2016 HSC Economics: Worked Solutions

Worked solutions to the 2016 HSC Economics examination.

Get the paper first. These solutions describe each question rather than reproducing it, so open the official paper alongside. NESA publishes it free in the 2016 Economics exam pack. The answers below are checked against the official marking guidelines. The explanations are our own.

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Section I: multiple choice

Answer key

Q	A	Q	A	Q	A	Q	A
1	A	6	B	11	C	16	D
2	B	7	C	12	C	17	C
3	C	8	A	13	D	18	C
4	B	9	B	14	A	19	A
5	D	10	D	15	D	20	A

The reasoning

1. Example of a monetary union. A. The EU, whose Eurozone members share a common currency and a single monetary policy. APEC is a regional economic forum, ASEAN is a trading bloc, and NAFTA was a free trade agreement. Only the EU goes as far as a shared currency.

2. Policy mainly used to manage inflation. B. Monetary policy. The RBA targets inflation of 2 to 3% on average over the cycle, and the cash rate is the primary instrument. Fiscal policy affects inflation but its main purposes are stabilisation, resource allocation and redistribution, while competition and labour market policies operate on the supply side over much longer horizons.

3. Increased budget surplus. C. Reduced government spending and increased taxation. Revenue rises while expenditure falls, so the surplus grows on both sides. Every other combination has at least one component working against the surplus.

4. Trading partners experience a slowdown. B. Australia's unemployment rate increases. Weaker foreign income reduces demand for Australian exports, which lowers aggregate demand and therefore the derived demand for labour. Options A and C move the wrong way, and the CPI would face downward rather than upward pressure.

5. Government reduces tariffs. D. A redistribution of income from local producers to importers. Cheaper imports mean import-competing domestic producers lose sales, revenue and profitability, while importers and consumers gain. Tariff revenue per unit falls, and although import volumes rise, option A asserts the wrong direction with certainty.

6. Gini moving from 0.3 to 0.4. B. A rising Gini means more inequality, so look for a regressive change. Increasing the GST is the only one, because low-income households spend a larger proportion of their income on consumption and therefore pay a larger proportion of income in GST. Higher company tax, higher marginal rates on high income earners and higher taxes on property profits are all progressive and would lower the Gini.

7. Frictional unemployment. C. The self-employed worker between businesses is between jobs, which is exactly what frictional unemployment means. Check the distractors: the student struggling in a recession is cyclical, the fruit-picker retraining is structural (or seasonal), and the part-time worker seeking more hours is underemployed rather than unemployed at all.

8. Change in income inequality. A. Consumption. The Lorenz curve moved towards the line of equality, so inequality fell and income shifted towards lower-income households. Those households have a higher marginal propensity to consume, so aggregate consumption rises. Options C and D describe effects of rising inequality, which is the opposite of what the diagram shows.

9. Increasing the retirement age. B. Both increase. Older workers remain in the labour force, so the participation rate rises. They continue earning and paying income tax while no longer drawing the Age Pension, so taxation revenue rises and expenditure falls. Both halves must be right.

10. Shifting the demand curve for labour. D. A decentralised method of determining employment contracts allows wages to reflect firm-level productivity, lowering the effective cost of labour and increasing the quantity of labour firms wish to employ at each wage, which shifts demand right. A global downturn shifts demand left, a change in participation shifts supply rather than demand, and minimum employment standards raise employment costs.

11. Switching from domestic to overseas borrowing. C. The current account deficit will increase. Borrowing from overseas creates foreign liabilities, and the interest paid to service them is recorded as a net primary income debit on the current account. Foreign debt rises rather than falls, the size of the deficit is unchanged since only the financing method changed, and domestic borrowing costs actually fall, because the government has stopped competing for domestic savings.

That last point is the real merit of overseas borrowing: it avoids crowding out, at the cost of a permanent external servicing obligation.

12. Increase in the official cash rate. C. A redistribution of income and wealth towards those with a relatively high marginal propensity to save. Higher rates raise the return to savers and the cost to borrowers, so income transfers from borrowers to savers, and savers by definition have a high MPS. Options A and B both get the exchange rate wrong, since a higher cash rate causes an appreciation, and they pair it with the wrong inflation expectation.

