Question

Question: illustrate the Macroeconomic policy options for Australia to combat Covid-19 using the IS-LM-BP

Answer 1

Throughout the first half of 2020, the COVID-19 pandemic has caused major economic disruption and

a deadly health risk to cities across the world. The rapid spread of the virus has caused widespread

lockdowns and travel bans for countries, bringing world economies to a halt and critically affecting

many industries like aviation and tourism. As a result, Australian Government policymakers have

implemented significant stimulus packages and expansionary monetary policy aimed at supporting

industries that have been most impacted, as well as protecting the health care system. The aim of this

report is to assess the international macroeconomic impact of COVID-19 on the Australian economy

through analysing fiscal and monetary policy decisions under theoretical frameworks. With this

information, more accurate and informed decision making can occur when the focus is on the recovery

from the external shock that COVID-19 has created.

Balance of Payments, Net Foreign Wealth (IIP) and the Intertemporal Model

Balance of Payments There is likely to be a significant change to Australia’s Balance of Payments (BOP) and international investment position (IIP) over the course and duration of the COVID-19 pandemic. Australia’s BOP is comprised of the Current Account (CA) and the Financial Account (FA). Transactions in the BOP are recorded as double-entry bookkeeping; once as a credit and once as a debit, in either of the CA or FA’s depending on the type of income or expenditure it is. The CA measures Australia’s net exports of goods and services and net international income receipts. According to the findings from the Australian Bureau of Statistics (ABS), Australia has recorded a CA surplus for the September 2019 quarter, and through to the December quarter 2019 the CA fell again to $955m (ABS 2019). In the latest statistics released by the ABS on 2 June, there has been an increase in the CA to $8.4bn (Appendix A1). This is primarily due to the increase in export demand and fall in imports as a result of the value of the Australian dollar falling compared to other currencies. However, once the value of the domestic currency begins to rise, we are likely to see changes flow through to the CA through the balance of trade, most likely in the September or December quarters of 2020.

Net Foreign Wealth (IIP)

Australia’s net foreign wealth at the end of March 2020 increased to a deficit of $801.4bn (ABS 2020).

This was primarily due to a sharp increase in foreign asset transactions of $41.1bn in the March 2020

quarter compared to an inflow of $5.4bn in the December 2019 quarter (ABS 2020). The continuation

of fiscal stimulus by the Federal Government in response to the external shock of COVID-19 will be

under review in June to July, and this will allow policy makers to make well informed decisions

regarding if Australia needs to borrow additional funds or it can sell down existing.

Intertemporal Model

Australia can also use the intertemporal model framework to boost future consumption through

external means (Sinclair 2020). Instead of consuming all resources domestically, Australia can export

the excess in supply, implying a balance of trade surplus and therefore a FA deficit. This is what we

are seeing in the present domestic economy. In the future, foreign countries will have to repay the

borrowing for choosing to sacrifice future consumption for current consumption, to the Australian

economy. This enables an increase in future consumption at the cost of current consumption

domestically. The opportunity cost of future consumption in this situation is what could have been

earned through domestic investment (Sinclair 2020).

The Intertemporal Model in some instances have helped to predict crises. However, there have been

drawbacks with the use of this framework as a reliable source of prediction. One of the most common

occurrences with inaccurate prediction is through overall uncertainty and volatility in countries’

financial markets. This lends itself to the volatility in the Australian share market, flagged by the RBA

in the Financial Stability Review and in Appendix A3. The sharp rush for liquidity in the equity market

can be a shortfall of using the Intertemporal Model to predict a crisis, even though the market had

understood for some time the affect that COVID-19 would have on the domestic and world economies.

Australia’s Exchange Rate Determination and Choice of Exchange Rate

Exchange Rate Determination

Australia’s exchange rate can be determined through different short and long run models, and from

the COVID-19 pandemic there are likely to be implications on both timeframes to the value of the

domestic currency. To analyse Australia’s exchange rate determination in the short run, we will look

at the asset market model, where under different theories and expectations the exchange rate can be

determined. Under Covered Interest Parity (CIP), where the use of a forward contract covers the

exchange rate risk for the foreign currency side of the equation (Appendix B1). This will affect the

determination of the exchange rate, as foreign investors, particularly global fund managers have been

purchasing Australian Government bond issues from the RBA (Turner 2020). Similarly, Uncovered

Interest Parity (UIP) is where the expected change in the exchange rate is equal to the nominal interest

rate differential. Illustrating a change in expectations on the spot exchange rate in Australia will mean

that with an increase in e, the value of the domestic currency will fall. As a result, there will be an

increase in the expected AUD return on foreign currency assets, also known as capital outflow.

Therefore, an increase in the expected spot exchange rate will result in an increase in the current spot

exchange rate, shown in Appendix B2, as we have seen in the short run with Australia so far taking

into account the impact of COVID-19.

