Australian economy hit by falling iron ore price
Australia's economy, heavily reliant on commodity exports, is facing significant headwinds due to falling commodity prices and a depreciating currency. Iron ore, the country's largest export, has experienced a dramatic price decline, exacerbated by slowing Chinese demand and increased Australian production. The price of iron ore has plummeted more than 67% between February 2013 and July 2015.
The Australian dollar (AUD) has depreciated by 10% against the US dollar (USD), further eroding the profitability of mining companies. This depreciation has also contributed to a worsening current account deficit, as the value of imports has risen relative to exports.
Australia recorded a monthly trade deficit of AUD 2.61 billion in May 2015, compared with a deficit of AUD 1.61 billion a year earlier. This increasing deficit is a cause for concern, as it could lead to slower economic growth and job losses.
The decline in iron ore prices has had a significant impact on Australia's GDP growth. In 2015, the country's real GDP growth slowed to 2% from 2.5% in the previous year. Economists estimate that falling commodity prices reduced Australia's export revenues by more than 2% of GDP in 2015.
To mitigate the impact of these adverse conditions, an increasing number of economists are calling for further interest rate cuts by the central bank. They argue that global economic uncertainty, falling commodity prices, weak consumer demand, and persistent weakness in non-mining sectors, such as tourism and education exports, warrant additional monetary stimulus.
Australia has been a popular destination for tourists and attracts many international students. However, the slowdown in the global economy and the appreciation of the Australian dollar have negatively impacted these sectors.
Table 1: Australia's Trade Deficit (in AUD billion)
Table 2: Australia's GDP Growth and Trade Balance (2014-2015)
Define the term current account.
A component of the balance of payments which is the sum of the balance of trade in goods and services,
income and current transfers.
List two reasons why iron ore prices may have fallen.
- Slowing Chinese demand for iron ore has reduced global market demand, putting downward pressure on prices.
1 mark - Increased Australian production of iron ore has contributed to oversupply in the global market, driving prices down.
1 mark - Global economic uncertainty has reduced demand for steel and related products, causing iron ore prices to decline.
1 mark
Using information from Table 1, calculate Australia's trade deficit for 2015.
Correct formula and substitution of values:
Correct final answer:
Draw a demand and supply diagram to illustrate the fall in iron ore prices.
- The diagram correctly shows the initial equilibrium at point A with price Pe and quantity Qe, representing the iron ore market before the price decline.
1 mark - The rightward shift of the supply curve (from S₁ to S₂) accurately illustrates increased Australian production of iron ore mentioned in the case study, contributing to global oversupply.
1 mark - The new equilibrium at point C shows the significant price decrease from Pe to P₁ (reflecting the 67% price decline mentioned in the case study) and a change in equilibrium quantity.
1 mark
Using a PED diagram, explain how the price elasticity of demand for iron ore affects Australia's export revenue.
- In the case of inelastic demand for iron ore (PED < 1), a decrease in the price of iron ore will lead to a relatively smaller percentage change in the quantity demanded.
- As shown in the PED diagram, when prices decrease, even by 67% as stated in the case study, the increase in quantity demanded is not enough to offset the reduction in price, causing a decrease in total revenue. Therefore, despite higher quantity sales, Australia's export revenue will fall due to the inelastic nature of demand.
(Note: the diagram units should be adjusted to the text values).
Using a PES diagram, explain how the price elasticity of supply of iron ore influences Australia's production levels.
- In the case of inelastic supply (PES < 1), Australian producers are less responsive to changes in price, meaning that even if the price of iron ore falls significantly, production levels will not decrease substantially in the short run.
- The inelasticity illustrates that mining operations have limited flexibility to adjust production levels in the short term due to fixed capital investments, long development timelines, and capacity constraints.
- With inelastic supply, when iron ore prices fell by 67% (as mentioned in the case study), Australian producers were unable to proportionally reduce their output in the short run, leading to continued high production levels despite falling prices.
- This inelastic supply explains why Australia increased production despite falling prices, contributing to oversupply in the global market, further depressing prices, and ultimately worsening Australia's export revenue and trade deficit as shown in Tables 1 and 2.
Using a market structure diagram, explain how the oligopolistic nature of the mining sector impacts competition in the industry.
- In an oligopolistic mining industry, firms have significant market power and are interdependent in their decision-making, causing them to be very aware of competitors' actions when setting production levels and prices.
- The diagram shows price (AC=P) equals average cost at the profit-maximizing output (where MC=MR), indicating normal profits in the long run for monopolistic competition, but oligopolistic mining firms can earn above-normal profits even in the long run due to high barriers to entry (capital requirements, access to resources).
- The interdependence of firms in the oligopolistic mining sector explains why increased Australian production continued despite falling prices - firms were attempting to maintain market share and revenue in response to competitors' actions, contributing to the industry's oversupply problems mentioned in the case study.
Using an AD-AS diagram, explain the impact of falling iron ore prices on Australia's economic growth.
