5/2/24

a. Describe the importance of trade for the Australian economy (6)

Australia has historically relied on international trade for economic growth as its
domestic market, relatively speaking, is not as strong as the likes of the economies of
China, or Japan who both have lower trade intensities than it. This is why total trade
(X + M) for Australia accounted for 46% of GDP in 2022 as it holds a comparative
advantage on the global stage for primary commodities - with mineral and energy
exports comprising 67% of Australian exports in 2022. With Australia’s GDP and
exports largely hinging on resource trade, it is no wonder that 24% of Australian jobs
are directly derived from trade-related activities. This boost to employment that trade
gives increases production of Australia’s resources, increasing household incomes
and productivity of the Australian economy.

However, it is not just exports that benefit the Australian economy - we are also a
large importer of manufactured goods. This is because, while Australia holds a
comparative advantage in the exports of primary commodities - its comparative
weakness is in its manufactured goods exports. This was most evident in the
automotive industry, whereby Holden halted domestic production of vehicles in 2016
as the Australian Government ceased the subsidy program which had offset the
losses incurred by automotive production and now Australia imports the majority of
its vehicles from Japan, Thailand, Korea and Germany - amounting to roughly 1.1
million vehicles imported in 2021. By importing manufactured goods such as
vehicles, consumers benefit by being able to access a wider variety of goods at a
lower price than what domestic producers alone can supply the market with.

a. Describe the composition and direction of Australia’s trade (6)

Composition of trade can be defined as to what makes up Australia’s trade, reflecting
its comparative advantage - how much Australia can produce while using the least
amount of resources to do so. Historically speaking, Australia’s exports consisted of
a large proportion of rural goods to Europe, especially the UK. However, in the past
few decades, there has been a shift towards a greater concentration of trading
resources - accounting for 40% of trade. OThough, it can also be said that there has
been growing importance in service exports, as this category (including tourism,
education, and business services) are the next largest component of exports at 22%.
Other categories like agriculture (13%) and manufacturing (14%) are relatively
weaker to resource and service exports as Australia holds a comparative weakness
in those categories for various reasons.

Due to Australia’s concentration in resource exports, it can then be inferred that

imports would be the inverse - which is true. Australia’s largest imports are capital
(machinery, computers) and intermediate goods (fuel) and make up half of imports.
Then, consumer goods (vehicles, furniture, communications equipment) comprise
28% of imports while service imports account for 22% of the total figure, and is
mostly freight and personal travel. The composition of imports and exports implies
that Australia holds a comparative advantage in resource production and a
comparative weakness in the production of manufactured goods.
The direction of trade concerns the countries Australia chooses to trade with.
Historically, Australia exported many of its rural goods (wool and livestock) to
Europe, especially the UK as Australia has had strong ties to them in the past.
However, as the UK entered the EU who placed high tariffs on international trade -
Australia was forced to look elsewhere. That elsewhere was Asia, specifically China,
which was experiencing rapid growth and needed resources to sustain it. This
marked the beginning of Australia’s trade shifting to the Asia-Pacific region, and over
the last 30 years, trade with Asia now makes up 80% of Australia’s total trade. As
Australia holds a comparative advantage over resources that Asia does not have and
it being closer geographically to Australia as well, this shift in direction of trade
served only to Australia’s benefit. Asia’s prominence in Australia’s trade composition
is further reinforced by the fact that it makes up 65.2% of Australia’s two-way trade.
 8/2/24
1. Define a free trade agreement.
An international treaty removing barriers to trade between members of the
agreement to facilitate stronger trade and commercial ties, increasing economic
integration between countries that participate.

2. How do Australian exporters gain from an FTA?

They open up opportunities for Australian exporters to expand their businesses into
overseas markets and improve market access across all facets of trade and allow for
Australian firms to remain competitive.

3. How do Australian consumers gain from an FTA?

Consumers benefit through access to an increased range of better value goods and
services.

4. Explain how an FTA can contribute to higher GDP growth.

Foreign businesses may import more Australian products as FTA’s reduce barriers to
trade and can increase Australia's own productivity by allowing domestic businesses
access to cheaper inputs, as well as the introduction of new technologies - creating
competition and innovating.
 7/2/24
Explain the benefits of free trade for the Australian Economy.

History has shown that there is a very strong positive relationship between economic growth
and trade. The fastest period of growth in trade (1950-73) was simultaneously also the
fastest period of global economic growth. Free trade offers countries and their economies
higher incomes, more employment, and higher standards of living through specialisation and
trade as exports benefit production and imports benefit consumption. Australia’s comparative
advantage being in the export of resources means that Australia is able to procure higher
amounts of resources with less inputs as opposed to more resource-limited countries such
as China who imported 67% of their iron ore supply from Australia in 2023. It is because of
this comparative advantage that Australia holds that having free trade is a benefit.
Furthermore, households benefit from imports as goods are cheaper and offered to them in
a wider variety than if they were limited strictly to Australia’s domestic output of
manufactured goods.

An example of a free trade agreement is the Comprehensive and Progressive Agreement for
Trans-Pacific Partnership (CPTPP) which is an FTA involving Australia and it aims to reduce
virtually all trade barriers across all sectors of trade.
12/2/24

Part 1: MCQ
7. B
8. A
9. C
10. D
11. C
12. C

Part 2: working with models

1.
2. Land A
3. Land A
4. For land A: 1 orange per apple
For land B: 2 oranges per apple
5. For land A: 1 apple per orange
For land B: 0.5 apples per orange
6. Land A
7. Land B
8. Land A will export apples and Land B will export oranges
9. Land A will want their exports of apples to be sold for >1 apple per orange and Land
B will import apples at a price of <2 oranges per apple.
Land A will import oranges at a price of <1 apple per orange and Land B will export
oranges at a price of >0.5 apples per orange.
 16/2/24
1. Summary of China’s imposition of tariffs on Australian exports

