Impact of Macroeconomic Variables on My Business
Abstract
I examined in this report the impact that the changes on the different macroeconomic variables e.g., price level, interest rate, and exchange rate have on the economy. Also, an analysis of how fiscal and monetary policies of the Australian government are presented as these policies and variables influence the success or failure of my business, the CadsBerri. Then my analysis dwell on the net value model by Brandenburger and Nalebuff to show that rational strategy could help my business survive despite the uncertainties posed by the macroeconomic environment.
Introduction
My business is on manufacturing and exporting of good and is based in Australia. My business, the CadsBerri, focuses on the manufacture and exporting of chocolates. My major export market is in Asia. Hiring workers from South East Asian countries like the Philippines enables my company to lower down cost (because of low wage paid to workers).
In this report, I examined the possible effects of the changes in the macroeconomic variables as well as government policies in the Australian economy have on my business. As a business entity in the economy, I believed that the changes in the economic environment have implications on the operations of my business. Hence, monitoring such changes will at least help me strategize and come up with rational decisions to protect my operations.
Australia is a small open economy (SOE). It is a small part of the world market that is certainly engaged in global trading but relatively small if compared to its trading partners since the changes in any of its macroeconomic variables have negligible impact on other countries. This is to say that the conduct of fiscal or monetary policy by the Australian Government only affects the domestic interest rate as well as output.
As a small open economy, the interest rate in Australia is equal to the world interest rate; this also suggests that the domestic interest rate will always have to adjust in order for the uncovered interest parity condition to hold. Likewise, the trade balance is determined by the difference between savings and investment at the world interest rate. These imply that when the saving in the domestic economy fall short of domestic investment, investors tend to borrow capital from abroad, and when saving is above the investment level, the excess capital is lent to other economies. In relation to the uncovered interest parity condition, any deviation from the world interest rate will result in large capital flows either to or from the country.
Changes in Macroeconomic Variables
How will the changes in macroeconomic variables affect my business? The very important variables to watch are the real interest rate and real exchange rate. Nevertheless, this is not to say that the level of prices, tax rate and other macroeconomic variables are not equally important since they also influence the behavior of the economy through their impact on the interest rate and exchange rate of a small open economy like Australia.
What happens if the interest rate changes? It was emphasized earlier that a small open economy takes the world real interest rate as given, which implies that the prevailing real interest rate in Australia is equal to the world real interest rate. The effect in the changes in this variable can be explained using the model developed from the ideas of Mundell (1968) and Fleming (1962), which is an open economy version of the IS-LM model.
According to the model, in the goods market (represented by the IS curve and by the equation IS: Y=C(Y-T) + I(r) + G + NX(ɛ)), the income of the economy is determined by consumption (dependent on disposable income), investment (negatively influenced by the real interest rate), government purchases, and net exports (dependent on the real interest rate). Meanwhile, the money market is given by the equation LM: M/P = L(r, Y). The supply of real money balances equals the demand of real money balances (depends negatively on the real interest rate and positively on income). Again, the world real interest rate determines the interest rate in Australia as a small open economy.
A decrease in the domestic interest rate makes the prevailing interest rate in Australia to be lower than that of the world interest rate. Lower domestic investment results to capital outflow as investors seek higher return for their investments elsewhere. The flow of capital from Australia to other parts of the world tends to prevent the domestic interest rate to fall further. The fall in the interest rate that leads to the fall in the level of investment in the economy results to the depreciation of Australian dollar (given that Australia is under a floating exchange rate regime), see Figure 1. The depreciation in turn, stimulates net exports as foreign goods become expensive while domestic goods are relatively cheap in the world market.
A rise in the interest rate has the opposite effect. Higher domestic interest rate relative to the world interest rate makes investment in Australia to be very attractive. Hence, profit-seeking investors from other countries will be enticed to invest in Australia. The inflow of capital increases the level of investment in the country leading to the appreciation of Australian dollar. Such appreciation makes exports of Australia to be relatively expensive in the world market. This will in turn lower the level of income as net exports declines; see Figure 2.
