Unit 1
Unit 3
External Stability
Supply Factors and External Stability
Unlike the impact of demand factors, a change in a supply factor has a relatively predictable impact on our external stability. This is due to the fact that when aggregate supply increases it leads to a higher level of production, but no upward pressure on prices. As a result, an increase in supply will give us more stocks to sell overseas AND increase our international competitiveness.
An example will help to make this clear. In theory, an improvement in Australia’s rate of productivity should lead to an increase in aggregate supply. This is because as we are able to produce a higher quantity from the same number of inputs, the effective cost per unit decreases, and so the margin on each item increases. With an increased margin on each item suppliers will be willing to allocate more of their scarce resources to the production of that item, as it will help them to maximise profits. In so doing, the aggregate supply curve will shift to the right.
The impact of this can be seen on the graph below. We should see an increase in GDP, and this will be achieved with no upward pressure on prices. As a result of the increase in supply we will also see an increase in the quantity demanded, and this is where the impact on external stability becomes apparent.
As there has been no upward pressure on prices, the increased quantity will be consumed (ie purchased). Without inflation our international competitiveness will improve, and our exports will become more desirable. In this situation producers will be able to clear their excess stocks by selling them on the international market – they will export them.
It is reasonably safe for you to conclude that an increase in supply will lead to an improvement in the CAD/GDP ratio (although this will not always be immediately apparent), and through an increase in demand for our exports it may also lead to an appreciating currency.
In 2008/09 there was a small improvement in labour productivity outcomes for the Australian market, and this coincided with a structural shift in the current account in this country. In that year the CAD contracted slightly, and was recorded at -4.3% of GDP. As the global economy improved during 2009-2011, demand for Austraila's exports improved. This country tends to operate with an absolute advantage in the production of certain commodity exports, such as coal and iron ore, and as a result the decline that was seen in labour productivity during this period did not place too much pressure on the current account balance at that time. By 2011 the CAD was -2.3% of GDP, which was predominantly due to the net income deficit that was evident at that time. The balance on merchandise trade was operating with a small surplus., and therefore should not be considered a factor contributing to the deficit that was seen at that time.
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