National Economy Policy Issues - Thesis Example

NATIONAL ECONOMY POLICY By Student’s Name Code+Name Course Professor Date National Economy Policy ‘Terms of trade’ is an important economic ratio, which refers to the proportion of prices of exports to prices of imports. It shows the ability of a particular amount of exports for a quantity of imports (Kohli 2004). An increase in terms of trade increases domestic real income as it enables a country to purchase additional imports for a set quantity of exports. Nonetheless, volatility in terms of trade usually stimulates volatility in economic growth, consumer spending, inflation, and investment (Berkmen 2009). Australia ‘terms of trade’ has two important components; composition of the import and export basket and world prices of Australia imports and exports. An increase in the terms of trade raises domestic real income through increasing the country exports purchasing power. A reduction in terms of trade level reduces domestic real income through reducing the country purchasing power of exports (Solow 2005). Consecutively, this has an impact throughout the economy to a point where it leads to changes in business profits, household spending, employment, and production. The ‘terms of trade’ changes – the relative values of Australia imports and exports- affects the real national income. Imports provide the country residents with access to products and services, which cannot be produced or cannot be cheaply produced in the domestic economy whereas exports enable a country to fund its purchase of imports and maintain income, domestic production, and employment levels1. The products and services, which encompass any country exports, are usually exceedingly diverse from the ones that make up the imports (Perotti 1999). For instance, in Australia a large percentage of exports consist of mining and agricultural products while manufactured products as well as some services make up the country imports. Between 1999 and 2009, the country terms of trade have experienced an unanticipated increase of 75%, revealing changes in both traded good and services composition and prices. In 2009 export prices increased by 86% and this increase was attributed to an increase in metal ores and coal, which reductions in prices of most imported manufactured goods helped in keeping the import prices down (ABS 2009a). The table and the chart below show the changes in terms of trade from 2002-2012. Year 2002/2003 2003/2004 2004/2005 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011 2011/2012 Terms of Trade 100 125 100 106 98.7 118.1 100.0 116.9 119.9 Terms of trade is obtained by measuring the relation between the prices a country acquires from goods and services that it is exporting and those that it pays for importing goods and services. It is determined by “dividing a country’s export price index by its import price index multiplied by 100 to express the terms of trade in percentages.” “Terms of Trade= Export Price Index/Import Price Index ×100” It is evident that since 2002, Australia has enjoyed less volatile and stronger terms of trade- this has reduced inflationary pressures, raised real incomes, and led to macroeconomic stability (Gillitzer & Kearns 2005). This positive combination has been supported by an efficient and more dynamic private sector in an environment of sound macroeconomic policy, increased internalization, as well as continuous microeconomic reform. Several factors have led to a relatively strong and more stable terms of trade. The first factor is Australia’s exports diversification across both markets and products. The second factor, which has strengthened terms of trade, is considerable fall in Australia imports prices, particular for information and communications technology (ICT) products. The Australian sound macroeconomic policy and microeconomic reform advancements have lead to good prospects in terms of trade volatility.2 The strong demand for minerals has also led to sharp increases in prices, which have pushed the country terms of trade higher. The increases in price have been spread across numerous commodity exports however coal and iron ore have made a particularly large contribution to an increase in terms of trade. Their prices increased by 100 to 180 percent in US dollars from mid-2007 to later 2010 when they constituted around one-quarter of Australian exports. From the later 2008, the country terms of trade reduced as commodity prices fell with the deterioration of financial and economic conditions. Australian exports earnings fell substantially during this period, although the export volumes were up, as the export prices declined sharply. From the second half of 2009, the bulk commodities prices rose sharply and caused the terms of trade to rise. Gillitzer and Kearns (2005) argue that Australian exports compositional changes have meant an increase in the average export prices in relation to world commodity prices. Generally, Australia has a good economic policy. Inflation targeting delivered stable inflation expectations and credible monetary policy expectations that consecutively allowed large reductions on nominal to lead to a considerable cut in real interest rate. The exchange rate floats freely and hence plays an important role as a shock absorber for external shocks (Becker & Mauro 2005). Part B A ‘terms of trade’ decline in Australia would negatively affect the balance of payments equilibrium as indicated in the ISLM-BP model3, the balance of payment would be less than zero as there would be a balance of payment deficit. There would be a rightward shift in LM to LM’ which would cause a new equilibrium F which would be below the balance of payment curve, hence leading to a deficit in balance of payments. A decline in terms of trade4 would negatively affect the Australian economy. High volatility levels in terms of trade would seriously disrupt the economy, increase economic growth rate volatility, and make macroeconomic policy quite hard to implement. The monetary personnel would also be at an increased risk of under- or over- estimating the contraction/stimulus needed to maintain stable and low inflation, which tends to increase inflation volatility, hence contributing more to the general economic instability5. A decline in terms of trade would also mean lower living standards as there would be a growth lag in employment movements, partly because of employers attempt to adjust their utilization of existing labor to meet demand fluctuations as they seek to shed employees. It would also undermine the domestic economy growth momentum (Magud & Fernandez 2010). A general decline in terms of trade would cause a general prices reduction of commodities