- Falling iron ore prices reduce Australia's export revenue, leading to a leftward shift in the Aggregate Demand (AD) curve from AD₁ to AD₂, as lower exports decrease national income.
- This causes the economy to shift to the new equilibrium at a lower price level (PL₂) and lower real output (Y₂), reflecting the decrease in economic growth mentioned in the case study (from 2.5% in 2014 to 2.0% in 2015).
(Note: the diagram need not include the cyclical unemployment reference).
Using information from the text/data and your knowledge of economics, evaluate the potential effects of further interest rate cuts on Australia's economic growth.
Answers may include:
Definition
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Interest rate: The cost of borrowing money, set by the central bank as a monetary policy tool to influence economic activity.
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Economic growth: An increase in a country's real output (real GDP) over a period time.
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Economic development: The process of increasing real per capita income while improving living standards and reducing poverty within an economy as whole.
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Economic growth refers to increases in real output over time, whereas economic development refers to a process that leads to improved living standards for a population as a whole.
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Increasing levels of output and incomes resulting from economic growth do not, by itself, guarantee economic development.
Boost to Aggregate Demand Through Consumption and Investment
Lower Borrowing Costs for Households and Firms
- Cutting interest rates reduces the cost of borrowing, encouraging households to spend more and businesses to invest, especially in the non-mining sectors like tourism and education which have been weak.
- This stimulates aggregate demand (AD), potentially reversing the GDP slowdown from 2.5% in 2014 to 2.0% in 2015 (Table 2).
Diagram: AD/AS Model
- Interest rate cuts lead to a rightward shift of the AD curve, increasing real output (Y) and reducing unemployment, while price levels may rise slightly depending on spare capacity.
Limitations
- If consumer and business confidence is low, especially during global uncertainty, monetary policy may be less effective, as people may save rather than spend.
- Household debt levels in Australia are already high, so additional borrowing may be limited.
Exchange Rate Depreciation and Export Competitiveness
Weaker AUD Supports Export Sectors
- Further rate cuts are likely to lead to depreciation of the Australian dollar, making exports cheaper and imports more expensive, improving net exports and potentially reducing the trade deficit, which increased from AUD 1.61B in 2014 to AUD 2.61B in 2015 (Table 2).
- A weaker AUD may offset the negative impact of iron ore price drops (down by 67% between 2013 and 2015) by increasing dollar-denominated revenues and boosting tourism and education exports.
Diagram: Exchange Rate and Net Exports
- A depreciation causes the AUD to fall, increasing foreign demand for Australian goods and reducing import demand, improving (X – M).
Limitations
- With global demand slowing and key commodity prices still low, even a weaker AUD may not fully recover lost export revenue (estimated to have reduced GDP by 2% in 2015).
- Currency depreciation also makes imported goods more expensive, potentially leading to cost-push inflation.
Incentivising Investment in Non-Mining Sectors
Rebalancing the Economy
- Rate cuts encourage diversification away from mining, which is experiencing reduced profitability due to low iron ore prices and reduced Chinese demand.
- Non-mining sectors such as education, tourism, construction, and manufacturing may receive more investment, creating jobs and sustaining growth.
Multiplier Effect on Growth
- Increased investment has a multiplier effect, leading to increased employment, higher incomes, and further increases in consumption, supporting growth across sectors.
Limitations
- Structural issues like skills mismatches and lack of capacity in non-mining sectors may limit how quickly they can absorb new investment.
- If businesses are pessimistic due to global uncertainty, investment demand may remain subdued despite lower borrowing costs.
Risk of Inflation and Asset Bubbles
Low Inflation Creates Policy Space
- Inflation is currently below the 2% target, so rate cuts are unlikely to create immediate inflationary pressures.
- Lower interest rates may help bring inflation closer to the target, avoiding deflation risks and supporting price stability.
Limitations
- Continued low interest rates may contribute to asset bubbles, particularly in property markets, increasing financial instability in the long term.
- Real estate speculation may crowd out productive investment, reducing the long-term effectiveness of monetary stimulus.
Overall Evaluation
Strengths
- Interest rate cuts can stimulate AD via consumption and investment, helping counteract the effects of falling export revenue and weak non-mining sectors.
- A weaker currency improves export competitiveness, supporting GDP and employment in tourism, education, and agriculture.
- Policy is well-timed, given low inflation and slowing growth.
Weaknesses
- With global uncertainty and low commodity prices, the effectiveness of monetary policy may be limited, especially if business confidence is weak.
- Risks include currency depreciation-driven inflation, rising household debt, and housing market overheating.
- Structural reforms may be needed alongside monetary policy to improve productivity and sectoral diversification.
Conclusion
Further interest rate cuts are likely to support short-term economic growth in Australia by boosting domestic demand and export competitiveness, especially amid falling iron ore prices and slowing GDP. However, their effectiveness depends on external conditions, business confidence, and whether structural adjustments occur to reduce the economy’s reliance on mining exports. For long-run growth, monetary easing must be complemented by investment in skills, infrastructure, and innovation in non-mining sectors.