What happens in the small open economy if the price level changes? Using the Mundell-Fleming model, Mankiw (2007) discussed how changes in the price level (price adjustments) affect the economy. A fall in the price level increases the real money balances in the money market (Figure 3), resulting to a depreciation of Australian dollar. The depreciation makes the Australian exports cheaper in the world market, thus increasing the value of the net exports of the economy. In effect the economy settles at a higher level of income. In relation to my manufacturing and exporting business, a fall in the domestic price level obviously would be advantageous for me. Because of the resulting depreciation of Australian dollar, I will be able to sell more of my products abroad. Also, the increase in the demand for Australian goods abroad will require more production in the domestic economy (as well as on my firm) that will require producers-exporters like me to hire more workers to meet the increase in demand abroad.
So what have these changes to do with my manufacturing and exporting business? The depreciation of Australian dollar, as a result of a fall in the domestic interest rate will be very beneficial to my business as it means higher export demand from abroad. On the other hand, higher domestic interest rate leading to Australian dollar depreciation signifies that I will incur losses if I will increase production since there will be lesser demand for Australian products in the world market because it will be relatively expensive for the foreigners to buy the products (stronger Australian currency!).
Meanwhile, the increase in the price level has the opposite effect. Figure 4 shows that the rise in the price level leads to the appreciation of the Australian dollar, thereby making the exports of the economy to be relatively expensive in the world market. Also, domestic consumers will find imported goods to be relatively cheaper as compared with domestically-produced goods; this will likely result to a fall in the level of income of the economy. If this is the case, I will respond by cutting production due as I am anticipating increases in unsold goods.
What about taxes? Change in the tax has effect on the disposal income that determines the level of consumption. Certainly, any change in the tax will affect the goods market, which in turn influences the behavior of the exchange rate, and therefore the trade balance. Suppose there is a decrease in the tax. A fall in the tax obviously increases the disposable income of consumers. Higher disposable income increases consumption spending which in turn increases the level of income in the economy. The increase in consumption is depicted as an outward shift of the IS curve, leading to the appreciation of the Australian currency. The appreciation leads to reduction in the net exports because Australian products become expensive on the perspective of foreign buyers in the world market.
An increase in tax, on the other hand, results to the depreciation of Australian dollar as increased tax lowers the disposable income of the consumers. This in turn decreases consumption spending. The depreciation makes Australian products to be cheaper in the world market.
Moreover, changes in the level of income of consumers tend to increase consumption spending and also demand for real money balances; both a change in the goods market and money market. On the one hand, an increase in income leads to higher disposable income giving the consumer higher purchasing power. This shifts the IS curve upward. The rise in income, on the other hand, increases the demand for real money balances because people now want to get hold of more money as their income rises; this shift the LM curve to the right. In effect, appreciation of the Australian dollar will occur. Depreciation occurs if there is a decrease in income.
Implications of Policies
What will be the likely effect of policies namely, monetary and fiscal policies implemented by the Australian government to the economy and on my business? Here is a closer look to each of the policy.
As we are all aware of, on the one hand, fiscal policy pertains to the use of tax and expenditure policies by the government to affect the behavior of the economy in terms of the level of national output and total employment. On the other hand, monetary policy refers to the use of monetary variables like the interest rate and money supply by the Central Bank also to affect the behavior of the economy.
Suppose the economy of Australia is initially in a balanced trade position (exports equal imports; investment equals saving). And suppose the government implements expansionary fiscal policy through increase in government purchases that increases production in the economy. The IS curve shifts upward indicating an increase of output in the goods market. The increase in the IS curve results to a rise in the domestic interest rate, thereby making the interest rate in Australia higher than the world interest rate. This makes investment in Australia very attractive for investors who are seeking for higher returns. Higher domestic interest rate entices investors from the rest of the world, hence the inflow of money to Australia as investors take advantage of the higher return on their investment. This eventually leads to the appreciation of Australian dollar, which affects the economy as follows: reduction in the net exports and shifting of the IS curve back, thereby decreasing the interest rate; and, the appreciation of Australian dollar today will increase the expected depreciation of the domestic currency. Likewise, a tax cut (which is also a version of expansionary fiscal policy measure of the government) leads to an increase in disposable income thereby increasing the domestic demand for consumer goods. Still such policy leads to the appreciation of the Australian dollar. These results signify that the overall impact of expansionary fiscal policy is the increase in output.