In May 2020, China placed tariffs to prevent dumping and subsidies totalling 80% on
Australian barley. Two tariffs were introduced - one being 74%, to address the claim that
Australia exported the product to China for a price cheaper than it cost to grow - dumping.
The remaining 7% was to address the supposed subsidies that the Australian Government
granted Australian farmers to grow their crops, as claimed by China. Australia has ostensibly
denied the dumping allegations as well as going on to state that there was no evidence of
the practice of selling barley to China for lower than the production cost. While it was an
initiative taken on by China, economic research estimates that the loss to China was $3.6
billion, while Australian farmers lost an estimated $330 million - largely due to China’s
reliance on Australian barley to brew beer.
 With tariff Tariff removed

Price Increases Decreases

Qty consumed Decreases Increases

Qty produced Decreases Increases

M Decreases Increases

CS Decreases Increases

PS Increases Decreases

Govt. rev. Increases Decreases

DWL Increases Decreases

1. Government and domestic producers benefit from the tariff

2. Consumers and exporting nations
3. They artificially raise prices for consumers, and restrict imports, resulting in
consumers paying more to consume less goods, inhibiting consumer surplus by a
severe margin. The tax revenues earned are outweighed by the loss to consumer
surplus as that is contingent on aggregate demand which will have decreased with
consumer surplus.
19/2/24

1. Consumer surplus stays the same

2. Producer surplus increases
3. The area DABW
4. The area ABC

Before subsidy After subsidy removed

P Same Same

Qty consumed Same Same

Qty produced Increases Decreases

M Decreases Increases

DWL Increases Decreases

2. Illustrate and explain the effects of a subsidy

Subsidies are a grant to domestic producers by the government and hence, lower their
production costs to increase their competitiveness with imports. Therefore, the subsidy
pushes the supply curve outward to Ss and domestic production increases from Q1 to Q3
whereas imports are reduced to Q2. Subsidies do not affect consumer surplus in any way,
but still result in a deadweight loss (area ABC) as the cost (area DABW) outweighs the
increase in producer surplus (area DACW). An example of a subsidy is the $30 billion grant
given to domestic automakers by the Australian government as part of the Automotive
Transformation Scheme which ostensibly failed as soon after Holden exited, many other
manufacturers followed suit.

3. Explain how a subsidy differs from a tariff

Tariffs are the only form of protection that provide government revenue and are a tax on
imports coming into the country to discourage consumers from consuming imported goods
by increasing their prices. This reduces domestic consumer surplus and is generally seen as
unfavourable as consumers end up paying more to consume less variety of goods as the
gain to domestic producer surplus does not make up for the loss to consumer surplus,
resulting in a deadweight loss. While subsidies also result in a deadweight loss, the
government instead reduces the cost of production for domestic producers to increase their
competitiveness with imported goods through grants - hence increasing domestic producers’
surplus.This is seen as more favourable by consumers as their consumer surplus is not
affected, however the grant itself is a hidden burden on government revenue - a deadweight
loss as well.
Benefits of trade liberalisation
1. Increases consumption relative to production:
Through specialisation and trade, nations can expand their consumption possibilities
2. Decreases inflation:
Countries import when the world price is lower than the domestic price, hence by
importing, households have access to lower priced goods and services with almost
no changes in quality.
3. More variety of goods and services available:
As there are limitations as to what goods and services countries can produce,
through trade, households can access goods and services that can’t be produced in
Australia or are too costly.
4. Increases real income and living standards
The fastest period of global economic growth coincided with periods of high world
trade growth, and Australia’s GDP rose dramatically in this time due to trade reforms
allowing increases in real income to occur. Additionally, trade allows for higher
consumption (as per point 1), and increases living standards.
5. Increases competition and resource efficiency:
Trade forces domestic producers to be more efficient or change production and
forces inefficient resources to join expanding sectors of the economy. Even if this
creates structural changes and unemployment in the short-term, this is outweighed
by gains in long-term output and employment.
6. Creates higher paying job opportunities:
Trade creates more new and higher-paying jobs. It has forced the structural change
in Australia’s economy from a manufacturing country to a resources and services-
based economy. Hence, jobs in resources and services industries provide higher
incomes than manufacturing jobs did. Example is mining.

Reasons for protection

1. Protecting infant industries:
Protection allows young/new industries to develop their comparative advantage and
economies of scale to be more competitive in the global market. It is used in Australia
to justify protecting manufacturing industries domestically. However, they may
become dependent on assistance and may never increase efficiency due to an
artificial lack of competition. Hence, what is intended for short-term assistance,
becomes long-term and invalidates this argument.
2. Increased employment in protected industries
As consumers purchase more from the domestic market, employment in the
protected industry increases. However, unprotected industries, and other industries
that use protected industries’ goods can suffer higher costs - negatively impacting
them. The inherent inefficiency of protectionist policies reduces productivity in the
long run due to the misallocation of resources, dampening growth and job creation in
the future.
3. Protection against cheap foreign labour
Imports are usually produced at wage rates lower than the domestic economy,
making them cheaper. This argues that domestic producers need insulation from the
low cost and exploitative labour policies of the exporting economy. But the surplus of
labour in certain countries is what gives them a comparative advantage in labour
intensive goods. Additionally, wage rates reflect labour productivity which is high in
 Australia. Hence, it makes sense for Australia to reap the benefits of importing goods
that are cheaper to produce elsewhere.
4. Anti-dumping
The practice of exporting goods to a country to drive out domestic producers by
selling at a lower price, sustaining short-term losses to increase prices in the long-
term. While difficult to prove as low prices can simply just be the product of
productive efficiency and calculating relative cost is complicated, if it can be proven
and is harming domestic producers, this argument holds water as a temporary
measure.
5. Diversification
Economies need to diversify industries in the case of a fall in export prices (Australia
is dependent on commodities). For Australia, protectionism can be argued to allow
for the increase in size of the manufacturing and industrial sector, reducing reliance
on exports as sources of income, and increasing employment in less efficient
sectors. However, it ignores the benefits of comparative advantage.
6. Defence
Industries vital to the military and national defence are protected to ensure
uncompromised supply in case of national emergency. However, it is difficult to
determine what industries are vital and while this argument was popular in the era of
global warfare, it can be seen as outdated in the modern era. Additionally, reducing
trade barriers will actually reduce the risk of war conflict as it promotes cooperation
between nations.
7. Balance of payments
Protection reduces imports, hence it improves the balance of trade (TB = X - M). By
reducing imports, it decreases debits in the trade balance, improving the current
account deficit. However, an increase in import costs means an increase in
production costs and domestic prices (cost-push inflation), decreasing exports, which
ends up reducing the trade balance anyway as well as increasing the deficit (CAD).
This argument implies that trade deficits are bad and surpluses are good, but
economies benefit from both imports and exports - so countries should aim to
increase both.
28/2/24