13. Repayment of an interest-free loan made to a developing economy. D. A credit in the capital and financial account. Australia previously held a financial asset in the form of the loan, and repayment of the principal extinguishes that asset and brings money into Australia, so it is a financial account credit.

The trap is the secondary income options. Secondary income records transfers where nothing of equivalent value flows back, which is what the original granting of concessional aid would be. Repayment is not a transfer, because a financial asset is being surrendered in exchange. Note also that the loan is interest-free, so no primary income arises at all.

14. Decline in Australia's terms of trade. A.

ToT = (export price index ÷ import price index) × 100

Export prices must fall, and two things lower a price: decreased demand and increased supply. Option A has both. Every other row contains at least one factor that would raise export prices.

15. Allowing an infant industry to benefit from globalisation. D. An increase in Australia's recognition of international educational qualifications. A developing industry needs skilled labour it cannot yet train domestically, and recognising foreign qualifications gives it access to the global pool of expertise, letting it build capability and reach efficient scale. Options A and B remove the protection an infant industry relies on, and C exposes it to competition from established transnational corporations.

16. Real GDP and HDI. D.

Real GDP = money GDP ÷ CPI × 100
  Year 1: 1000 ÷ 100 × 100 = 1000
  Year 2: 1500 ÷ 110 × 100 = 1363.6      →  real GDP INCREASES

Real GDP per capita
  Year 1: 1000 ÷ 100 = 10.00
  Year 2: 1363.6 ÷ 150 = 9.09            →  DECREASES

Population grew 50% while real output grew only 36%, so output per person fell. Since HDI incorporates income per capita, it most likely decreases even though the economy grew.

This is the best question in the paper, because it captures the central distinction in development economics: aggregate growth and growth per person are different things, and only the second raises living standards.

17. Lowering the NAIRU. C. Infrastructure investment. The NAIRU is determined by structural factors, and better infrastructure raises productivity, improves labour mobility by connecting workers to jobs, and expands productive capacity. Options A and B are demand-side, moving unemployment along the Phillips curve rather than shifting it, and centralised wage bargaining tends to raise the NAIRU by reducing wage flexibility.

18. Purchasing power at home and abroad. C. Two separate judgements.

AUD rose from 0.70 to 0.75 USD  →  APPRECIATION
  →  purchasing power overseas INCREASED

Inflation of 2%, then 1%       →  still POSITIVE
  →  domestic prices still rising
  →  domestic purchasing power DECREASED

The trap is inflation falling from 2% to 1%. That is disinflation, not deflation, so prices are still rising and domestic purchasing power is still being eroded, just more slowly. Falling inflation does not mean falling prices.

19. Net foreign liabilities. A.

Net foreign debt   = 600 − 150 = $450 billion
Net foreign equity = 100 − 250 = −$150 billion   (Australians own MORE foreign
                                                  equity than foreigners own here)
Net foreign liabilities = 450 + (−150) = $300 billion

The negative equity component is what makes this harder than the usual version. Australians hold more foreign equity assets than foreigners hold here, so equity reduces total liabilities rather than adding to them. Option C ($600bn) is a single gross figure, and option D adds everything together with no netting at all.

20. Why a public road is not a public good. A. Travel times vary with usage, which means the road becomes congested, and congestion is rivalry: one driver's use reduces the quality of the road available to others. A public good must be both non-rival and non-excludable, so failing rivalry is sufficient.

Option C is the designed trap, because it argues the road is non-rival, which supports the opposite conclusion. Option B is about who provides it, which has no bearing on whether something is a public good.

Where marks were lost. Question 16 caught candidates who calculated real GDP and stopped without dividing by population. Question 19 caught candidates who added the equity component instead of recognising it was negative. Question 18 caught candidates who read falling inflation as falling prices.

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Section II: short answer

Question 21 (10 marks): subsidies

(a) Why a government might prefer a subsidy to a tariff (2 marks).

