Australian inflation causes a degree of panic

There are interesting reactions to the latest inflation figures for Australia. The contribution to the Australian annual inflation rate for the last quarter (three months Jan to March) was -0.2%. In Australia this is being reported as 'deflation' and the stock market and Australian dollar both fell sharply.

As shown by the two articles below Australia is taking this news far more seriously than the rest of the world. The Guardian reports that CPI inflation has fallen to 1.3% per year, while the Australian uses the word deflation - i.e. just the change over the last three months.

Deflation is "the persistent fall in the average price level leading to a rise in the purchasing power of money" (Russell and Heathfield, Inflation and UK Monetary Policy 3/E). Clearly Australia has some way to go before it achieves deflation then. However the fear that the economy isn't doing as well as everybody thought and might be headed for recession is capturing the popular imagination.

As the data below shows there were particular classes of goods where prices fell, while other classes exhibited increases. On balance the general price level fell.

It will have to be the subject of another post to discuss the effects of deflation. The important point to note for now i that this weak inflation figure, well below the RBA target, and possibly indicating that inflation will fall further, means the RBA really should cut interest rates further. Given the time lags involved in the effect of monetary policy that means next Tuesday should see a rate cut.

The Guardian takes a detached view here

The Australian panics a bit here

The above shows how groups of goods in the CPI changed over the last three months

The Australian annual inflation rate over the last four years and the quarterly change is shown at the bottom. A falling general price level is highly unusual and may indicate a great deal of spare capacity in the economy.

This article is essential to VCE students who will need to be able to explain influences on both inflation and monetary policy.

Coping with air pollution

Pollution is a well known market failure. The negative externalities imposed by, say, driving cars are significant and the market has no way of applying a price to these effects. Therefore governments must intervene to mitigate against the worst effects.

There are several possible ways to deal with this. In order of effectiveness, least to best:

Do nothing
Ban the activity
Regulate the activity
Impose a tax or subsidy
Create a tradeable permit scheme

When it comes to pollution caused by traffic there are many difficulties. The 'do nothing' approach has been tried (usually this leads to building more roads which cause more congestion and pollution) and bans on certain vehicles at certain times is also used in some places (such as no lorries allowed 7.30am to 9am).

The article below explains a British scheme to impose charges on high polluting vehicles in certain areas. The aim is to discourage there use in those areas, it is, in effect, a tax. Will it work? Well that depends on the Price Elasticity of Demand for road use by the vehicles operators and whether they simply operate elsewhere simply redistributing the pollution.

The article below discusses some wider issues, but it is clear that when it comes to coping with the negative externality of pollution, or carbon emissions, a comprehensive policy is required. Not only geographically comprehensive but a policy that integrates with transport policy across all modes of transport.

The BBC covers the issue here

This article is relevant to both VCE and IB students. The methods of dealing with environmental problems is the key for VCe students whereas IB students should consider the alternative methods and their merits. My list suggests tradeable permits are the most efficient method, but why?

A little history

I don't usually post opinion pieces, but this one caught my eye as providing useful background to the next Federal Budget and the importance of understanding the policy mix.

The article points out the legacy of the Howard government's economic policy. They made Australians believe that a Budget surplus was 'good economic management' rather than achieving the economic goals we usually point to (inflation, unemployment, growth, external balance and income distribution).

The article suggests that giving Australians large tax cuts (especially to the better off) and making even less well off Australians believe Budget surpluses are always good has made the effective economic management of the Australian economy all but impossible.Monet

This is an opinion piece, however from my point of view I can't fault the analysis. I'd particularly like you to notice how the mismanagement of the mining resources boom has put monetary and budgetary/fiscal policy in almost perpetual conflict. It is also clear that the author sees Australia's deficit problem as one of too little revenue, not too much government spending.

The Canberra Times article is here

This article is most appropriate for VCE students who must understand the context and detail of Budgetary policy over the last four years. This provides context for current events. IB and VCE students will be able to see how different policy measures are interdependent and can be mutually supportive or cancelling. IB students should note - this is not suitable for an IA being an opinion piece.

HM Queen Elizabeth II of Australia

On this the birthday of our own dear Queen, Elizabeth, Queen and Head of State of Australia I link below 90 images from the BBC for your enjoyment.

The BBC article is here

"Monetary policy is not enough."

The Governor of the Reserve Bank of Australia (RBA) has told a New York conference that monetary policy is not enough to allow faster growth. he suspects that the world has entered a period of much lower 'trend growth'.

