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 or 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.

This is clearly reflected in the statistics that have been observed over the last 10 years. In the graph below we can see that in 2001/02 productivity increased by 3.6% (the best result since 2000), and the CAD/GDP ratio was at -3.2% at the same time.

Labour productivity and the CAD in Australia

By 2005, you can see that labour resources were actually being allocated less efficiently. The impact on the current account deficit is obvious - the worst result for labour productivity coincides with an extended period of poor results for the current account deficit. Our inability to generate more positive outcomes for labour productivity since that time has contributed to the large deficits that were recorded through until 2006/07.

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.

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