A subsidy leaves the domestic price at the world price, so consumers continue to pay the same price and consumption is unchanged. A tariff raises the domestic price, so consumers pay more and consume less. The subsidy therefore avoids the consumption-side distortion entirely and produces only one deadweight loss triangle rather than two, making it the more efficient method of achieving the same increase in domestic production.

The efficiency argument is what earns the second mark. Note the trade-off worth mentioning: the subsidy is more efficient but more expensive for government, since the cost appears in the Budget rather than being paid by consumers.

(b) How removal of a subsidy might promote greater efficiency (3 marks).

A subsidy artificially lowers producers' costs, allowing firms to survive that could not cover their costs at the world price. Resources are therefore retained in an industry where the economy lacks comparative advantage, which is a misallocation.

Removing the subsidy exposes those firms to the true world price. The least efficient exit, and the land, labour and capital they employed are released and reallocated to industries where the economy is internationally competitive. That improves allocative efficiency, since resources move to their highest-valued use, and technical efficiency, since the firms that remain must minimise costs to survive without assistance. Over time the removal of guaranteed support also improves dynamic efficiency, because firms must innovate rather than rely on the subsidy.

Government expenditure previously committed to the subsidy is also freed for uses with a higher return, such as infrastructure or education, which is a further efficiency gain.

(c) Discuss the likely impacts on government revenue and expenditure of removing a subsidy (5 marks).

The question names both revenue and expenditure, so cover both, and discuss means arguing more than one direction.

Expenditure falls directly. The subsidy payment itself is removed from the Budget, which is an immediate and certain saving and the primary motivation for removal.

Expenditure rises in other areas. The firms that exit the industry retrench workers, and because the displaced workers hold industry-specific skills and are typically regionally concentrated, they experience structural unemployment that is slow to resolve. Government then pays more in unemployment benefits, and usually funds retraining, relocation assistance and regional adjustment packages. Australia's motor vehicle industry assistance is the standard illustration. In the short term these costs can offset a substantial share of the saving.

Revenue falls in the short term. Company tax receipts from the industry fall as firms contract or close, income tax receipts fall as workers lose jobs, and GST receipts fall as those households reduce spending.

Revenue rises in the longer term. Resources reallocated to internationally competitive industries generate higher output and profits than they did in the subsidised industry, so company and income tax receipts from the expanding sectors exceed what was lost. Higher productivity raises the sustainable rate of growth and therefore the tax base as a whole.

Discussion and judgement. The Budget impact is negative or roughly neutral in the short term, because transitional costs and lost revenue offset much of the saving, and clearly positive in the long term once reallocation is complete. The size and speed of the improvement depend on the state of the economy at the time: if growth is strong, displaced workers are absorbed quickly and the transitional cost is small, whereas removing a subsidy during a downturn leaves workers unemployed for far longer and the Budget worse off for years. That timing consideration is why subsidy removal is politically easier in an expansion.

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Question 22 (10 marks): externalities and the environment

(a) Outline the difference between a private benefit and a social benefit (2 marks).

A private benefit accrues to the individual or firm directly involved in a transaction, and it is the benefit they consider when deciding. A social benefit is the total benefit to society, comprising the private benefit plus any benefit accruing to third parties who are not part of the transaction.

Where a positive externality exists, social benefit exceeds private benefit. Because decision-makers act on private benefit alone, the market under-provides the good relative to the socially optimal level.

The under-provision conclusion is what turns a definition into an economic point.

(b) Why developed and developing nations may take different approaches to environmental sustainability (4 marks).

Competing priorities and opportunity cost. Developing economies face urgent needs in poverty reduction, health, education and basic infrastructure. Resources directed to environmental protection carry a high opportunity cost when a substantial share of the population lacks clean water or adequate nutrition, so growth is rationally prioritised over abatement. Developed economies, having met those needs, can afford to trade some output for environmental quality.

Income and demand for environmental quality. Environmental quality behaves as a normal good, so demand for it rises with income. Wealthier populations press their governments harder for clean air, water and biodiversity protection, and developed economies have the fiscal capacity and administrative institutions to regulate and enforce.