Stevens has made a number of points and this is a quick summary of what I think he means:

1. With nine years of low interest rates there is no longer any room to boost Aggregate Demand (AD) with lower rates.
2. Simply 'printing money' ('Quantitative easing' or 'helicopter money) will also be ineffective.

Low confidence among both consumers and firms contribute to these first two points, but simply that the incentive provided by these measures is now too small. He therefore thinks the use of negative interest rates (as in Japan and the EU) will fail to raise economic growth.

3. More than monetary policy is needed to promote growth and that should be provided by increased government infrastructure spending.

He makes the point that this can be funded very cheaply by issuing bonds (government debt) at record low interest rates and that the return on this investment will far exceed the borrowing cost.

Stevens is not calling for a naive Keynesian fiscal boost. However he is calling for an end to 'austerity' and a blind adherence to the idea that any government Budget deficit is bad. (Some are, some are not.) What Stevens is calling for are projects that will assist the private sector to grow through active supply side policies which have the advantage of adding to AD as well.

Finally Stevens talks about the wider implications of monetary policy. He pointed out that the low interest rates are destroying retirement plans. Pension (superannuation) funds rely on investing in safe assets such as bonds. The interest rates earned on these assets are so low many find their retirement plans are being ruined. A short period of low interest rates will not affect pensions too badly, they can catch up, but we are now nearly a decade into low rates and that has serious implications.

Business Insider covers his comments here

This article is applicable to VCE and IB students. Australia has record low interest rates and the 'policy mix' between monetary and budgetary policy in Australia is a crucially important area of study. For IB students the limitations of monetary policy and the interaction between fiscal and monetary policy and the operation of supply side policy in the policy mix is directly relevant to Paper 1.

Unemployment and Monetary Policy

The Australian unemployment rate has fallen to 5.7%. This is the lowest rate for two and a half years and so people are generally pleased.

5% remains the 'full employment' target rate, but at least things are going in the right direction. The end of the mining investment boom meant many economists feared 7% unemployment would become a reality, a level not seen in Australia for a considerable period.

Why has Australia done so well? There are a few factors we can identify.

1. Accommodating monetary policy
2. A lower exchange rate
3. A Federal Budget deficit.

The Reserve Bank of Australia (RBA) has reduced interest rates to 2%, the lowest ever, and this has helped boost consumer and investment spending, both components of Aggregate Demand, by making it cheaper to borrow while also reducing the interest on existing loans.

The exchange rate has fallen significantly since 2013, making the non-mining sector more competitive overseas, and so boosting exports.

The government, despite the desire to return the Budget to surplus, has maintained a substantial deficit, so helping maintain Aggregate Demand.

As the article below points out the lower unemployment rate and slower growth in house prices, along with low inflation, means the RBA could cut interest further to encourage a depreciation in the AU$ which has strengthened recently and threatened Australia's export competitiveness.

The Sydney Morning Herald covers the story here

The Australian government debt problem

There is an unhealthy obsession with balancing the budget in Australia. Politicians constantly tell us they will "return the Budget to surplus" faster than their opposition as if this is unquestionably a goal that is worthy of pursuing.

Following the Great Depression governments embraced the idea of maintaining full employment through manipulating Aggregate Demand, which they did by varying the size of the government Budget deficit (or surplus). Today the New Classical view is that the private sector should allocate resources and governments should spend less and balance their budgets.

New Classical ideas were put aside in the GFC when it was clear only government action could save the global economy from catastrophe. The Australian government, like every government in the developed world ran larger Budget deficits and the worst outcome was, only just, avoided.

Today Australia is warned that if the government does not cut the deficit Australia will lose its top 'credit rating' of AAA. Only eight countries in the world have this. A high credit rating means that the government can borrow more cheaply than countries with a poor credit rating. A poor credit rating means that you are more likely to fail to repay a debt.

There is no doubt that the May Australian Federal Budget will make a great deal of cutting the deficit. And the dire consequences of not doing so.

However is this really that important? The UK has a lower credit rating (AA) yet can borrow more cheaply than the Australian government. The UK has a much higher debt also (as a percentage of GDP). Indeed most OECD countries are much more heavily in debt as the table below shows.

The trade off for a lower government deficit is lower Aggregate Demand. The New Classical argument is that government spending just replaces private sector spending and the private sector spends the money more efficiently. This is why they emphasize cutting spending and not raising taxes as a way to cut the deficit.

