International Impacts on Australia, 1974 - 1990s

Question 1

What major events occurred in the international economy over the 1970s and 80s?

Answer 1

• Two worldwide inflationary booms: 1976 - 1979; 1984 - 1989
• Three deep worldwide recessions: 74-75; 80-83; 90-92 (only non high inflationary one)
• Collapse of the post-war monetary system
  
  • Bretton Woods - fixed exchange and capital controls
  • US doesn’t feel a need to maintain the system
• Slowdown in the growth of productivity and per capita incomes
• Crisis of international bank debt in developing world following OPEC crisis
• Rising protectionism in industrialised countries
  
  • following inflation w/ unemployment for first time
• Increasing unemployment in Europe

Question 2

What was the state of the international economy as the Long Boom neared it’s end?

Answer 2

• Inflation was increasing, cost-push (wages, materials(no room for slowing the economy)), not demand pull (room for economy-slowing)
  
  • Keynesianism wasn’t able to deal with this kind of inflation
• Social unrest was increasing
• World exchange rates had not undergone any major revision since 1949
• The US has a trade deficit and budget deficit

Question 3

What was the state of the US$ towards the end of the long boom?

Answer 3

• 1949 - US current account surplus, German & Japanese economies destroyed
• Late 60s - US current account deficit, Germany and Japanese in current account surplus
• Prices therefore are wrong, US exhacnge rate is extremely over valued

Question 4

What happened to inflation during the long boom?

Answer 4

• During the Long Boom prices were stable because:
  
  • The fixed exchange rate system imposed price discipline in high price export economies
    
    • High production cost countries - South Korea - depreciates currency so cheaper to US - only possible under flexible exchange - As this was not an option firms had to be very responsible to keep costs low
  • The USA suffered from higher unemployment and lower capacity utilisation (spare capacity) than others and this kept prices low
  • The opening of trade once international monetary system was in place resulted in productively growth in manufacturing
  • Expansion of labour supply kept wages stable
  • The climate of wage bargaining was mild

Question 5

Was inflation high at the end of the 1960s and why?

Answer 5

• Governments had used deflationary policy to slow down inflation during the Long Boom (50s) through contractionary fiscal policies
• By late 1960s people no longer willing to suffer periods of deflation
• Expectations adjusted in line with higher inflation
• Expansionary monetary policies in US, Britain, France, Italy and Japan

Question 6

What happened to inflation in the 1970s and why?

Answer 6

• Inflation accelerated in the 1970s because
  
  • Collapse of Bretton Woods and introduction of floating exchange rates
  • The erosion of price constraints, the emergesce of strong inflationary expectations
  • Supply side shocks in early 1970s
    
    • Prices of primary products rose
    • Energy prices, especially crude oil rose
  • A weakening of government commitment to Keynesian demand management
    
    • Rise of monetarism

Question 7

What was the state of employment towards the end of the long boom?

Answer 7

• European labour market was volatile
• The pace of wage increases in Europe quickened after 1969
• Labour demand had been high throughout the Long Boom
• Attracting migrants to satisfy demand became more difficult
• During the 1960s nominal wages rose faster than labour productivity and governments tried to take corrective measures
• By 1969 labour objected to government attempts to modify wage increases
• Workers began to factor full employment and price rises into their wage demands - expectations

Question 8

What were the developments in economic theory towards the end of the long boom?

Answer 8

• (Classic) Phillips Curve
  
  • Unemployment-inflation rate trade-off
  • Non-accelerating inflation rate of unemployment
  • Question its validity
• Decline in support for Keynesian economics
  
  • No growth theory
  • No way to deal with supply side inflation
  • Question role of fiscal policy, question impact of fiscal policy
• Increase in support for mainly Monetarism but also other
  
  • Friedman
  • Control economy through changes in the money supply - if you can affect the inflation rate you can affect the interest

Question 9

What happened to foreign exchange markets over the course of the long boom?