Historical responsibility and equity. Developed economies industrialised without environmental constraint and generated the majority of the accumulated stock of atmospheric emissions. Developing economies argue it is inequitable to be denied the same path, which is the basis of the principle of common but differentiated responsibilities in international agreements.

Comparative advantage and structure. Developing economies often specialise in resource extraction, agriculture and heavy manufacturing, which are emissions and resource intensive, and they may attract polluting industries relocating from economies with stricter regulation. Developed economies have shifted towards services, which lowers their measured domestic emissions partly by importing goods whose emissions are counted elsewhere.

Technology and capacity. Abatement technology is expensive and largely developed in advanced economies, so developing economies face higher effective abatement costs and weaker regulatory institutions to enforce standards.

(c) An advantage and a disadvantage of international environmental agreements (4 marks).

Two marks each.

Advantage: they address the free rider problem. Climate change and ozone depletion are global externalities, so any country acting alone bears the full cost while the benefit is shared worldwide, which means no country has an individual incentive to act. Agreements coordinate action so that countries abate simultaneously, and each can be confident others are contributing. They also create reputational pressure, provide a framework for technology and finance transfer to developing economies, and establish common measurement standards. The Montreal Protocol on ozone-depleting substances is the clearest success, achieving near-universal ratification and a measurable recovery of the ozone layer.

Disadvantage: they lack enforceability. International agreements depend on voluntary compliance, because there is no supranational authority able to compel a sovereign state. Under the Paris Agreement targets are self-nominated, there is no penalty for missing them, and countries can withdraw, as the United States did in 2017. Negotiation is slow, since agreement among nearly two hundred parties with conflicting interests produces lowest-common-denominator outcomes, and the free rider incentive persists: any country that does not ratify still enjoys the benefit of everyone else's abatement.

The pattern across both is that agreements work where abatement is cheap and substitutes exist, as with ozone, and struggle where the cost falls on major industries, as with carbon.

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Question 23 (10 marks): exchange rates

(a) Draw a new supply curve showing a depreciation of the AUD (1 mark).

Draw the new supply curve to the right of the original, and label it clearly, for example S1.

An increase in the supply of Australian dollars on the foreign exchange market pushes the equilibrium down the demand curve, lowering the value of the AUD in US dollars. Make sure the new equilibrium price is visibly lower on the vertical axis, and mark it, because a shifted curve with no new equilibrium price does not clearly show a depreciation.

(b) Why there might be an increase in the supply of Australian dollars (2 marks).

An increase in Australian demand for imports increases the supply of Australian dollars, because Australians must sell AUD to obtain the foreign currency needed to pay overseas suppliers. Increased capital outflow has the same effect: Australians investing abroad, or repaying foreign debt, must convert AUD into foreign currency, shifting the supply curve right.

Any of these works if you supply the mechanism: more imports, more outbound tourism, higher capital outflow, or speculation that the AUD will fall.

(c) How a decrease in the TWI may affect inflation (3 marks).

A fall in the Trade Weighted Index means the currency has depreciated against the weighted basket of Australia's major trading partners, so the domestic-currency price of imports rises across the board.

This raises inflation through two channels. Directly, imported consumer goods enter the CPI at higher prices. Indirectly and more significantly, imported intermediate goods, capital equipment and fuel become dearer, which raises production costs for domestic firms. Those firms pass the increase into prices, producing imported cost-push inflation across a wide range of goods, including ones with no obvious import content.

There is a second-round effect. Domestic producers competing with imports face less price pressure once foreign substitutes are dearer, so they can raise their own prices too. Higher export competitiveness also raises aggregate demand, adding demand-pull pressure.

The TWI is the appropriate measure here rather than a bilateral rate, because it captures the currency's movement against all trading partners weighted by their share of trade, which is what determines the overall cost of imports.

(d) Assess the impacts of a depreciation on the level of employment in Australia (4 marks).

Assess requires a judgement.

Employment rises in trade-exposed industries. A depreciation makes Australian exports cheaper in foreign currency, so export volumes rise and exporters expand output and hiring, particularly in tourism, education, agriculture, mining and manufacturing. Import-competing firms also benefit, because imported substitutes become dearer and consumers switch to domestic production. Since the demand for labour is derived from the demand for output, employment rises in both groups, and the increase in net exports raises aggregate demand and, through the multiplier, employment more broadly.