Would Australians rather have a comprehensive public health service (like the UK NHS) an education system that educates 90% plus of school children well rather than the 60% at present and would they like 3% not 5%+ unemployment? Or would they prefer a lower government Budget deficit?

The Ghana News covers the credit rating issue here

VCE students need to track the state of the Federal Budget closely and the policies introduced to change the size of the deficit and influence the economy. IB students need to understand the different schools of thought on macroeconomics (Keynesian vs Classical) and also be able to judge the effectiveness of fiscal policy.

The cost of economic growth may be falling

In economics there are costs and benefits associated with every decision and every change. In recent years when considering the desirability of economic growth the costs have become somewhat more important than they were.

For generations economic growth was seen as good. The benefits of higher real incomes and a higher material standard of living were seen as the primary long-run goal of economic activity. It was not until the 1960's when E.J. Mishan wrote 'The Cost of Economic Growth' that economists began to seriously consider that there was a serious downside to continuous growth.

Today we understand that non-material living standards can be seriously affected by growth (take for example China's atmospheric pollution) often through negative externalities. Also we know that material living standards are are threatened by some elements of growth, such as global warming.

Some economists supported continued economic growth following Mishan's criticism, such as W. Beckerman in his 'In Defence of Economic Growth'. He argued that technical progress would allow society to overcome many of the problems of growth and that the higher real incomes obtained through growth would allow us to devote the necessary resources to deal with the problem.

There had been little to support Beckerman's contention until recently. The article from the New York Times described how growth and CO2 emissions have become 'decoupled' in some advanced economies. This holds out the possibility of economic growth without greater environmental damage. There is a long way to go however, only 21 out of 191 countries have achieved growth without more CO2.

The New York Times article is here

This article is well suited to VCE students as they look at living standards and economic growth in Outcome 2 of Unit 3. It also provides IB students with the opportunity to look at the wider aspects of growth and to evaluate its impact. It provides all of us with the reminder that there are always costs and benefits to consider.

The problem with protection

There has been a surge in the popularity of ''economic nationalism" among politicians recently. Talk of tariffs to 'level the playing field' has become common in Europe, the US and Australia. It's a really dumb idea.

The arguments run something like this. "Imported goods are replacing domestic goods, our industries can't compete and that means they shrink or close leading to unemployment. We should put a tariff on imports to save jobs."

This thinking led to disastrous rounds of tariffs being imposed in the 1930's making the Great Depression much worse than it otherwise would have been.

Today Donald Trump wants a tariff to protect US jobs from China, there is a danger of a steel 'tariff war' and in Australia it's not just steel which raises the protectionist instincts of opportunist politicians.

Tariffs will raise prices and reduce imports. But the implications are much wider than this. While tariffs will be popular with those who might keep their jobs for a little longer they impose costs on the rest of the population, cause inflation and restrict growth, so lowering the long term standard of living.

The New York Times article below goes through the implications of the imposition of a tariff. This is an excellent analysis on the dynamic effects of a tariff and provides multiple evaluative points.

The New York Times article is here

IB students will find this an excellent resource for evaluating tariffs and understanding how the simple tariff diagram is only a static analysis. VCE students will be able to apply this to the idea of placing a tariff on imported steel to protect Australia's unprofitable industry.

The Australian exchange rate - it's complicated!

Prices are set by demand and supply in a free market and that applies to exchange rates - the price of one currency in terms of another. For exchange rates there are, however, many competing influences on demand and supply and government monetary policy has a significant impact.

The purpose of this post is not to say too much because The Guardian article linked below says a great deal you need to know.

The Australian dollar is presently experiencing a modest rise in value (from around 70 cents to 75 cents to the US$). This is spoiling the hoped for improved competitiveness of Australian non-mining exports which suffered from the very high value of the dollar caused by the mining investment boom.

The article is wide ranging, explaining some current influences on the exchange rate and the importance of monetary policy of both the home country and other countries on exchange rates.

The question I would want to consider is about if a country should really rely on devaluations (or depreciation's) to maintain competitiveness and so economic success? A fall in the exchange rate might provide a short term boost to exports (Marshall-Lerner conditions allowing) and so higher Aggregate Demand. However long term economic success is based on the level of productivity and comparative advantage.

