External Stability

Demand Factors and External Stability

Demand factors that affect external stability are the same as the demand factors that affect other goals, but they must be assessed in a slightly different way. It is not as simple as reading the impact on a supply and demand graph – we must carefully examine the impact on the external sector of the Australian economy.

For example, an increase in consumer confidence is a demand factor that can affect our external stability. This may lead to an increase in aggregate demand, however if domestic production is not sufficient to meet this demand then we may choose to import goods and services. By importing the desired products we can make the deficit balance in the current account even larger. We also provide a higher supply of AUD on the foreign exchange market, and this may lead to a depreciation of the dollar. And so an increase in consumer confidence may ultimately lead to more instability in our external sector.

In the graph below, this can be clearly seen in 2006/07. At this time, consumer confidence (as measured by the Westpac Index) increased. As a result, spending on imports increased, and the current account deficit expanded to -5.5% of GDP. In the following year confidence fell, and as a direct result our spending on imports also fell. This led to a contraction in the current account deficit, which can also be seen in the graph. Confidence levels in 2011 did not return to the levels that were seen prior to the financial crisis, and as a result spending on imports was offset by the strong demand from overseas for Australia's commodity exports, and therefore the CAD contracted during this period.

Consumer confidence and the CAD

On the other hand, increasing economic activity amongst our trading partners may also lead to an increase in aggregate demand. However, in this instance the initial impact will be an increase in exports. If our exports increase, while our imports remain constant, then this creates demand for the AUD on the foreign exchange market, and therefore the AUD may appreciate. In addition, our balance on current account may improve, as the increase in exports will lead to more credits in the net merchandise and net services accounts.

And so as you can see, we must carefully analyse the impact of any change in a demand factor before we draw conclusions about the impact on external stability. Both of the factors listed above resulted in an increase in aggregate demand, and yet the impact on external stability was quite different.

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