“Describe the structure of Australia’s balance of payments accounts. Include

examples of international transaction that would occur in each category.”
(8 marks)

The balance of payments (BOP) captures transactions between Australian residents (people
who live in Australia and businesses which operate in Australia, the Australian government,
and organisations operating in Australia). Australia’s balance of payment accounts are split
up into two broad categories - that being the CAB (Current Account Balance) and the KAFA
(Capital And Financial Account).

The CAB captures the net flow of money that results from Australia’s international trade and
is non-reversible by nature. It records the flow of the goods and services and income
between Australian residents and the rest of the world. There are three components to the
CAB:
1. Trade balance, which is the value of goods and services that Australian residents
export less than what they import. The most attention is given to this component as
this forms part of Australia’s GDP.
2. Primary income, which is the income that Australian residents earn from the rest of
the world from working (e.g, wages) and from financial institutions (e.g., dividends)
less than what they pay to the rest of the world.
3. Secondary income, which is comparatively speaking, the smallest component as it
concerns itself with the income Australian residents earn (less what they pay to) from
the rest of the world from the government (e.g., tax payments and returns from
foreign governments) as well as current transfers - transactions between AUstralian
residents and the world where one party provides something to be consumed by
another with no expectation of returns (such as food aid).

The KAFA records capital and financial transactions between Australia and the rest of the
world. This has two components: capital and financial. The capital account records two main
types of transactions involving capital - that being capital transfers and the
acquisition/disposal of non-financial, non-produced assets. Capital transfers are transactions
where one party has transferred ownership of something to another without anything specific
being received in return and can include debt forgiveness and transfer of assets between
residents and non-residents. The other type of transaction recorded in the capital account
involves intangible assets (e.g., intellectual properties) and rights to use land/water (e.g.,
mining or fishing).

The much larger component of the KAFA, the financial account, has five sub-components.
Both direct and portfolio investment fall under this, as the purchasing of equity or debt
(shares of bonds) where the former is long-term capital investment and the investor has a
>10% stake in the business with voting power whereas the latter tends to be more short-
term as the investor has little to no influence in the business’ operations with a <10% stake.
The third category are the purchase/sale of financial derivatives and involve the exchange of
risk between parties in lieu of funds. Then, the purchases/sales of reserve assets held by the
Reserve Bank is another category of its own (reserve assets). These reserves are assets
controlled by the Reserve Bank to meet policy objectives like intervention in the foreign
exchange market. Lastly, are other investments - these transactions do not fit into any other
category like trade credit - where an importer pays for goods only when they are received,
not when they are purchased.

Now, if Australia residents were to go on holiday in another country, the money spent there
would be recorded as debit (service debit) as it is classified as an import in the trade
balance. However, the payments that overseas households and businesses receive (from
accommodation, food etc.) are recorded as credit due to them being classified as “Other
investment - currency and deposits”.

A second example involving the KAFA is a scenario where a Chinese investor buys shares
in an Australian mining company. The investor purchasing shares is a credit in the BOP,
falling under the financial account and is an inflow on the KAFA, however, the mining
company paying dividends to the Chinese investor is an outflow on the KAFA and is a debit.
29/2/24
Test recap

Tariffs are a tax placed on imports by a government to reduce competition with domestic
producers by increasing the prices of previously cheaper imports. Before the abolishment of
tariffs, the price was P1 and then dropped to world price (Pw). Due to this decrease in price,
consumer surplus increases from areas A + G to now A + B + D + E + F + G. As the price of
imports falls below their domestically produced equivalents, demand for them increases, and
conversely, the demand for domestic goods decreases - hence supply for imports increase
from Q2-Q3 to Q1-Q4 and domestic production of goods contract from 0-Q2 to 0-Q1. This
contraction in domestic production is reflected in the loss to producer surplus, decreasing
from area B + C, to just C, as consumers now demand more imports. Additionally, the
government revenue is reduced from area E to zero as it, as well as the loss to producer
surplus, is absorbed by consumer surplus - which also absorbs the previous deadweight loss
of areas D + F caused by the tariff. Hence, the areas of D + F, which were previously lost in
the economy, are now part of consumer surplus and reflect the economic welfare gained
from abolishing tariffs and liberalising trade.
Describe how the following factors may affect the Current Account Balance:
a. An appreciation of the exchange rate
If the Australian Dollar appreciates, it makes it expensive for foreign countries
to import Australian goods, whilst making it cheaper for Australian
residents to import foreign goods. If demand for exports and imports are
both perfectly elastic, then imports into Australia will increase at the
expense of our export sector - decreasing credits and increasing debits
which decreases the trade balance and current balance account.

b. Australia’s inflation rate increasing at a faster rate than our major trading
partners
If Australia’s currency inflates at a rate faster than our trading partners’, then it
becomes cheaper for foreign countries to import Australian goods, but
conversely, real national income falls and Australian residents will
consume less (I.e, import less foreign goods) - increasing credits whilst
decreasing debits, increasing the trade balance and the current balance
account.

