RDP 9003: The Balance of Payments in the 1980s IV. Causes of Fluctuations on the Current Account

To understand the development of the current account at a more fundamental level, we need to go behind the proximate relationship between demand and supply and the current account, to examine the exogenous factors affecting the economy. These include:

• terms of trade;
• shocks to savings/investment;
• foreign capital flows; and
• monetary policy.

(i) Terms of Trade

There has been a long-term decline in Australia's terms of trade. This trend has been punctuated by a number of large, transitory shocks. In Section II it was argued that the longer-term decline in the terms of trade is unlikely to have had an important effect on the current account deficit. Results reported in Section VI are consistent with this. Slower GDP growth has been one of the ways in which the Australian economy has adjusted to the decline in the terms of trade. FitzGerald and Urban(1989) argue that this adjustment was policy induced. They argue that the restrictive demand management and protectionist policies implemented in response to earlier terms of trade crises limited any adjustment through a lower real exchange rate and resulted in relatively slow output growth.^[17] This does not seem to have been the only adjustment. There has also been relatively rapid productivity growth in the agricultural sector^[18] and a large increase in non-rural commodity exports.

Thus, an expansion in export volumes relative to GDP has helped to offset the relative decline of export prices.

In contrast, transitory shocks to the terms of trade can have large effects on the current account – see discussion in Section II and references in footnote 12. In the short-run, the price effects of these shocks impinge directly on the current account. Over time, expenditure and real exchange rate adjustment may offset the initial effects.

During the 1980s there were two major shocks to the terms of trade. One in a downward direction in which the terms of trade fell by almost 14 per cent between March 1985 and March 1987 and one in an upward direction with the terms of trade rising by 27 per cent between March 1987 and June 1989. Figure 8 plots the terms of trade and one measure of the real exchange rate.

At the most superficial level, the effect of a change in the terms of trade can be seen by comparing the actual development of the nominal and real trade balance. This is done in Figure 9. The difference between the two bars approximates the impact of the terms of trade.

This mechanistic approach makes two simple points:

• the magnitude of the price effect of terms of trade shocks can be large within the cycle;^[19] and
• actual export and import volumes changed very significantly following the change in the terms of trade.

It was noted in section II that one channel through which transitory disturbances to the terms of trade may effect the current account is consumption smoothing on the part of the private sector. Can this effect on savings be directly detected in the data? Figure 10 shows private saving adjusted for inflation.^[20] The rise in the terms of trade in the early 1970s roughly coincided, with a rise in private saving at that time. The fall in the terms of trade commencing in March 1985 may have contributed to the decline in private saving around that time. However, it appears that this fall proceeded the terms of trade decline. The subsequent large rise in the terms of trade was not reflected in a rise in private saving. The data in the graph do not provide compelling support for a significant consumption smoothing response (apart from, perhaps, the early 1970s) to transitory terms of trade shocks.^[21]

The evidence that there was only a small savings response in the mid-1980s may be surprising at first sight. Australia's greater integration into world financial markets meant that it was easier to maintain expenditure in the face of such shocks by drawing on foreign saving. But, at the same time, the floating of the exchange rate resulted in more immediate relative price adjustment. On the export/import side of the identity, the exchange rate change facilitated the switching of production into net exports (when the terms of trade fell). This fits with the impression in Figure 9 that the impact of the terms of trade fall in 1985/86 was relatively quickly offset by adjustment of trade volumes. Figure 11 looks at this process.

The top panel shows expenditure, production and a measure of the scale of the terms of trade on income. The bottom panel decomposes the change in the trade balance into terms of trade and volume changes.^[22] Clearly, the direct terms of trade effects on the deficit were large but tended to be offset by subsequent volume changes. On the savings/investment side, the float may have altered the previous income distribution effects of terms of trade changes: rural exporters would have previously borne the brunt of a deterioration and, accustomed to expenditure smoothing, dissaved. In the mid 1980s, the depreciation spread the burden more rapidly to others (users of imports) with possibly different saving behaviour. Another important influence during the 1985/86 episode was the policy tightening which meant that the terms of trade decline was quickly offset.

Whatever the detail, it is clearly important that the exchange rate can now adjust quickly to export price shocks to encourage production responses and moderate fluctuations in export incomes in Australian dollar terms. The link between the terms of trade and the exchange rate is illustrated in Figure 8. The shocks to the terms of trade in the early 1970s and mid-1980s contributed to large changes in the real exchange rate at those times. Blundell-Wignall and Thomas(1987) and Blundell-Wignall and Gregory(1989) have shown that the relationship between the terms of trade and the real exchange rate is statistically significant and that the strength of this relationship increased after the float.

Blundell-Wignall and Gregory(1989) compare the most recent terms of trade shock to several earlier ones. They argue that the response of the economy to such shocks has changed over lime because of changes in the institutional structures. In earlier terms of trade shocks (the Korean war boom and the resources boom of the early 1970s) much of the required relative price adjustment, i.e. an appreciation of the real exchange rate – came through higher domestic inflation rather than by movements in the nominal exchange rate. In the 1987–89 period a good part of the adjustment came through the nominal exchange rate.^[23] So the required change in the tradable/non-tradable price relativity came about mainly through falls in tradable prices (measured in $A), rather than rises in non-tradables prices. In both periods the price signal (inevitably) discouraged tradable production, but in the 1987–89 period this may have been softened by the restraint on nominal wage growth and the fall in real unit labour costs. For example, employment, output and profits in the import-competing manfuacturing sector have been relatively strong and the volume of manufactured exports continued to grow quickly, increasing by about one half of one per cent of GDP in the past few years.