The Guardian article is here

This article is important for VCE and IB students. VCE students need to understand influences on Monetary Policy and the level of the exchange rate and how it can affect the economy. For IB students it is also important to understand how to evaluate the effects of a change in policy or the exchange rate. Looking at the long term vs. short term effects of a change offers one possible path to evaluation.

 

The A$ vs US$ over the last year

The carbon tax worked. Proof of what economists always knew.

Australia is a pariah for its callous disregard of the global warming crisis. While it is fashionable within Australia to believe that the government is acting in the best interests of Australia's standard of living the rest of the world looks on them as bigots.

An example of the extraordinary behaviour of Australia is the repeal of the carbon tax. Various reasons were given including 'it didn't work'. (The other reasons are beyond the scope of the space we have.)

Taxes work by raising the price of a good and so changing the relative price of the good. As a result some consumers move to relatively cheaper substitutes and consumption of the taxed good falls.

The practical difficulties of taxing a good like carbon are significant. Demand for energy is price inelastic and so small rises in price have only a very small effect on demand. Demand is inelastic partly due to the lack of substitutes, the fact that energy is a necessity and it takes a long time to be able to switch to alternatives. Therefore the effect of the carbon tax was difficult to detect.

The chart below shows the changes in electricity generation, coal's share of that generation and emissions. Notice this shows percentage changes in totals, not absolute amounts. This is much more useful in tracking the effect of the policy changes.

 

The chart clearly shows that coal's share of electricity generation falls after the carbon tax was introduced in 2012 and that emissions fell even faster. Since the carbon tax was scrapped in 2014 coals share of generation has risen and so have emissions.

It is important to concentrate on the economics rather than the politics of this policy. Taxes do work (a Pigovian tax - see a post form last month) because changing relative prices will alter the allocation of resources. The problem is that it does take time to work.

The Guardian Australia covers the story here

As an extra here is a chart of how each state was generating their electricity on 7th April 2016.

 

Brown coal is the dirtiest fuel in terms of CO2 emissions. 

This article is relevant to both VCE and IB students. It can be used as an example for IB students and an Australian environmental policy is required knowledge for VCE.

UK trade deficit

The UK has just recorded a record trade deficit on the Current Account. At 7% of GDP for the last quarter it is quite a large one.

The BBC article linked below describes what a trade deficit is and why running one might be a bad thing and when it can be coped with. Overall an excellent educational article on a current event.

I want to talk about why the trade deficit has widened and what it's implications are.

The UK economy grew in the last year. By 2.5% according to the latest data. That is actually quite high compared to the rest of the EU and other developed countries. As imports are a function of income economic growth means higher imports. (M = mY where M = total value of imports, m is the fraction of income spent on imports, known as the marginal propensity to import, and Y is Real GDP or national income.) So if a country grows faster than its trading partners it can expect its imports to grow faster than its exports.

The UK has recently seen a fall in the value of the Pound (a depreciation). This will make exports cheaper and imports more expensive so an improvement in the current account balance will follow if the Marshall-Lerner conditions are met. The chart below shows the UK pound against the US$.

 

The recent fall in the pound is seen clearly in the graph. So why has the UK current account not improved? The Marshall-Lerner conditions certainly apply to the UK. The answer lies in the J-Curve effect, the current account worsens before it improves because the UK Pound value of imports rise while the Pound value of exports remains the same after the depreciation.

We should also consider the impact on UK Aggregate Demand (AD). (X - M) is a component of AD and so this worsening current account will act as a drag on UK growth, at least until the J-Curve effect works through to an improvement in the Current Account deficit.

The BBC article is here

VCE students will find the article an excellent explanation of the significance of foreign debt. IB students will also understand the process of the depreciation of a currency and the application of both the Marshal Lerner conditions and J-Curve effect. All students should consider the impact of a larger Current Account deficit on the wider economy through AD/AS analysis.

Steel tariffs may hurt more than just the steel industry

The world is presently seeing a bout of 'economic nationalism' over steel. The US and China are just two countries who are raising tariffs on steel but this will have wide ranging implications for many.

A tariff is a tax on imports. The aim of raising the price of imports on the domestic market is to reduce demand for them. It is hoped that this will lead to import substitution, domestic consumers switch to domestically produced products. This will raise domestic output and employment and might reduce a current account deficit.

The diagram below shows the effects of the imposition of a tariff on steel by the Chinese on British made steel. (This is referred to in the BBC article linked below.)

Rather than analyse this standard graph today I want to look at the wider implications of the imposition of tariffs. Space will mean much of this article just suggests further investigation.