c. An increase in domestic growth

If domestic (Australia) growth increases, households will increase
consumption spending (especially discretionary spending as well as on
luxury goods and services), which increases consumption imports.
Businesses will also import more capital and intermediate goods as
production and output increases due to higher household consumption,
and as a result, this increase in consumption and capital imports increases
debits in the trade balance, decreasing the trade balance and current
account balance.

d. A rise in TOT
If commodity prices rise, Australia’s export prices rice relative to that of
imports - therefore, the export price index and terms of trade increase.
This increase in TOT means that foreign residents pay more for importing
Australian goods - increasing credits and hence, rising our trade balance
and current account balance.
 Question 29 (20 marks)

- Explain the concept of the terms of trade and how each of the following
events would affect Australia’s terms of trade: (12 marks)
1. An increase in global oil prices
2. A global recession
3. A global drought

The terms of trade refers to the relative movements in the price of exports and
imports. As the terms of trade increases, the country receives higher prices for its
exports than what it pays for imports - and vice versa if it decreases. It is calculated
by dividing the export primary index by the import primary index, times 100.

If there is an increase in global oil prices, as Australia is dependent on importing oil,

the terms of trade would decrease for oil as Australia must now pay more to import
the same amount.

If there is a global recession, then demand for Australia’s major commodity exports
will decrease, meaning that Australia receives a lower price for them and as such,
the TOT decreases.

If there is a global drought, as Australia is a major agricultural exporter, demand for

its exports will increase and hence will receive a higher price for exporting
agricultural goods and this will increase the TOT.

- Discuss two positive and two negative effects of a rise in Australia’s terms of
trade. (8 marks)

Positive:
If Australia’s TOT increases, this will benefit net primary income as Australia can
earn more on exporting goods and services and hence, purchasing power of
Australian residents increases as income rises. Another benefit is that the
government can collect an increased amount of tax revenue off of the increased real
incomes of Australian residents.

However, there are several demerits to an increase in TOT. One being that the
appreciation of the AUD may contribute to a decrease in services (tourism,
education) exports as well as causing a higher rate of inflation as higher income
means more circulation of money in the economy as consumption spending
increases, especially on discretionary items.
18/3/24
1. Distinguish between foreign direct and foreign portfolio investment.
Foreign direct investment (FDI) is overseas ownership of >10% of a company or
establishment of a business and grants the overseas investor controlling ownership
over said business. As such, it is seen as the more stable of the two since it is often a
long-term investment due to its association with a degree of ownership and/or
influence over Australian enterprises and resources. In contrast to this is foreign
portfolio investment (FPI) which involves overseas firms purchasing <10% of shares
in an Australian company, hence it does not grant foreign control/influence over
Australian enterprises. The level of FPI is speculative in comparison to FDI because
of its non-permanent nature. FPI comprises both equity securities and debt
securities, of which the latter is the dominant, accounting for roughly 63% of FPI.

2. Provide an example of direct investment and portfolio investment.

An example of FDI can be the establishment of Australian branches of multinational
companies (MNC’s) and an example of FPI would be overseas residents purchasing
property and/or shares in Australian companies.

3. What was the value of direct and portfolio investment in 2022?

FDI: $90bn
FPI: $210bn

4. Which type of foreign investment is usually more volatile? Explain why.

(Answered in question 1)

5. Outline two factors that would cause an increase in direct investment.

Consistent and stable profit expectations over a long period of time
The political stability of the country.

6. Outline two factors that cause an increase in portfolio investment.

Australia’s interest rates being higher than average attracts portfolio investment
chasing high yields.
The Australian economy outperformed most OECD countries.

7. In which years did direct investment exceed portfolio investment?

2019-20

8. Describe and explain the change in foreign investment after 2020.

The COVID pandemic caused an economic recession globally, affecting portfolio
investment much more than its direct counterpart as it is more sensitive to changes in
the economy due to it not being a long-term investment, hence the significant
withdrawals. However, as the global economy (and Australia too) began to recover
from COVID, as global trade began opening up, so did foreign investment back into
Australia.

9. Explain why direct investment is viewed as more beneficial to the economy than
portfolio investment.
FDI brings with it possible new technology and managerial expertise as countries
such as the US, UK, and Japan can help improve the efficiency of the Australian
economy and aid its long-term growth. On the other hand, FPI can be short term and
speculative - hence not stable. As it can be withdrawn at any time (unlike FDI), it is
simply just a function of short-term profitability and highly sensitive to changes in the
interest rate.
19/3/24

MCQ (pg 140)

1. B
2. B
3. B
4. C
5. D
6. B
7. B
8. D
9. C
10. C
11. C
12. A
13. D
14. B
15. B
21/3/24
Page 140
8. Explain why Australia’s net foreign liabilities have decreased over the last decade.
Even if Australia’s foreign liabilities have been increasing over the last decade, our foreign
assets have been increasing at a faster rate than liabilities, hence actually decreasing net
foreign liabilities and also proves that Australia’s foreign liabilities (i.e., foreign debt) has
been used to increase Australia’s worth.

9. Why is Australia’s net foreign equity liability negative?

Australia prefers to borrow (foreign debt) over selling assets (foreign equity) which is why
foreign debt has risen from 50% of GDP in 2012 to 52% in 2022 and the net foreign equity
has decreased from 4% of GDP to -15%. The reason for this is because Australia’s growth in
superannuation funds has enabled it to hold an increased amount of foreign assets.

10. What proportion of Australia’s net foreign debt is held by the private sector?
74%

12. Why have the servicing costs of Australia’s net foreign debt, measured as a % of
Australia’s exports, been falling over time?

