Problems with protection   Is the CAD a problem? Goal of external stability   The exchange rate   International investment position   Free trade v protection

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1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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Definition of External Stability

The Australian government is trying to ensure that Australia is able to meet its international financial obligations that result from transactions with the rest of the world.  The government can make our country more 'externally stable' by, for example, ensuring that (as a country) we do not have a large imbalance between spending and income such that our national debt levels become difficult to service (i.e. repay).

Two key variables the government focuses on to provide it with an indication of whether it needs to act are:

  1. The size of the Current Account Deficit (CAD) in the Balance of Payments; and
  2. The level of Australia's Net Foreign Debt (NFD)

The government tries to ensure that our CAD is sustainable, such that its size does not pose problems for the wider economy.  Whilst there is no specific target documented by the government, it is generally recognised to be below approximately 5-6% of GDP.  Accordingly, a CAD much higher than this is likely to trigger some contractionary government policies in order to reduce its size.  

With respect to NFD, again the government has not set a specific target.  Suffice to say that governments of both persuasions try to ensure that Australia's level of NFD (like to CAD) is at a level where it can be adequately repaid without causing problems to the domestic economy (such as a rapidly depreciating currency).  Some suggest that a sustainable level of NFD is one that is below approximately 50% of GDP, but there is much disagreement on this point.  

It can be useful to think about external stability by using the analogy of a simple household.  Every household typically has the objective of being financially stable such that any imbalance between household spending and income is sustainable and any debt it incurs (e.g. mortgages) can be serviced.  Like a country, there is no problem with spending being greater than income so long as you have the ability to pay off the debt (or equity) that is incurred along the way.  So 'signs' that suggest a household may be financially unstable are a large gap between spending and income (which is equivalent to the CAD) and high levels of net debt (which is equivalent to NFD).  Of course this situation is caused by insufficient income being earned or excessive amounts of expenditure!

When the economy does experience signs of external instability, such as a very high CAD and/or NFD, this will, ceteris paribus, lead to instability in the value of the currency.  The government (via the RBA) will seek to smooth out any damaging fluctuations in the currency.  Hence, a third key variable that provides an indication of Australia's external stability is:

  1. The value of the Australian dollar (i.e. our exchange rate)

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