Answer 9

• Under Bretton Woods exchange rates were fixed and linked through a system of multilateral payments
• Long term adjustments could take place if the BoP position required it
• Currencies were tied to the US dollar, the US dollar was convertible to gold at $35 an ounce
• Current convertibility from the end of the 1950s and increasing competitiveness meant that counties were acquiring dollars and often using the dollars to purchase gold from the US
• US gold reserves declined over time and other countries began holding US dollars as reserve currency to help out with BoP problems
• The US dollar became vulnerable - it would not be able to provide gold to the value of dollar reserves held in Europe and Japan
• Options included devaluing the dollar with respect to gold but that would change the values of all the other currencies or revaluing the other currencies with respect to the dollar
• Germany revalued twice but other countries were skeptical
• Speculative attacks on the prevailing exchange rates
• The US could have used deflationary policy to protect the currency but government commitments made that difficult
• in 1971 Nixon suspended dollar gold convertibility
• Other countries floated their exchange rates to avoid the
  inflationary impacts of dollar inflows not their countries
• Resulted in an international economic boom as credit constraints were eased - countries didn’t have to worry about current account deficit, didn’t have to limit money supply, the market corrects the price/currency - don’t have to restrict imports etc.

Question 10

What was the Oil price shock?

Answer 10

• In the immediate post war period oil prices were low, controlled by oil countries and the middle east colonisers and western oil depndency increased
• By 1973 Middle East oil producers are more independent
• Established and oil cartel, OPEC
• OPEC raised the price of oil and limited the supply in 1973

Question 11

What was the effect of the oil price shock?

Answer 11

• Direct loss in real income due to terms of trade
• Structural changes in prices, demand and output, changing consumer demand and leading to recession
• Direct contribution to inlfaiton
• Uncertainty about how OPEC countries would recycle their profits

Question 12

How was the oil price shock dealt with?

Answer 12

• Domestic policy concerned with inflaiton
• Fiscal policy couldn’t control inflation and unemployment - recessions followed (Aus included)
• Switch to monetarism (not to be confused with monetary policy)
• Loose monetary policy (low nominal rates) led to negative real interest rates
• Hard to cut government spending due to transfer payments
• long-term strategy to reduce dependency on oil

Question 13

What were the capital and financial issues resulting from the OPEC shock?

Answer 13

• Oil price shock changed the BoP of lots of countries
  
  • Previous surplus countries became deficit coutnries
  • OPEC countries become surplus countries
• OPEC countries deposited their new income with international banks
• This quickly increased liquidity
  
  • Also, western foreign reserves increased from the increased in OPEC despots offsetting the BoP
• International banks, which had developed sophisticated lending practices, used those deposits to lend to countries needing to borrow after the increase in oil prices
• Private banks were more attractive to developing countries because they attached fewer restrictions on the use of loan funds than agencies like the World Bank
• This led to over-borrowing and many developing countries experienced a debt crisis as economic conditions failed to recover sufficiently during the 70s
• During the 1980s banks focused their lending on firms in the deregulating industrial nations
• Business activity was stimulated in an era of financial freedom
• Stock markets rose under these condition
• Stock markets crashed in 1987 but not as severely as in 1929

Question 14

What was the effect of the OPEC shock on the international economy?

Answer 14

• The oil price rise resulted in a recession in many industrialised counties in 74/75
• A weak recovery occurred form 76-80
• Oil prices stabilised (apart from another increase in 1979)
• But inflation continued to rise and unemployment increased
• By 1980 government were once again imposing deflationary measure on their economies
• A recession resulted until 1983/1984
• While economic growth recovered in the second half of the 1980s, it was lower than that in the 1970s recovery
• Unemployment remained high and growth could not be sustained
• Inflation did fall
• Protectionism increased during the 1980s on commodities, food and services
• The growth of some South East Asian countries expended world trade and benefited Australia