As with the contractionary fiscal policy of the Australian government, a cut in the spending of the government or an increase in tax reduces the level of production. The decrease in output shifts the IS curve downward resulting to a decrease in the domestic interest rate. Lower Australian interest rate relative to the world interest rate leads money to flow out of the country as investors seek high yielding investment elsewhere. The outflow of money results to depreciation of Australian dollar, which has the following effects: increase in net exports that leads to a shift of IS curve upward. The depreciation of Australian currency today decreases the expected appreciation of the domestic currency.
How about monetary policy? Again, suppose the economy is in a state of balance. If the government through the Central bank increases the money supply, such policy will decrease the domestic interest rate that in turn increases the level of output as lower interest rate encourages investment spending. However, a lower domestic interest rate relative to the world interest rate leads to outflow of money from Australia to other country since investors will seek higher returns elsewhere. The outflow of money has the following effects: first, the outflow of money results to the depreciation of Australian dollar that in turn, increase the net exports of Australia as Australian products become cheaper in the world market and shifts the IS curve upward leading to a rise in the domestic interest rate; and second, because of higher return on investment in other countries than in Australia, investors rush to move out their money outside Australia to take advantage of it thereby causing the Australian dollar to depreciate which makes the expected depreciation of the domestic currency to be smaller.
Another important change in policy that has to be considered is the change in the trade policy of the Australian government. If the government decided to reduce the demand for imported goods through the imposition of tariff or import quota, will such policy affect the economy in general? A reduction in imports implies that net exports increases. The increase will shift the IS curve upward, increasing the value of Australian dollar (appreciation). A trade restriction does not affect the income of the economy as it does affect the level of consumption, investment, government purchases, or the trade balance. Though initially the imposition of tariff or import quota increases the net exports, the resulting appreciation of Australian dollar offsets the increase. Hence, trade policy has no effect on the income of the economy.
The Macroeconomic Environment and My Company
The above information are highly significant in formulating strategies that will protect my business against the vagaries of the domestic and external macroeconomic shocks. The analysis that follows dwells on Brandenburger and Nalebuff’s Value Net Diagram (Figure 5). According to Brandenburger and Nalebuff, cooperation and competition are both important when doing business. Cooperation is perceived to be the key for market growth, that is, to increase the benefits to all players (e.g., customers, suppliers, competitors, and complementors) in the market while competition is required to split the existing benefits among the players.
The characteristic of Australia as an open economy subjects the country to volatility. In fact, as shown in the above discussion changes in the price level and interest rate affect the value of Australian dollar that eventually impacts economic activity in Australia. As emphasized by Dennis (2001), the most important variable for a small open economy is the exchange rate. Movement in the value of currency influences the price of goods that are traded in the world markets. Obviously, the volatility in the exchange rate could have a negative impact on my business if I will not adapt rational strategies for my business. Dennis (2001) discussed volatility as follows: “As the economy's exchange rate depreciates, imported goods’ prices increases and this directly increases the consumers’ price index in Australia. On the production side, higher production costs also contributes to the rising prices of consumer goods as firms pass higher costs of production to consumers (Dennis, 2001).
My analysis above tells me that during recession, the government tries to stimulate economic activity by implementing expansionary fiscal policy, that is, either through increase in government purchases or lower tax to increase demand. But, analysis in the previous section showed that such policy results to appreciation of Australian currency that will obviously hamper my exportation business. To protect my business interest for this kind of shock in the economy, a good strategy will be to coordinate with local producers (domestic competitors) in attracting suppliers. Coordinating as a group of producers in seeking supplies is a way of accessing resources for production at lower cost. In this way, producing goods at lower production costs will enable my business (as well as other local producers) to offer these at lower prices to consumers. And in the advent of currency appreciation as a result of the expansionary policy, the loss will only be minimal since domestically produced goods are offered at competitive prices (because of lower production costs!). Another strategy is, in the case of the use of imported raw materials for production, I could, in coordination with other domestic producers, take advantage of the cheap price of imported materials abroad. According to Brandenburger and Nalebuff, suppliers prefer to tailor the needs of large number of producers. So a combined transaction with other domestic producers will enable us to acquire imported raw materials at law costs (especially if the transactions are made during the time when there is appreciation of Australian dollar). This strategy will be beneficial even in the long run because of the economies of scale, declining average cost as production is expanded.