13. Why is private debt considered to be superior to public debt?

Private debt is often incurred with a profit motive as incentive and hence, is more likely to
generate further investment and income growth which can then be used to service the debt.
However, public debt can burden future generations if the funds are misappropriated (e.g.,
using loans to fund the government’s current expenditure instead of investments and/or
public infrastructure which would have gone towards servicing the debt).

14. What effect will the COVID-19 pandemic have on the government’s share of foreign
debt?
It would increase the government’s share of foreign debt because the government will
increase their expenditure to compensate for the recession of the private sector, creating a
twofold effect in which the government will incur more foreign debt, whilst the private sector
may incur less.
22/3/24

1. How does Australia access foreign savings?

Either through borrowing or through equity (selling Australian assets to foreign
residents).

2. Clearly explain the difference between FDI and domestic investment.

FDI is the equity ownership of more than 10% of a company by a foreign resident.
However, domestic investment concerns itself with domestic expenditure related to
the creation of new fixed assets (e.g, machinery, buildings, infrastructure).

3. What proportion of total fixed capital expenditure is accounted for by FDI?

Around 8%.

4. Why does Australia rely on foreign investment?

To meet the gap between domestic savings and domestic investment needs. It
allows for Australia to increase its rate of economic growth, employment, and a
higher standard of living that could not have been achieved through domestic savings
alone.

5. Why is FDI regarded as one of the more stable flows of capital inflow?
FDI is considered for its stability because its requirement for a significant
commitment from foreign investors in acquiring ownership of companies and hiring
staff means that it is harder to be recalled as quickly as portfolio investment and debt
financing which don’t not require as much commitment to qualify for.
23/3/24
Extended answer rewrite:
Explain the structure of Australia’s current account and explain how the following
events would influence the current account balance:
1. A decrease in the terms of trade due to a fall in commodity prices.
2. A decrease in national savings.

In your response include:

- Definition of the balance of payments
- The two main balances in the current account, with examples of international
transactions in each category.
- The effect of a decrease in the terms of trade due to a fall in commodity
prices on the current account balance.
- The effect of a decrease in national savings on the current account balance
with reference to the savings/investment gap.

The balance of payments (BOP) can be defined as the systematic record of all
transactions between Australian residents and the rest of the world. It’s made up of
the Current Account Balance and the Capital and Financial Account. The CAB is
made up of two balances: the Balance on Goods and Services (BOGS) and the
Income balance (sum of net primary and net secondary income), of which BOGS is
the larger.

The BOGS measures the value of exports (X) less that of imports (M) where imports
are recorded as debits and exports as credits in the CAB. It is equal to the sum of net
goods and net services. In the case of Australia, its main goods exports (credit) are
minerals and agricultural goods - that being coal, iron ore, gas and beef, with main
goods imports (debit) being manufactured goods such as motor vehicles,
telecommunications equipment and computers. On the other hand, an example of a
service X (credit) could be an Indian student studying in Australia and an example of
a service M (debit) could be the import of freight transport from Japan.

The income balance is the sum of both net primary (NPY) and net secondary income
(NSY). NPY measures the value of income that Australian residents earn (credit)
from the rest of the world (e.g., earning in USD in wages from an American company)
less than what is paid (debit) to other countries (e.g., paying back dividends on
Australian company stock owned by a Chinese investor). NSY consists of two parts:
one being the income that Australian residents earn (credit) from foreign
governments (e.g., tax refund from the American government) less what they pay
(debit) to foreign governments (e.g., tax payments to the American government). The
second component are current transfers where real or financial resources are
transacted and provided with no economic value to be received in return. A credit
transaction of this nature could be a German resident providing an Australian
resident with a gift, and a debit transaction could be Australia providing foreign aid to
disaster-stricken countries.

(i.) Terms of trade (TOT) measures the relative movements in price of X’s and M’s. If
it were to decrease with commodity prices, given that Australia’s X’s are commodity-
reliant, Australian exporters will earn less income, decreasing credits in the trade
balance because a decrease in the TOT means that export prices fall relative to
import prices. This reduces the BOGS which then negatively impacts the CAB.

(ii.) A country’s CAB is reflected by the difference in national savings and investment.
A decrease in the level of national savings will widen the national savings-investment
gap (SI gap) and will increase the chances that a country will experience a CA deficit.
As a result, Australia becomes increasingly reliant on foreign investment or selling
Australian assets to foreign entities to bridge the gap created by Australia’s relatively
small population and low national savings rate. However, both of these remedies will
create net primary income outflows through the creation of future servicing
obligations (e.g., paying interest on foreign loans as well as paying back dividends on
foreign-owned equity), which decreases NPY.
24/3/24
Question 1
Australia has recorded nineteen consecutive current account surpluses since June 2019.
(15 marks)

a. Explain three factors that have contributed to the increase in Australia’s current
account balance. (9)

1. Increase in the terms of trade - Australian commodity export prices rose due to
strong demand from overseas, especially iron ore which reached a record export
value of $53.3b. This significantly increased the BOGS through exports which are
classified as credit transactions and hence, contributed to the current account surplus
in recent years.
2. Reduction in foreign investment due to worries associated with the COVID pandemic
in 2020 meant that Australia was servicing less costs and relying more on domestic
savings to fund investment which shrunk the savings-investment gap. This meant
that less income outflows (debit transactions) were spent on interest from foreign
loans as well as on dividend payments on foreign equity - reducing the burden on
net primary income and contributing to the surplus even if NPY was still running a
deficit at this time.
3. The level of imports dramatically reduced amidst COVID, particularly service imports
as restrictions on international travel meant tourism imports fell to all-time lows -
however this served to reduce the level of imports overall (debit transactions) and
contributed to the current account surplus.

b. Explain two effects of an increase in foreign direct investment into Australia on the
balance of payments. (6)

1. The financial account records foreign investment flowing in (and out of Australia). If
FDI were to increase, this would be reflected by an inflow in the financial account -
contributing to a financial account surplus. For example, the money Australia
receives from China investing in 15% of a mining company would be received in the
financial account under FDI.