Employment falls in import-dependent industries. Firms relying on imported inputs, capital equipment or fuel face higher costs, which squeezes margins and may force them to reduce output and staff. Retail and industries with high import content are most affected.

The timing qualification. The employment gain is not immediate. The J-curve means import values rise before volumes adjust, and firms take time to expand capacity and hire, so the benefit accrues over quarters rather than weeks, while the cost increase for importers is immediate.

The inflation constraint. Imported cost-push inflation from part (c) may prompt the RBA to raise the cash rate, which reduces aggregate demand and works against employment. This offset can be substantial.

Judgement. The net effect on employment is positive over the medium term, because the trade-exposed sector is large and employment intensive and the gains exceed the losses in import-dependent industries. But the effect is delayed by the J-curve, uneven in its distribution across industries and regions, and it can be partly reversed if the resulting inflation triggers monetary tightening.

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Question 24 (10 marks): the multiplier and aggregate demand

(a) Change in national income if investment declines by $100 million, with MPC = 0.9 (1 mark).

k = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.9) = 1 ÷ 0.1 = 10
ΔY = −$100 million × 10 = −$1000 million

Answer: national income falls by $1000 million ($1 billion). Keep the sign, because the question says "declines".

(b) How changes in the MPC affect an economy's growth (4 marks).

The marginal propensity to consume is the proportion of each additional dollar of income that is spent rather than saved, and it determines the size of the multiplier:

k = 1 ÷ (1 − MPC)  =  1 ÷ MPS

A higher MPC produces a larger multiplier. More of each dollar received is respent, so it becomes income for someone else, who respends most of it in turn. Each round of the circular flow leaks less to savings, so any given injection generates a larger total increase in national income and faster economic growth. At an MPC of 0.9 the multiplier is 10, whereas at 0.5 it is only 2, so the same stimulus produces five times the effect.

A higher MPC also makes the economy more volatile. The multiplier works in both directions, so a fall in investment or exports contracts income by a correspondingly larger amount, as part (a) shows.

The long-run relationship runs the other way. A high MPC means a low marginal propensity to save, and domestic savings are what fund domestic investment. An economy that consumes almost everything it earns generates little investable capital, so it must either invest less, which lowers the future capital stock and productive capacity, or import foreign capital, which creates foreign liabilities and a net primary income deficit.

This is the paradox of thrift in reverse. High consumption supports growth in the short run through aggregate demand, while high saving supports growth in the long run through investment and aggregate supply. The desirable level of the MPC therefore depends on where the economy sits in the cycle: high consumption helps in a downturn with spare capacity, and high saving helps at capacity when investment is the constraint.

(c) How changes in both aggregate demand and aggregate supply influence economic activity (5 marks).

Aggregate demand is total spending on goods and services, comprising C + I + G + (X − M). An increase shifts AD right, raising both real output and the price level, with the balance between them depending on how close the economy is to capacity. Where substantial spare capacity exists, firms respond mainly by raising output and employment with little price effect. Near full capacity, the response is mainly inflationary, because firms cannot readily produce more. This is why the same stimulus has entirely different consequences at different points in the cycle, and it is the central practical insight of the model.

Aggregate supply is total output firms are willing to produce at each price level, determined by the quantity and quality of the factors of production, productivity, technology and input costs. An increase shifts AS right, raising real output while lowering the price level, which is the unusual and desirable case of growth without inflation.

The interaction determines outcomes. AD growth alone eventually exhausts itself in inflation once capacity is reached. AS growth raises the ceiling, so demand can expand further before generating inflationary pressure. Sustained non-inflationary growth therefore requires both: demand growing to use available capacity, and supply growing to extend it.

Adverse supply shocks show the model's power. A sharp rise in oil prices shifts AS left, which simultaneously reduces output and raises prices. That is stagflation, and it presents an acute policy dilemma, since demand-side policy can address one problem only by worsening the other.

