Policy mix has to be right

Governments have a range of tools they can use to influence the economy. The trouble is that they have to be used together and in the 'right way' so they don't counteract each other.

The Governor of the Reserve Bank of Australia, Glen Stevens, has spoken of the need to not rely on the tool of monetary policy. In a speech he has pointed out that whilst getting the short and medium term demand side policies right (monetary and budgetary policy) in addition it is necessary to get the conditions for growth right too.

It is important to realise that economic growth is a long-run phenomenon. When politicians refer to growth 'this year' being a certain amount they are usually referring to a rise in GDP which represents moving towards the Production Possibility Frontier (PPF), known as short-run economic growth. 

Economic growth is a really a movement of the PPF, an increase in the potential output of the economy. To distinguish this from simply moving towards the PPF we refer to it as long-run economic growth.

To achieve a movement of the PPF it is necessary to increase the factors of production or improve the quality of the factors of production. For this the economy will need investment in capital and people.

Hence Governor Stevens is suggesting that there must be conditions which promote competition, innovation and investment. This is the stuff of supply-side or microeconomic policy.

 The movement of the PPF represents long run economic growth.

Stevens speech is reported by SBS here

China - the most important demand side factor

There is no doubt that demand side factors have been important in Australia in the last four years.

The main driver of the Australian economy recently has been the mining boom, caused by very strong exports to China. China has experienced nearly a decade of growth rates above 10% and that demanded a great deal of mineral resources.

Now the Chinese economy is growing more slowly. It's still growing, but now by only 7.2% a year. But that's still growth isn't it?

Chinese growth demanded a great deal from the mineral suppliers of the world and supply constraints meant that the prices of commodities rose quickly. Australia saw the Terms of Trade rise substantially and that made Australia a lot better off. The Mining Resources Boom.

Today most mineral producers have expanded capacity compared to just four years ago. Australia has developed mines, opened new ones and improved port and railway facilities to allow the export of more mineral resources. World supply has expanded.

But now Chinese growth is slowing and demand for mineral resources is moderating. Mineral prices are falling as the graph of the iron ore price shows.

This means a lower value of exports for Australia, and a falling Terms of Trade. Whatever way you look at it the demand side of the economy is weakening.

This means lower Exports and Investment (as the 'Age' article linked below shows a port development has been shelved) and so lower Aggregate Demand. The multiplier effect will cause National Income to fall further and this means fewer jobs.

Last year everyone thought the Terms of Trade (then at a record high) would feature in the exam. You would be very brave not to revise this topic for 2013.

The Age reports some consequences of lower Chinese growth here