2. However, the income outflows associated with servicing the costs from the FDI are
recorded in the current account and thus contribute to a large deficit in the current
account. In that example mentioned earlier, Australia servicing the costs (i.e., paying
back dividends on China’s investment) would be recorded as an outflow of income in
the current account balance.

Question 2
(15 marks)
a. Outline the concept of foreign direct investment and explain one benefit and one cost
of an increase in foreign direct investment into the Australian economy. (7)

Foreign direct investment is the ownership of at least 10% equity of a company by a foreign
investor. Usually, it is considered to be more long-term than its counterpart, portfolio
investment, due to the high level of commitment barring investors from backing out quickly.
As such, it’s the more stable form of foreign investment and is geared towards long-term
gains to the economy.

b. Describe two effects of foreign direct investment into Australia on each of the
following: (8)
- Australia’s macroeconomy

- The balance of payments

Notes on the test:
- All BOP + FI syllabus points
- Benefits/costs of FI excluded
- Structure of CA and effects on CA excluded
- Most extended questions based on syllabus points and past exams
- Increased superannuation (11% contribution rate) contributes to SI gap closing
without needing foreign investment (CAS)
- CAS = $11.1bn

Key data
- Net foreign equity position: -$369.6 bn
- Net foreign liabilities (net international investment position): $836.6bn as at 31
December 2023
- Net foreign debt: $1206.3bn
- Australia budget deficit: $37.2 (October 2023)
2022 WACE extended questions
28a. Explain the meaning of the terms of trade and describe four factors that may influence
Australia’s terms of trade. (10 marks)

Terms of trade (TOT) is calculated by export price index (XPI) divided by import price index
(MPI) times 100 and it measures the movements in the price of exports and imports relative
to each other. There are favourable and unfavourable movements in the TOT. Favourable
movements in the TOT describe scenarios in which either the XPI increases or the MPI
decreases, reflecting an increase in the TOT. Unfavourable movements are the exact
opposite of those scenarios. There are several factors which may influence Australia’s TOT,
including:

Australia’s commodity prices experiencing a rise or fall. Rising commodity prices may lead to
favourable movements in the TOT as Australian exporters receive greater levels of income
from exporting. (e.g., China’s demand for iron ore exceeds supply, driving prices up).

Changing supply conditions for major commodities. If oil becomes more scarce due to its
non-renewable nature, then MPI will increase as Australia’s demand for overseas oil will
exceed its supply.

Improvements in technology can make production of a good efficient (i.e., cheaper). As

Australia’s major imports include high value manufactured goods such as computers, and
motor vehicles, a decrease in the price of imports for those items will decrease MPI and
create a favourable shift in the TOT.

Changes in transportation costs can increase or decrease the MPI. If, for example, there is
an increase in the price of fuel for shipping - then this will be reflected in an increase in the
cost of importing, increasing the MPI. As such, Australia’s TOT will decrease due to the cost
of imports increasing.

28b. Describe the contemporary trend in Australia’s terms of trade and explain four impacts
of this trend on the level of economic activity. (10 marks)
[UNRELATED]
29a. Outline the concept of the current account balance and describe four cyclical reasons
for the current account surpluses since 2019. (10 marks)

The current account balance (CAB) captures the net flow of money resulting from Australia’s
international trade in three categories: goods, services and income. The trade balance, the
largest component of the CAB, is relatively volatile and easily influenced by both Australia’s
and the world’s business cycle. Since 2019, the Australian economy has recorded a current
account surplus (CAS) for the first time since 1975 and several reasons for this are:

The increase in the level of exports was driven by strong demand for Australian commodities
by China, especially in iron ore, which recorded a record export value of $53.3bn. As such,
the large increase in credit from export income has contributed positively towards the
balance on goods and services (BOGS).

The AUD depreciating makes Australian exports seem more appealing to foreign residents
whilst making importing more expensive for Australian residents, creating a two-fold effect in
which the BOGS will increase significantly from an expansion in exports and a contraction in
imports.

The COVID-19 pandemic severely inhibited service exports and imports - but more so on the
latter. This is because the restriction of international travel meant travel imports decreased
significantly during this period of time, reducing the income outflows from the economy and
increasing the BOGS.

The pandemic-induced recession and its related worries caused a severe reduction in the
level of foreign investment, both direct and portfolio. This meant that Australia was forced to
rely on its national savings to fund investment and this reason was one of the main drivers to
creating the current account surplus (CAS) reflected in a net equity asset position of $369.6b
- reflecting a reduction in foreign liabilities.

29b. Discuss three ways in which foreign investment has affected the Australian economy in
recent years. (12 marks)

Foreign investment (FI) helps bridge the gap between investment and savings (SI gap)
created by Australia’s relatively small population and low national savings rate. Hence
Australia has usually run a CAD (reflected by a KAFA surplus). In recent years, FI has
actually fallen, and Australia was then forced to rely on its national savings to fund domestic
investment.
ETAWA 2023 Sem 1 exam

30a. Explain why Australia has a net foreign liability position and distinguish between
Australia’s two main types of foreign liability.

Australia has a net foreign liability position because of the national savings investment gap
that exists as a result of our relatively small population and low national savings rate,
creating a need for foreign investment to bridge the gap between domestic savings and
domestic investment needs. Net foreign liabilities is calculated by the sum of net foreign debt
and net foreign equity and as at 2023, it sits at around $869.6bn.

Foreign debt is the accumulated amount borrowed from non-residents by Australian

residents. Net foreign debt is then the foreign debt owed to other countries less what
Australia is owed to by foreign residents. As of 2023, it stands at $1206.3bn. The private
sector accounts for 74% of foreign debt, with public debt making up the remaining 24%. This
is because firms prefer borrowing to selling assets as it provides them with greater flexibility.

