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CPI shows why foreign investors like the Australian economy

Recently released inflation figures imply that with underlying inflation at 2%, Australia is faring better in terms of growth in comparison to Europe and Japan. Depreciation of the Australian dollar has contributed to rising inflation but has been countered by a sharp fall in oil prices. An increase in excise tax and domestic holiday prices prior to school holidays has further contributed to the rise in inflation in the last quarter. Overall, Australian inflation figures are on the lower end of the target range, but far better than the rest of the world. This means that Australia faces less pressure to decrease its cash rate.

How does this relate to the HSC syllabus?

  • With underlying inflation in the Reserve Bank of Australia's (RBA) target inflation range of 2-3%, the RBA faces less pressure to lower the cash rate in comparison to the rest of the world (HSC Topic 3 – Economic Issues; HSC Topic 4 – Economic Policies and Management). In comparison, other economies, like the US, Japan and Europe, have far lower inflation rates, with fears of deflation. 
  • Less pressure to lower the cash rate comes from the fact that higher inflation is generally indicative of economic growth. Higher growth means that prices will increase, leading to inflation (HSC Topic 3 – Economic Issues). 
  • Australia’s depreciated exchange rate has contributed to imported inflation (HSC Topic 2 – Australia’s Place in the Global Economy; HSC Topic 3 – Economic Issues). Since it costs more Australian dollars to purchase imports, prices for imported goods have increased. 
  • Given that oil is an input to a substantial proportion of all produced goods and services, oil prices can severely impact price levels (Preliminary Topic 3 – Markets). Recalling that oil prices have plummeted over the past few months, the price of goods and services in general have fallen globally, adding to deflationary pressure.  

Is Oil Rout Fuelling Recession Fears? 

Financial markets have fallen sharply within the first month of 2016 amongst mixed global macroeconomic news. The U.S. market has released increasingly positive unemployment and consumer confidence data, signalling economic recovery. In contrast, the Chinese market has faced declining equity and currency markets due to questionable economic policies and slowing economic growth. What has contributed most to struggling financial markets has been falling oil prices as a result of oversupply. 

It has been speculated that falling oil prices may lead to a global recession. Since emerging markets are primarily commodity producers, falling oil prices would significantly hurt export revenues and therefore, economic growth. Given that emerging market growth contributes to 67% of global economic growth, this poses a significant risk. However, there has never been a recession driven by low oil prices. A recession is not likely because developed economies appear to be recovering, and there is possibility that the impact of oil prices has already been factored into financial markets and economic data signalling recovery from developed economies.  

How does this relate to the HSC syllabus?

  • Although prices are already low, the production of oil has not slowed. This means that supply is outstripping demand, leading to falling prices (Preliminary Topic 3 – Markets).
  • Emerging markets are primarily commodity producers, which includes oil. Falling oil prices means that these emerging markets face decreasing revenues (revenue = price × quantity) for the production of the same amount of units (Preliminary Topic 1 – Introduction to Economics). Decreases in export revenue leads to decreases in economic growth (Y = C + I + G + X – M). With emerging markets contributing to 67% of global economic growth, slowing economic growth from these regions may lead to a contagion effect due to trade and financial ties onto the global economy, causing a global recession (HSC Topic 1 – The Global Economy). 
  • Emerging markets have borrowed extensively, with 45% of debt being attributed to commodity businesses. Inability to generate sufficient income due to falling export revenues means that these emerging markets may not be able to repay their debts. With emerging market interest rates higher than developed market interest rates, an inability to repay debts at present means that a large proportion of future emerging economy income is used to repay debt rather than improve economic development. This further entrenches the gap between economic development between developed and emerging economies (HSC Topic 1 – The Global Economy). 
  • Falling oil prices will be reflected in emerging market oil company prices on their respective stock exchanges. Since these companies will be unlikely to deliver the profit expected of them by shareholders, investors would sell these stocks, causing a decrease in price as demand decreases and supply increases (Preliminary Topic 2 – Consumers and Business; Topic 5 – Financial Markets). A substantial decline in financial markets may be an indicator of an impending recession. However, it is argued that falling oil prices have already been priced into the market (since financial markets also reflect consumer expectation) and the fall in financial markets have already reached a trough. 
  • An increasing participation rate and monthly wage growth in the U.S. is signalling economic recovery. With a majority of the jobs created in the U.S. market being full-time as opposed to seasonal, it is suggested that businesses are more confident in future economic outlook to support the hiring of full time employees who are legally more difficult to retrench than seasonal workers (Preliminary Topic 4 – Labour markets; HSC Topic 3 – Economic Issues).

Negative Interest Rates

Japan has loosened monetary policy and adopted a negative interest rates in response to deflationary pressures. It is an unorthodox choice that may backfire on the global economy, but if it works, then there will be a new way to drive an increase in aggregate demand.

How does this relate to the HSC syllabus?    

  • Deflation is extremely undesirable.
    • First, when people expect falling prices, they become less willing to spend and borrow because holding cash is a positive investment.
    • Second, deflation worsens the situation of those who have debt, since they have to pay the same dollar amount in interest, but that money is worth more in real terms. This leads them to spend less.
    • Third, there is downward pressure on wages, and due to downward nominal wage rigidity (difficulty in reducing wage rates), this means that employers fire their workforce instead, causing unemployment.
  • Decreased interest rates (loosening monetary policy) mean that individuals and businesses can more capital more cheaply to fund investment (Preliminary Topic 2 – Consumers and Business, HSC Topic 4 – Economic Policies and Management). This would therefore increase economic growth (Y = C + I + G + X – M). 
  • Implementation of negative interest rates may not be as effective as believed as it also means that lenders pay for the banks to hold their money which may cause bank runs (everyone quickly withdrawing their money which can cause solvency problems for banks). 
  • Another argument against negative interest rates is that the decreasing profit margin for banks (since banks are receiving less revenue for lending) may make banks reluctant to lend.

Further reading

Why Is Deflation Bad? http://krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/ 
Deflation: The Trouble with Falling Prices: http://www.bloombergview.com/quicktake/deflation


Theresa Dang THERESA DANG

Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.

Gary Liang GARY LIANG

Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.

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