing domestic workers. This could even further constrain record low wage growth in the Australian economy and continue to increase labour underutilisation and underemployment.

Question 40

bilateral agreement: AUSFTA – Aus/US

Answer 40

a. Has involved reduced tariffs, particularly on agricultural products and manufacturing
b. In 2004, only 46% of imports entering Australia from the US were tariff free, this has risen to 90% as of 2014.
c. US accounts for 8.3% of Australia’s two-way trade, making it Australia’s 3rd largest trading partner and making this deal significant for Australia’s economy
d. Two way trade between Aus and US increased from $41b to $60b from 2004 (year before implementation) to 2014, signalling significant increase in Australia’s export growth as a result of this agreement
e. Two-way investment has also doubled from around $642b in 2004 to $1.3 trillion in 2014, with the US being the number one investor in Australia and the US being the number one source of Australian investment abroad.

Question 41

Multilateral agreements/international organisations

WTO

Answer 41

a. Australia’s most important FTA as it has 162 member countries, all of which must abide WTO rules:
i. All WTO members must be granted the same trading conditions as members, such as equal trade concessions for all nations. This benefits a smaller economy such as Australia through preventing it from being cut off from favourable trading conditions between larger economies with more bargaining power in trade negotiations
ii. Conditions for imported goods and services are the same as for domestic goods and services
iii. Trade agreements must be made publicly available
b. Advocates for the removal of trade barriers, assisting Australia in reaching new export markets
c. WTO also assists in resolving trade disputes. This dispute resolution has benefitted Australia, for example in 2001 Australia successfully disputed illegal US import restrictions on lamb, providing economic benefit to agricultural exporters.

Question 42

Multilateral agreements/international organisations

APEC - Asian Pacific Economic Cooperation forum

Answer 42

a. Has 21 member countries, of which Australia is one.
b. Accounts for 44% of world trade.
c. Aims for trade liberalisation of region. This is beneficial for Australia as it allows Australia access to significant markets for trade, with APEC member countries accounting for 2/3 of Australia’s trade.

Question 43

Multilateral agreements/international organisations

TPP - 2016

Answer 43

a. 12 member countries around the Pacific Rim – Australia one of them
b. The TPP would have been significantly beneficial to Australia’s economic growth, as the member countries accounted for approximately one third of Australia’s exports and 44% of outward investment
c. Would have eliminated 98% of tariffs in the region
d. However, in January 2017 Trump exited the TPP in favour of implementing protectionist policies in the US.
e. China is now developing a rival trade agreement, the RCEP, which will allow for open trade around the Asia-Pacific region. This agreement consists of 13 member countries which together account for 60% of Australia’s two-way trade and 65% of goods and services exports.

Question 44

Multilateral agreements/international organisations

IMF

Answer 44

a. 188 member countries – note: Australia is a member country but the IMF is not particularly relevant as Australia is not in significant financial struggle
b. Aims to maintain financial stability
c. Promotes exchange rate stability through advocating for the use of a floating exchange rate
d. Grants emergency loans to countries experiencing balance of payment difficulties

Question 45

Multilateral agreements/international organisations

World bank

Answer 45

a. 189 member countries – Aus is one
b. Two goals
i. End extreme poverty
ii. Increase equality through fostering growth for the bottom 40% of every country
c. Provides soft loans with little/no rates of interest for developing countries in order to encourage economic growth, improving global levels of equality and assisting in maintaining financial stability

Question 46

Multilateral agreements/international organisations

OECD – Organisation for Economic Cooperation and Development

Answer 46

a. Conducts and publishes economic research on key economic issues in order to coordinate effective policy responses
b. Regarded as some of the most reliable and highest quality research in the world next to the IMF and World Bank

Question 47

Economic Forums: G20 and G7

Answer 47

a. Is the world’s leading economic forum and consists of 20 member states
b. Together these nations cover 2/3 of the world population, including developing countries and the EU
c. Objectives
i. Policy coordination for eco stability and growth
ii. Financial regulation to decrease risk of financial crises
iii. Creation of international financial architecture
If not on Aus, also include G7. Essentially does the same thing, but is losing power as world power shifts towards emerging and developing economies.