Foreign equity is the amount of assets owned by non-residents in Australia, and net foreign
equity is the amount of foreign equity less assets owned overseas by Australian residents.
An example of foreign equity is a Chinese investor owning shares (either direct or portfolio
investment) in an Australian mining company. Typically, Australia runs a liability position
(i.e., foreign residents own a larger amount of Australian assets than Australia owns foreign
assets) but in recent years, this has switched to a net equity asset position of -$369.6bn as
of 2023. This means Australia owns a greater amount of foreign assets than foreign
residents own Australian assets.
16/3/24

1. Why is Australia ‘better off’ with foreign debt?

The expanding foreign debt is increasing Australia’s national income, and the
servicing costs are actually less than the extra production gained from foreign debt,
which makes Australia ‘better off’.

2. Explain the link between the CAB and the level of foreign debt.
If Australia records a trade deficit, compounded with high levels of foreign debt, a
CAD is recorded.

3. Why does Australia normally record a CAD?

Mostly because Australia has a significant SI gap as a result of the nation’s relatively
small population being unable to produce enough domestic savings to fund domestic
investment needs, requiring large amounts of FI to fill in the gap - creating income
outflows contributing to a CAD.

4. Why will a CAS result in falling net foreign liabilities?

A CAS means that Australia is not as reliant on FI to fund investment as it reflects
that the country is experiencing greater income inflows rather than out. For Australia,
the recent trade surplus means the nation can afford to incur less foreign debt to fund
investment, decreasing net foreign liabilities.

5. Why does FI increase the income deficit in the BOP?

FI creates servicing costs to pay back the debt as well as dividends, which then
creates income outflows that contribute to the income deficit.

6. How is a CAD financed?

Either through foreign debt or foreign equity.

7. What are the positives of FI?

It expands the productive capacity of the economy, increasing national income levels
that are often greater than the servicing costs themselves. It can be used to better
the nation’s infrastructure and the development of industries and resources.

8. Why do some analysts see an increase in the foreign debt as a problem but others
see it as a benefit?
The income deficit will increase as well because profits and dividends will always
have to be paid back to overseas owners to service costs. However, the growth to
production outweighs the income deficit created so it’s a net gain.

9. Who owes Australia foreign debt?

Both the private sector (76%) and public sector (24%).

10. Australia’s net foreign debt is now over $1100 bn. Should we be worried?
No, because Australia has always relied on foreign debt to develop domestic
resources and industries.
MCQ
1. a
2. a
3. b
4. d
5. a
6. c
7. b
8. b
9. b
10. a
11. b
12. c

18/4/24

Events Demand for AUD Supply of AUD Exchange rate

Increased imports No change + -

Increased exports + No change +

Number of outbound No change + -

tourists increases

Interest rates decrease in - No change -

Australia relative to the
rest of the world

World economy grows - No change -

faster than the Australian
economy

Mining boom increases + No change +

investment

Inflation in Australia falls - No change -

relative to our trading
partners

Australia’s terms of trade + No change +

increases

Japanese investors + No change +

purchase Australian
shares

China’s economy slows - No change -

22/4/24

10. What are the advantages of a freely floating exchange rate?

There are three main advantages of a freely floating exchange rate:

1. It helps to provide automatic adjustment in the balance of payments (BOP). The

exchange rate varies and changes the prices of traded goods, services and assets
based on supply and demand. If the AUD is in excess, its depreciation will raise the
prices of imported goods and services in domestic currency terms whilst decreasing
the price of exported goods and services in terms of foreign currency, which aids to
remove the excess supply.

2. Free exchange rates help reduce swings in the current account balance (CAB).
Typically, a fall in the trade balance leads to the depreciation of currency - increasing
prices of imported goods and services whilst simultaneously increasing prices of
exported goods and services. After an initial lag, demand for imports should
decrease, and then demand for exports increase, decreasing the trade deficit.

3. It also helps insulate the domestic economy from external shocks. If the currency
appreciates, it mitigates impacts from a positive external shock. An example would
be the Australian mining boom increasing mining investment and raising national
income and wages. Usually this would create inflationary pressures but the high
valuation of the AUD increased export prices and reduced import prices, helping to
slow the economy down.

If the currency depreciates, it then shields the economy from negative external
shocks. Following the end of the mining boom, the AUD depreciated by 33% from
2012 to 2015. This reduces the prices of exports and increases import prices,
working to help the economy recover from negative external shocks.

11. Explain how the uncertainty associated with a floating exchange rate can be reduced.

Foreign exchange hedging strategy helps to avoid fluctuating exchange rates. Instead of
buying currencies for immediate use in the “present” market, they can instead be bought in
the futures market at a set price. These forward contrasts are risk mitigation tools allowing
countries to agree on an exchange rate in the present to buy or sell currency at a later date.
Future payments or payments receivable can then be priced with certainty, avoiding possible
losses should fluctuations in exchange rates occur.

MCQ
1. C
2. B
3. C
4. B
5. B
27/4/24

1. By how much did the AUD depreciate against the USD during 2022?
By around 8%.

2. Explain why the AUD did not fall on a trade weighted basis.
Despite depreciating against the USD by around 12%, the AUD did not fall on a trade
weighted basis as it appreciated against JPY. The higher prices of coal also offset
the decrease in prices of iron ore and base metals.

3. Explain two reasons from the extract for the depreciation of the AUD.
There has been a decline in yield differentials between Australian Government bonds
and those of other major advanced economies.
The prices of iron and base metals declined, though partly offset by increases in
prices of coal.

4. Choose one of these reasons and using a model of the AUD, illustrate and explain
why the AUD depreciated.

Falling prices in iron ore reflect poor demand for Australian iron ore - a key export
product of the Australian economy. This means that Australia will receive reduced
export income, as demand for AUD decreases, reflected by the leftward shift in
demand from D1 to D, and the AUD falling from 0.6USD to 0.5USD - a depreciation.
Quantity will also fall as less is demanded - from Q1 to Q2.