Conclusion
As a small open economy, Australia’s economy is highly sensitive to changes in the world economy as Australian currency (exchange rate) reacts to changes not only in the macroeconomic variables (domestic price, interest rate) but also with the policies (fiscal and monetary) of the government. The changes in the value of the exchange rate trigger the effects to the economy through the so-called exchange rate pass-through.
The CadsBerri is a manufacturer and exporter of chocolate with Asia as its market. The fluctuation in the value of Australian dollar relative to other currency can make my business fragile and therefore very prone to losses. It was therefore imperative to examine the influence of the changes in the macroeconomic variables and economic policies Australia.
The analysis helped me to strategize using the Brandenburger and Nalebuff net value diagram. For instance, to buffer for adverse effects of appreciation of Australian dollar, coordination with other producers in the domestic economic will allow us to tap suppliers from other countries who will give us raw materials at lower costs (cheap import prices).
In general, the possible adverse effects of fluctuations in the economy can be overcome with the appropriate or right choice of strategy (coordination with local competitors).
Figure 1: Decrease in Australian Interest Rate
Figure 2: Increase in Australian Interest Rate
Figure 3: Decrease in the Price Level
Figure 4: Increase in the Price Level
Figure 5: Brandenburger and Nalebuff’s Value Net Diagram
References
Aoki, Kosuke, James Proudman and Gertjan Vlieghe (2004). “House Prices, Consumption, and Monetary Policy: A Financial Accelerator Approach “. Journal of Financial Intermediation, vol. 13, pp. 414-435.
Ball, Laurence. 1999. "Policy Rules for Open Economies." In Monetary Policy Rules, ed. J. Taylor. Chicago: University of Chicago Press.
Brandenburger, A.D. and Barry Nalebuff (2011). Co-Opetition. New York: Crown Publishing Group.
Batini, Nicoletta, Richard Harrison, and Steven Millard. 2001. "Monetary Policy Rules for an Open Economy." Bank of England Working Paper.http://www.frbsf.org/economics/conferences/0103/index.html
Clarida, Richard, Jordi Gal', and Mark Gertler. 2001. "Optimal Monetary Policy in Open Versus Closed Economies: An Integrated Approach." Universitat Pompeu Fabra Working Paper.
Dennis, Richard (2001). “Monetary Policy and Exchange Rates in Small Open Economies”. Federal Reserve Bank of San Francisco Economic Letter.
Fleming, J. Marcus (1962). "Domestic Financial Policies Under Fixed and Floating Exchange Rates". IMF Staff Papers 9: 369–379. Reprinted in Cooper, Richard N., ed. (1969). International Finance. New York: Penguin Books.
Leitemo, Kai, and Ulf Söderström. 2001. "Simple Monetary Policy Rules and Exchange Rate Uncertainty." Sveriges Riksbank Working Paper.http://hem.passagen.se/ulfsoder/ (accessed May 14, 2001).
Mankiw, N. Gregory (2007). Macroeconomics (6th ed.), New York: Worth, ISBN 978-0-7167-6213-3
Monacelli, T (2005), `Monetary Policy in A Low Pass-Through Environment', Journal of Money, Credit, and Banking , Vol. 37, No. 6.
Mumtaz, H, Oomen, O and Wang, J (2006), `Exchange Rate Pass-Through into UK Import Prices', Bank of England Working Paper No. 312
Mundell, Robert A. (1963). "Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates". Canadian Journal of Economic and Political Science, vol. 29, no. 4, pp. 475–485. doi:10.2307/139336. Reprinted in Mundell, Robert A. (1968). International Economics. New York: Macmillan.
Nimark, Kristoffer (2007). A Structural Model of Australia as a Small Open Economy. Research Discussion paper 2007-01. Economic Research Department, Reserve Bank of Australia.http://www.rba.gov.au/publications/rdp/2007/pdf/rdp2007-01.pdf
De Cordoba, Gonzalo Fernandez and Timothy Keho e (2000). "Capital Flows and Real Exchange Rate Fluctuations Following Spain's Entry into the Europ ean Community," Journal of International Economics, vol. 51, pp. 49-78.