The policy implication. Macroeconomic policy manages aggregate demand and is therefore a stabilisation tool, while microeconomic policy raises aggregate supply and is the only means of increasing the economy's sustainable rate of growth. Distinguishing the two is the point of the question.

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Section III: stimulus-based extended response

Question 25: how labour market policies affect both the employed and the unemployed

The stimulus was a Productivity Commission report noting that without regulation and collective bargaining "many employees are likely to have much less bargaining power than employers, with adverse outcomes for their wages and conditions", that awards carry "some undesirable inconsistencies and rigidities", that wages are "the key cost of employing labour" alongside workers compensation, leave, superannuation and payroll tax, and that "an increase in wages induces more people to enter the labour force to seek work".

Thesis. Labour market policies face a structural tension the stimulus states directly: the regulation that protects the wages and conditions of the employed raises the cost of hiring and can price the unemployed out of work. Australia's system attempts to hold both, using a safety net for those in work and supply-side measures for those out of it.

Structure the response around the two groups named, because that is the question.

1. Set up the framework. Outline the system: the Fair Work Act 2009, the decentralised enterprise bargaining structure, awards and the National Employment Standards, the annual minimum wage review, and training and employment programs.
2. Effects on the employed: protections. Awards and the NES set minimum wages, leave, hours and termination entitlements. Quote the Commission's observation about bargaining power asymmetry, since it is the economic justification for the whole regulatory structure: labour markets are not markets of equals, and without regulation individual employees negotiate from a much weaker position than employers.
3. Effects on the employed: enterprise bargaining. Wages linked to firm-level productivity allow real wage growth without raising unit labour costs. Workers in profitable, unionised, high-productivity industries do well. Note the distributional consequence, which is that decentralisation widens the wage distribution, because bargaining outcomes depend on bargaining power.
4. Effects on the employed: the cost side. Use the stimulus list. Employers face not only wages but workers compensation premiums, leave provisions, superannuation and payroll tax. This matters because it means the cost of employing someone substantially exceeds their wage, which is exactly what connects the two halves of the question.
5. Effects on the unemployed: the barrier. Because total employment cost exceeds the wage, a minimum wage set above the market-clearing level prices out workers whose productivity does not cover the full cost, and those workers are disproportionately the young, the low-skilled and the long-term unemployed. The rigidities the Commission names compound this. Use a labour market diagram to show the excess supply.
6. Effects on the unemployed: the participation effect. Quote the stimulus point that higher wages induce "more people to enter the labour force to seek work". This is a genuinely two-edged observation and worth dwelling on: higher wages raise participation, which is desirable, but if employment does not rise correspondingly, the additional entrants show up as measured unemployment. Higher wages can therefore raise both the participation rate and the unemployment rate at once.
7. Effects on the unemployed: the policies that help them. Training, retraining and apprenticeship programs, employment services and job matching, and mobility measures all reduce structural and frictional unemployment and lower the NAIRU. These are the instruments that actually target the unemployed, since wage regulation by construction operates on people who already have jobs.
8. Judgement. The system delivers real protection and reasonable wage outcomes for the employed, and the bargaining power argument justifies it. Its cost falls on the marginal unemployed, and the resolution is not deregulation but the supply side: raising the productivity of low-skilled workers through training so that they are worth employing at the minimum wage, rather than lowering the wage to match their current productivity.

Question 26: why an Australian Government may not be able to achieve all its economic objectives

Thesis. Government cannot achieve all its objectives simultaneously because the objectives conflict with one another, because it has fewer independent instruments than targets, and because significant determinants of Australian economic outcomes lie outside domestic control.