5. Describe the changes to the XPI between Sept 2020 and June 2022. Provide two
reasons for this change.
The XPI increased significantly, from 95 to 150, between September 2020 and June
2022. This was due to increased demand for commodities as the economy began to
recover from the pandemic-related concession towards the end of 2020. However,
during the war in Europe during 2022, as Russia is a significant exporter of oil and
natural gas, energy prices spiked, and demand for Australian equivalents soared,
marking another significant increase in its XPI.

6. Describe four effects of a rise in the terms of trade.

The exchange rate appreciates, as demand for the AUD has increased relative to its
supply.

The trade balance increases as more exports are being sold than imports being
purchased

Favourable movements in the ToT cause a higher rate of inflation because increased
export income increases national income, which results in more economic spending
and investment.

More export income then contributes towards decreasing a current account deficit,
reducing the national savings investment gap
7.
8.
29/4/24

Worksheet questions (pg119)

1. What is an exchange rate and why is it necessary?

Exchange rates define how much one country’s currency is worth in terms of
others. They are necessary because rates of exchange between countries
must be established for international trade to occur as each country uses
different currencies.

2. Previously done

3. What is the ‘trade weighted index’ (TWI)?

It is a basket of currencies weighted by importance in terms of trade flows
with a particular country and it accurately reflects changes in the value of a
country’s currency in terms of the countries it trades with the most.

4. What is the foreign exchange market? Explain what happens in the foreign
exchange market if Australia sells more exports to the US.
It is the market in which the currencies of different countries are bought and
sold. If Australia sells more exports to the US, American importers will supply
Australian exporters with more USD that the Australian exporters will
exchange with the bank for AUD as that is what they demand.

5. How is the balance of payments and the exchange rate linked?

The exchange rate can vary to change the prices of traded goods, services,
and assets. If there is an excess supply of AUD, depreciation can raise the
prices of imported goods and lower those of exported goods, increasing the
CAB.

6. Distinguish between the demand for a currency and its supply.

2/5/24

1. XPI = blue
MPI = red
2. December 2019
3. 153/118*100 = approx. 129.7
4. Commodities make up a key part of Australia’s exports so their price volatility makes
the Australian XPI fluctuates depending on how
3/5/24

1. Explain the effect of each of the following on the terms of trade:

a. An increase in iron ore and coal prices
This would result in a favourable movement in the terms of trade for Australia
as the nation is export reliant (commodities such as iron ore and coal prices).
This favourable movement would cause Australian exporters to benefit, as
higher commodity prices reflect stronger demand for them and as a result, the
export price index would increase.

b. An increase in oil prices

Because Australia is a heavy importer of oil, if oil prices increase, this makes
the export price index liable to increase, resulting in an unfavourable
movement in the terms of trade as Australia must now export more relative to
its increased import price index in order to maintain its previous terms of
trade.

c. A fall in ICT prices

(Unsure what ICT means)
 6/5/24
Identify and account for recent terms of trade. (2011-2022)
- Identify movements over the last 10 years
- Provide data to support
- Explain the reasons for said movements.

Over the last ten years, Australia’s ToT has been on a general upward trend, with several
key events occurring over time.

The mining boom, occurring from the early 2000’s until 2011 drove Australian commodity
export prices upwards significantly. During this period, global use for commodities (iron ore,
coal, natural gas, coal) rose sharply, driven by strong demand for steel and energy required
for rapid urbanisation especially in China. In 2012, mining investment increased from $20bn
to $130bn in 2012, peaking at a valuation of 12% of GDP.

However, the end of the mining boom came that same year, as Australia had managed to
increase its output of commodity exports at the same time countries in Asia found additional
sources of commodities to import. This meant that supply increased at the same time as
demand for Australian commodities decreased, reducing the ToT.

In 2016, commodity prices began to rise once more as global economic growth during this
period would increase. From 2016 to 2019, Australia’s XPI grew 40% (72 to 109). Though,
2020 marked the end of this era as the pandemic-caused recession shrunk XPI by 8% since
trade was reduced amidst border restrictions and demand for construction (which needed
commodities like iron to create steel) was also low during this period.

In 2021, the economy started to recover as border restrictions were lifted and trade could
occur as normal but in 2022, the Russo-Ukraine war increased energy prices as Russia,
being the second-largest oil producer and gas producer, stopped exporting. This meant that
Australian exports of the same commodities saw a strong spike in prices, increasing the
Australian XPI by over 50% and is why the ToT recorded its highest value in June 2022.
9/5/24

1. Explain how the ToT ‘drives’ the Australian economy.

Australia’s ToT represents the ratio between Australia’s exports and imports, and
given that exports are a integral part of its economy, an increase in the ToT means
increased national income from trade, driving the economy.

2. What are commodity exports? Explain their importance for the ToT.
Commodity exports are the exports of natural resources (such as iron ore, coal,
natural gas) often used as inputs to create manufactured goods. For Australia,
commodity exports make up a significant portion of its total export income as there is
strong demand from China for commodities to manufacture goods such as consumer
electronics and cars.

3. Explain how an increase in the ToT provides a stimulus to the economy.

An increase in the ToT means that the Australian economy’s export income
increases, which benefits household real income levels, as well as boosting
employment in the mining sector. This stimulates the economy as households are left
with higher levels of disposable income that can then be spent in the economy,
increasing economic growth.

4. Explain why Australia’s ToT increased during 2021-22?

As the world began to recover from the COVID-related recession in 2020, trade
began to open up and demand for commodities began to rise again as China began
to experience economic growth again, as such, increasing the ToT.

5. Explain the effect of a rise in the ToT on the TB?

It increases the trade balance, because as the ToT measures changes in the value of
exports and imports, if exports become more valuable, Australia is able to earn
higher levels of export income. As the trade balance measures net exports, this is
going to increase due to said increased levels of export income.