There are both gains and losses from using tariffs. When evaluating the imposition of a tariff we might look at the long-run and short-run implications, the effect on stakeholders, such as consumers, firms and governments and the advantages and disadvantages of the tariff.

There are no long-run justifications for putting a tariff on trade because it prevents specalization and the exploitation of comparative advantage. We know from economic theory that in the long- run everyone gains from trade. However in the short-run this might not be true. 

The article describes how China may be 'dumping' steel on the world market - that is selling steel below the cost of production. If this is the case then this is unfair and other countries steel industries will contract and jobs are lost. Even if the Chinese are not dumping (because they are able to produce steel more cheaply) another country might not want to see the sudden contraction of its steel industry with the resultant structural unemployment. Therefore in the short-run they protect their industry and manage its decline due to the loss of comparative advantage,

The stakeholders in the protected industry are often consumers. They lose out due to the imposition of tariffs because they pay higher prices and so lose consumer surplus. Another stakeholder is the government on the importing country. They gain tariff revenue and avoid paying greater unemployment benefits, both of which affect the government budget deficit. Notice here that the consumers who pay higher steel prices (by paying more for the goods made with steel) might be saved from higher taxes needed to pay unemployment benefits!

The static gains and loses represented by the diagram miss the dynamic gains and losses that can occur. The most obvious loss is that a trade war can result from placing tariffs on goods. This is evidenced in the article where one country imposing tariffs causes others to retaliate. The net effect is less overseas trade and slower economic growth worldwide. 

There are always more questions to ask in economics and students should look to find the right questions to ask to reach a valid judgement on the effects of any policy measure.

The BBC article is here 

This article is especially relevant to IB students who will find the tariff diagram is virtually always drawn at some point on Paper 2. However VCE and IB students need to practice evaluation - making a judgement based on economic theory and for that they need to ask wider questions about who is affected and how.

New minimum wage rates - good or bad for the British economy?

The UK today introduced a new 'National Living Wage' which is effectively a minimum wage. The UK already has a minimum wage, but that's 50p less an hour.

There is a great deal of support for this move, but also a great deal of opposition.

Those who support the 'Living Wage' argue that the present minimum wage is insufficient to provide workers and their families with a reasonable standard of living. This is where the term 'Living wage' comes from.

Those who oppose the move say that many workers will lose their jobs or be forced to accept shorter hours as employers cannot afford the higher wage rate. They suggest that the market won't support the employment levels currently enjoyed at the higher wage rate.

The economics of this can can complex, but the diagram below shows the most basic analysis.

 In the diagram above the free market wage rate is 0W* and 0N* hours of labour are hired by firms. Suppose that the National Living Wage (NLW) is introduced at 0WH. As this new NLW is above the market rate the effect on employment will be detrimental with hours of labour employed falling to 0Nd. Those who remain in work will, of course, be better off, but this is cold comfort for those who loose their jobs.

If the new NLW is imposed at 0WL then there is no effect on employment at all. Workers will continue to be paid the higher open market rate.

The BBC article below shows the situation is far from this simple. Here are a few considerations.

* There are people earning less than the new NLW. How could they be earning less than the free market rate (0W*) at present? Possibly because of an imbalance of power between employer and employee meaning the employer can exploit the weak position of such workers (perhaps in a non-unionised industry). In this case the employers are being forced to pay a fairer wage rate.

* If the new NLW is above the market rate how many workers might lose their jobs? This will depend on the elasticity of demand for labour and this in turn depends on the elasticity of demand for the product they produce (derived demand).

* Looking at the BBC article shows that different regions of the UK will see different proportions of the workforce affects receiving pay rises. The distribution of gains between regions will be very different therefore on real incomes and hours worked. Overall their may be an improvement in the equality of the distribution of income, this can be measured by the gini-coefficient.

* In the short run there may be job losses due to the higher NLW. In the long run the improved standard of living may result in high overall benefits to society (lower government spending, improved productivity etc.) 

There are many aspects of the introduction of the NLW to consider. Issues are rarely as simple as they first appear and further consideration often draws us to a different conclusion.

The BBC article is here  

 This article is more likely to be useful to IB students than VCE. However VCE students can still look at it as an application of demand and supply analysis. For IB students the evaluation of a measure is very important and this needs to be based on analysis (explaining using theory). Ther are numerous ways the initial demand and supply analysis could be developed.