The plan:

1. Name the objectives: economic growth, full employment, price stability, external stability, an equitable distribution of income, and environmental sustainability.
2. Conflict: growth against price stability. Growth beyond productive capacity generates demand-pull inflation, so restoring price stability requires deliberately slowing growth.
3. Conflict: full employment against price stability. The short-run Phillips curve. Below the NAIRU, competition for labour accelerates wage growth and feeds into prices. Draw it, and add the vertical long-run curve to show the trade-off is temporary.
4. Conflict: growth against external stability. Rising incomes draw in imports, given Australia's high marginal propensity to import, worsening the balance on goods and services. The float weakens this conflict by partially self-correcting.
5. Conflict: growth against distribution. Deregulation and decentralised wage determination raise productivity and growth while widening the income distribution.
6. Conflict: growth against environmental sustainability. Higher output raises emissions and resource depletion, reducing the natural capital available to future generations.
7. The instruments problem. Tinbergen's rule: a government needs at least as many independent instruments as targets. Australia has essentially two macroeconomic instruments for six objectives. Monetary policy is a single blunt lever applying uniformly across the whole economy, unable to target a region, industry or income group.
8. The limitations. Time lags of recognition, implementation and impact. Political constraints and the electoral cycle. Global factors including the international business cycle, commodity prices and financial contagion, which no domestic policy controls. The effective lower bound on interest rates.
9. The resolution, which is where the top band sits. Demand management can only move the economy along the existing trade-offs. Supply-side reform shifts the trade-offs themselves, raising capacity so that growth and employment improve without inflation, and lowering the NAIRU so lower unemployment is compatible with price stability. That is the only route to advancing multiple objectives at once, and its constraint is that it is slow and politically costly.

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Section IV: extended response

Question 27: assess the impact of the RBA's expansionary monetary policy on the Australian economy

Assess requires a judgement, so evaluate effectiveness rather than describing the mechanism.

Thesis. Expansionary monetary policy has been effective at supporting growth and employment and at cushioning Australia against external shocks, but its effectiveness diminishes as rates approach zero, and its distributional consequences, which fall outside the RBA's mandate, have become its most significant cost.

The plan:

1. Define expansionary monetary policy and the cash rate, and note the RBA's mandate of price stability, full employment and the prosperity and welfare of the Australian people.
2. The transmission mechanism, in full, because the assessment depends on it: cash rate to market interest rates to consumption, investment, cash flow, asset prices and the exchange rate, then to aggregate demand, output and employment.
3. Impact on growth and employment: effective. Lower rates reduce debt servicing for mortgaged households, freeing income for spending, and lower the cost of capital, improving the viability of investment projects. Trace the sustained easing after the mining investment boom peaked, which supported the transition to non-mining growth.
4. Impact on the exchange rate: effective. A lower cash rate narrows the interest rate differential, reducing capital inflow and demand for the AUD. The resulting depreciation improves international competitiveness for exporters and import-competing producers, which is a genuine second channel and worth separating from the domestic one.
5. Impact on inflation: mixed. Expansionary policy is meant to raise inflation towards the band, and the depreciation adds imported inflation. But inflation persistently undershot the 2 to 3% target through the second half of the 2010s despite sustained easing, which is direct evidence of diminishing effectiveness.
6. Impact on asset prices and distribution: the strongest criticism. Lower rates raise the present value of assets, inflating housing and equity prices. This generates a wealth effect supporting consumption, but it transfers income from savers to borrowers, penalises retirees dependent on interest income, and inflates the price of housing beyond the reach of first home buyers. Since asset ownership is far more concentrated than income, expansionary monetary policy widens the distribution of wealth. Note the institutional point: distribution is not part of the RBA's mandate, so the RBA has no instrument to address a consequence it creates, which means the response must be fiscal.
7. Impact on financial stability. Low rates encourage borrowing and rising household debt, raising Australia's household debt to income ratio to among the highest in the developed world, which increases vulnerability to any future rate rise or income shock.
8. Limitations. The effective lower bound, which removes the instrument once rates approach zero. Time lags of 6 to 18 months. The blunt, undifferentiated nature of the instrument. Incomplete pass-through by banks. And the inability to address supply-side inflation or structural unemployment.
9. Judgement. Highly effective in the early stages of an easing cycle and progressively less so as rates fall, since each successive cut delivers less stimulus and more asset price inflation. Expansionary monetary policy is necessary for stabilisation but has been asked to do too much, and the sustained reliance on it reflects the reluctance to use fiscal and microeconomic policy rather than any strength of the instrument.