relative to manufactured goods prices. The reduction in terms of trade would decrease domestic real income through reducing Australia’s exports purchasing power. In the long run, it would have flow on the effects throughout the economy to the point that it leads to a reduction in household spending, business investments, business profits, employment and production. Persistence volatility in terms of trade would destabilize the economy and affect economic effectiveness (Steigum & Thogersen 2003). For instance, producers and consumers might misdiagnose the duration and extent of changes in terms of trade. Effective resource movements might also be impeded due to misreading of price signals. This would inhibit both economic growth as well as productivity growth as there would be an impediment of free flow of resources to the utmost use. With the decline in terms of trade, companies would experience considerable costs arising from the high terms of trade instability. There would also be an increase in borrowing costs because the lenders would charge higher premiums in order to account for risks, whereas the instability might reduce the incentives for companies to invest (Aurelio 2005). The high volatility levels in terms of trade can hence disrupt an economy critically increasing the growth rate volatility and causing macroeconomic policy relatively more hard to implement. The higher volatility can cause an under-estimation or over-estimation of the contraction/stimulus needed to sustain stable and low inflation. This would increase inflation vitality, hence increasing the economic instability. The control and operation of fiscal policy might be likewise hard under such circumstances. The decline in terms of trade would be accompanied by significant unpredictability, with majority important movements relating to global economy slowdowns and changes in commodity prices (Cashin & McDermott 2002). Australia would be required to continue pursuing microeconomic reform and to maintain good macroeconomic policies to prevent a decline in terms of trade. This would entail providing quality education in order to improve human capital, promote labor market reforms, and reduce export costs through tax reforms (Allsopp & Vines 2005). Besides instituting measures for reducing Australia individual business costs, the support of sound economic policies throughout the world might add an additional dimension to the stability in terms of trade and eventually higher economic growth outside and within Australia (Cashin, Liang, & McDermott 2000). PART C A decline in terms of trade can negatively affect both the monetary policy and fiscal policy causing the country not to realize its macroeconomic policy6. The monetary policies usually affect asset markets whereas fiscal policies affect the goods market. The goods and assets markets are linked to each other through interest and output rates and hence the fiscal and monetary policies interact while influencing the interest rates and output (Bilbiie & Straub 2004). A decline in terms of trade would cause a negative supply shock would cause both monetary and fiscal authorities to follow different policies because monetary authorities would use contractionary policies in order to reduce the inflation caused by an output shortage. The fiscal authorities would use expansionary policies in order to restore the output to its original state (Kent & Cashin 2003). There would also be a considerable fall in aggregate demand because of the external aspects. The macroeconomic objective in this scenario would be to optimize between reducing the desired output level and the actual output7. Under this scenario, a contractionary monetary policy would increase the real interest rates and this would consequently reduce consumption hence dampening aggregate demand as well as inflation (Erceg, Guerrieri & Gust 2005). This would also increase the labor supply because the employees would be willing to forgo current consumption and leisure. This would dampen the rates of inflation further. The declining terms of trade would lead the IS and BP curves to shift to the right as shown in the diagram above (BP0 to BP2 and LM0 to LM1) where balance of payment is less than zero. The terms of trade shocks would have a major impact on output of all major categories of non-tradables, and real exchange rate appreciation would be a key mechanism in triggering an expansion (Magud & Fernandez 2010). Reference List ABS 2009a, Population Projections, Australia: 2006 to 2101, Catalogue no. 3222.0, Australian Bureau of Statistics, Canberra [www.abs.gov.au/Ausstats/abs@.nsf/mf/3222.0] Allsopp, C & Vines, D 2005, ‘The Macroeconomic Role of Fiscal Policy’, Oxford Review of Economic Policy, vol. 21, no. 4, pp. 485-508. Aurelio, M 2005, The Performance of Monetary and Fiscal Rules in an Open Economy with Imperfect Capital Mobility, Research Working Paper, 05-01, The Federal Reserve Bank of Kansas City, Economic Research Department. Becker, T & Mauro, P 2005, Output Drops and the Shocks that Matter, IMF Working Paper 06172. Berkmen, P 2009, Macroeconomic Responses to Terms-of-Trade Shocks: A Framework for Policy Analysis for the Argentine Economy, IMF Working Paper Bilbiie, F & Straub, R 2004, Fiscal Policy, Business Cycles and Labor-market Fluctuations, MNB Working paper, No. 2004/6. Cashin P, Liang, H & McDermott, C 2000, ‘How persistent are shocks to world commodity prices?’, IMF Staff Papers, vol. 47, no. 2, pp 177–217. Cashin P & McDermott, C 2002, ‘The long-run behavior of commodity prices: small trends and big variability’, IMF Staff Papers, vol. 49, no. 2, pp 175–199. Erceg, C, Guerrieri, L & Gust, C 2005, Expansionary Fiscal Shocks and the Trade Deficit, International Finance Discussion Papers, No. 825, Board of Governors of the Federal Reserve System. Gillitzer, C & Kearns, J 2005, Long-Term Patterns in Australia’s Terms of Trade, RBA Research Discussion Paper No 2005-01. Kent, C & Cashin, P 2003, The response of the current account to terms of trade shocks: persistence matters, IMF Working Paper No WP/03/143. Kohli, U 2004, Real GDP, ‘Real Domestic Income, and Terms of Trade Changes’, Journal of International Economics, vol. 62, pp. 83–106. Magud, N & Fernandez, D 2010, A Note on Terms of Trade Shocks and the Wage Gap, IMF Working Paper. Perotti, R 1999, Fiscal Policy in Good Times and Bad, Quarterly Journal of Economics, vol. 114, no. 4, pp.1399-1436. Solow, R 2005, ‘Rethinking Fiscal Policy’, Oxford Review of Economic Policy, vol. 21. , no4, pp. 509-514. Steigum, E & Thogersen, O 2003, ‘Borrow and Adjust: Fiscal Policy and Sectoral Adjustment in an Open Economy’, International Economic Review, vol. 44, no. 2, pp. 699-724. Read More