Flexible Exchange Rate vs Fixed Exchange Rate and Implications on Other Macroeconomic
Factors
Australia’s choice of exchange rate regime will also impact its recovery from the external shock of the
COVID-19 pandemic. It can also affect other macroeconomic variables such as the balance of
payments and employment.
Australia’s choice to operate with a flexible exchange rate, which is determined by the demand and
supply of Australian dollars on the foreign exchange market, is more favorable for the current
economic conditions. Under a flexible exchange rate, the nominal exchange rate can change the RER
more easily and uniformly (Appendix B6) (Sinclair 2020). In Appendix B4, starting at point A, an
external shock to the Australian economy will shift the IS curve to IS1 now operating at point B.
Assuming Australia has near perfect capital mobility, there will be a contraction in spending and
income to Y1, and a reduction in interest rates to i1. Now there is excess demand for foreign currency
which results in the exchange rate to increase, causing net exports (NX) to increase and the IS curve
will shift back to the right to point C. This is how Australia uses a flexible exchange rate to insulate
the economy from external shocks like COVID-19.
Alternatively, under a fixed exchange rate regime in Appendix B5 Australia would respond differently
to an external shock. Assuming the same changes as the flexible exchange rate scenario above, at point
B and with a fixed exchange rate, the central bank can only change the money supply in the economy
in response to an external shock. Therefore, the RBA would be selling international reserves and
purchasing domestic currency through open market operations, increasing the money supply MS, and
therefore shifting the LM curve to the left, arriving at point C. The result is Australia would operate at
the same interest rate, but with a fall in income.
Achieving internal balance is another strong argument for choosing a flexible exchange rate over a
fixed rate. An independent monetary will allow Australia to respond to a recession, brought about by
COVID-19, with expansionary monetary policy, however under a fixed exchange rate monetary policy
is most of the time diverted to deal with the balance of payments where the domestic interest rate is
tied to the foreign interest rate (Sinclair 2020).
Macroeconomic Policy Options – COVID-19
There are a range of macroeconomic policy options that Australia has in response to COVID-19,
through frameworks including the elasticities and absorption models, the SWAN diagram and the IS
LM BP model. Through the analysis and evaluation of these policies and the relative effects that they

he Elasticities and Absorption Model – Effects of the Exchange Rate on the Domestic Economy
The change in Australia’s exchange rate will also have effects on other parts of the economy such as
its relationship with the trade balance. The elasticities model is a framework that can be used to assess
the implications that a change in the foreign currency price of imports, exports or the exchange rate
will have on Australia’s trade balance. The potential drawback to this model is that it does not take
into account income changes, and it is under the assumption that the law of one price holds, Pd=Pfe.
Due to a increase in the exchange rate, Australian exports have become more competitive since the
beginning of the pandemic, therefore experiencing a sharp increase (Appendix C1). One explanation
for the improvement in the trade balance is that if the number of foreign currency exports increase, the
increase in the export quantity is likely to outweigh the effect of the lower foreign currency price,
leading to an improvement in the trade balance (Appendix C2). However, elasticities are greater in the
long run than they are in the short run, so there is likely to be a gradual trade flow adjustment, typically
following the J-Curve in Appendix C3. This economic theory states that an increase in the exchange
rate can initially result in the worsening of the trade balance, and therefore the CA, then an
improvement when quantities begin to adjust.
In addition, Australia is likely to experience exchange rate pass through as it emerges from COVID-
19. For example, if the value of the domestic currency in Australia decreases, initially there will be a
change to import prices of foreign goods, but changes to consumer prices and inflation take more time,
as the change to the exchange rate is passed through to the rest of the economy.
Alternatively, the absorption approach may also be used to assess changes in the exchange rate and
trade balance as it takes into account changes to income. Absorption (A) is defined as the total spending
by domestic residents, and denoted A=C+I+G+M. Income (Y) is defined as the total expenditure of
domestic residents, and denoted Y=C+I+G+X. The CA is the difference between real Y and A
therefore, the equation will be D(Y-A) = D(X-M). Furthermore, as (X-M)=(Sn-I), it follows that Y-
A=X-M=Sn-I.
With the value of the Australian dollar at an 11-year low, coupled with US-China trade tensions during
2019 and the catastrophic bushfires in early 2020 (Hutchens 2020), there is likely to be significant
economic impacts to income and output, and therefore absorption. The decrease in the exchange rate
will make Australian exports more competitive to the rest of the world. This translates to an increase
in export receipts, therefore an increase in aggregate demand (output), while indirectly increasing
income relative to absorption. The increase in Y will lead to an increase in national savings, Sn [­Y-
A=­(X-M)=(Sn-I)], as consumers with more disposable income are likely to save a greater proportion.
This can also be demonstrated diagrammatically. Starting at point A, there is a rightward shift of the
(X-IM) curve. At point B, the effects of the increase in exports has taken place, however the indirect
change income has not. So, at point C, there has been an increase in the level of income from Y0 to
Y1.
Policy makers in Australia can implement macroeconomic measures to influence the level .

The SWAN Model – How the Real Exchange Rate and Internal and External Balance can change as
a result of COVID-19
Another framework to assess macroeconomic policy implications of COVID-19 is the SWAN model
which represents internal and external balance of an economy. The objectives of policy measures in
the SWAN model are to restore internal and external balance to equilibrium from excess demand or
supply in either of the schedules, through changes to the level of absorption or the Real Exchange Rate
(RER).
The effects that COVID-19 have had on internal balance have been a significant increase in
underemployment and unemployment. This has been particularly evident in the tourism, aviation and
retail sectors (Derwin 2020). This increase translates to excess supply of non-tradable goods, and
unlike tradeable goods Australia cannot export the excess in unemployment. In other words, Qn>Cn,
so Australia is operating to the left of the IB schedule. Similarly external balance, which is concerned
with tradeable goods, is likely to be in trade surplus meaning Australia is exporting more than it is
importing at the present time. Therefore, the quantity of tradeable goods exceeds the consumption of
tradeable goods, Qt>Ct, so the remaining portion is able to be exported.
The internal and external balance position of Australia on the SWAN model is also shown in the
diagram (Appendix C5).
The Australian Government has two primary policy weapons that it can use to restore internal and
external balance to equilibrium. They are Expenditure Changing Policy (ECP) and Expenditure
Switching Policy (ESP). The Australian Government must use a combination of ECP and ESP in order
to come close to achieving equilibrium in the SWAN model, and this is done through changing the
level of absorption via fiscal stimulus and changing the RER through the nominal exchange rate