Question 28: analyse the influence of different factors on Australia's trade and financial flows

Analyse means drawing out relationships between the factors rather than listing them.

Thesis. Australia's trade and financial flows are shaped by the interaction of its resource endowment, the terms of trade, the exchange rate, its structural savings shortfall, and global conditions. The trade flows are dominated by commodities and by China, while the financial flows are dominated by the gap between domestic saving and domestic investment.

Factors influencing trade flows.

• Resource endowment and comparative advantage. Australia's abundance of iron ore, coal, LNG and agricultural land determines what it exports, so exports are concentrated in commodities and imports in manufactured and capital goods, which is the mirror image.
• The terms of trade, the largest single influence on export values. Chinese industrialisation drove the boom to the 2011 peak and again from 2020.
• The exchange rate. A depreciation improves competitiveness and raises export volumes over time, subject to the J-curve and the Marshall-Lerner condition. Note the circularity worth drawing out: the terms of trade drives the exchange rate, and the exchange rate then drives trade volumes, so the two factors are not independent.
• Trade agreements and protection. ChAFTA, JAEPA, KAFTA, the CPTPP and RCEP improved market access, while agricultural protection abroad restricts it.
• The international business cycle, particularly Chinese growth, which determines export demand.
• Structural change. The decline of protected manufacturing and the rise of services exports in education and tourism, and the shift from the mining investment phase, which drew in capital imports, to the production phase, which generates export volumes.

Factors influencing financial flows.

• The savings and investment gap, the fundamental driver. Australia has historically invested more than it saves, and the shortfall is financed by foreign capital.

  CAD ≡ investment − national savings
  

• Interest rate differentials, which determine the direction and volume of portfolio flows and are the dominant short-run influence on the exchange rate.

• Financial deregulation and the float of 1983, which removed the barriers to cross-border capital movement and made Australia a full participant in global capital markets.

• The superannuation system, which has raised national savings substantially and turned Australian funds into large-scale investors in foreign assets, reducing net reliance on foreign capital. This is the most significant structural change of recent decades and the factor most often overlooked.

• Global conditions. The decade of near-zero global interest rates drove a search for yield towards Australian assets and provided cheap offshore funding for Australian banks.

• Country risk and confidence, since political stability, institutional quality and sovereign credit ratings determine the risk premium Australia pays.

Now analyse, which means showing how the factors connect.

• Trade and financial flows are not independent. A commodity boom raises export income, which raises the terms of trade, which appreciates the currency, which reduces the competitiveness of non-resource exporters. That is Dutch disease, and it is one factor changing another.
• Today's financial inflow is tomorrow's current account debit. Foreign capital funding domestic investment creates liabilities whose servicing appears as net primary income debits, which is why net primary income dominates Australia's current account deficit.
• The accounts must balance under a float. A current account deficit is necessarily matched by a capital and financial account surplus, so the two sets of flows are two views of the same thing.
• The structural shift. Rising superannuation savings closed the savings and investment gap sufficiently that Australia recorded its first current account surplus in 44 years in June 2019. Distinguishing this structural change from the cyclical terms of trade boom that coincided with it is the strongest analytical point available.

Close on the judgement. The terms of trade is the dominant influence on the size and value of trade flows, while the savings and investment gap is the dominant influence on financial flows and on the composition of the current account. The exchange rate is the mechanism connecting them, and Australia's persistent vulnerability is that both sets of flows are concentrated in a narrow band of commodities and a small number of counterparties.

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What to do with this paper

Do it timed and closed-book first. Mark against NESA's published guidelines before reading any of the above, then classify every lost mark as knowledge, verb, data, timing or diagram.

Question 16 is the one to take away. Real GDP rose while real GDP per capita fell, and HDI followed the per capita figure. Any question giving you a population column is testing whether you will divide by it, and the same distinction underpins every development question in the course.

Related: 2017 worked solutions · 2018 worked solutions · The complete diagram guide · Every formula you need

Questions are described rather than reproduced. The 2016 examination paper and marking guidelines are © NSW Education Standards Authority and are available free from the NESA website. Answers verified against the official marking guidelines; explanations are our own.