(ii) Savings and investment

Changes in the current account deficit are identical to changes in the savings-investment balance. Therefore, if we go behind the identity to look at the behaviour of the components of the savings-investment balance, we may be able to identify the savings or investment shocks that have influenced the current account. Edey and Britten-Jones (1990) show that private savings and investment are fairly stable over time (although they exhibit substantial short-term fluctuations): government savings is the component of the overall savings-investment balance that has shown the most marked trend movement.

In the first half of the decade, Australia, like a number of other economies^[24], experienced a combination of expansionary fiscal policy and a rise in the current account deficit. Many commentators attributed the rise in the deficit to fiscal policy – the “twin deficits” hypothesis. Fiscal policy was adjusted in an attempt to reduce public sector dissaving and therefore reduce the current account deficit. The results have been mixed.^[25] The current account deficits of a number of countries (New Zealand, Belgium and Denmark) have narrowed since the fiscal consolidations in those countries. This has not been true for Australia, Canada or the United Kingdom. These casual observations raise two questions. Did fiscal expansion early in the decade cause the rise in the current account deficits and, if so, why has the subsequent fiscal consolidation not been reflected in a reduction of the deficit?^[26]

First, some facts. There has been a large fall in public saving (see Figure 12). This decline accounts for most of the fall in national saving seen in Figure 6. Public saving in the first half of the 1980s was well below the level of the previous two decades. A break from this trend occurred in 1983/84 and public saving has risen relative to GDP since then.

Figure 13 plots the net Public Sector Borrowing Requirement (PSBR) (i.e. the balance of government saving and investment) and the current account deficit. There is no contemporaneous one-to-one relationship between the two as the simple “twin deficits” notion suggests.^[27] That is, movements in the PSBR have been mitigated by shifts in the private sector savings-investment imbalance.

There may be some very general relationship in the 1960s. The rise in the PSBR after 1973/74 was not fully reflected in the current account in the late 1970s.^[28] Private investment was very subdued. The sharp rise in the current account deficit between 1979/80 and 1981/82 occured at a time when the PSBR was falling. The decline in the PSBR was offset by the rapid rise in investment associated with the resources boom. Similarly, a large rise in private investment during the latter years of the 1980s offset the reduction in the PSBR since 1983/84.^[29]

These observations suggest two things. First, the low level of public saving in the first half of the 1980s underpinned the series of large current account deficits at the time. This was exacerbated at the start of the decade by the rise in investment. Second, changes in the government fiscal position are not contemporaneously, or fully, reflected in the current account.^[30] The “twin deficits” notion relied on the ceteris paribus assumption that private savings and investment would remain unchanged. This did not turn out to be the case. Is this private sector response more than just co-incidental?

One possibility is that the private sector has behaved in a manner consistent with the “Ricardian Equivalence Proposition” – that the private sector changes its savings behaviour to offset permanent changes in public savings. Edey and Britten-Jones(1990) argue that Ricardian Equivalence does not hold in Australia because private saving was quite stable throughout the 1960s, 1970s and 1980s despite the major swings in public saving after the mid-1970s. They conclude that this behaviour suggests very little tendency for private savings to offset changes in the position of the public sector.

However, McKibbin and Morling(1989), suggest that part of the fiscal consolidation of the last few years has been offset by Ricardian-type behaviour. If the statistical discrepancy is treated as missing private expenditure, then net private saving fell by 3 per cent of GDP between 1983/84 and 1987/88, roughly matching the rise of public saving of 3–1/2 per cent of GDP. Gregory(1989) also lends support to this view. However, this case does not seem to be very compelling. If consumers now internalise the public sector budget constraint, why did they apparently fail to do so in the past? Also, if Ricardian equivalence holds closely, why have long-term real interest rates fallen for most of the period of the fiscal consolidation? Part of the explanation is that foreign rates were also falling. However, domestic rates fell relative to foreign rates until 1988.

A more likely explanation of the failure of the fall in the PSBR to show up in a lower current account deficit is that the economy has been influenced by offsetting shocks. The change in factor shares in the 1980s increased the profitability of the corporate sector and resulted in a substantial rise in private investment. A terms of trade rise also contibuted to a rise in expenditure and the real exchange rate.

The earlier model results (in footnote 30) suggest that fiscal policy induces offsetting private sector behaviour by altering real interest rates and private investment. It is certainly the case that the fiscal consolidations of the late-1970s and mid-1980s were associated with a rise in private investment. While it is difficult to find an empirical relationship between private investment and real interest rates, Alesina, Gruen and Jones(1990) note that six economies that experienced large fiscal consolidations in the 1980s also experienced rapid investment growth.^[31] They suggest that fiscal consolidation may boost corporate confidence and thus investment. The rise in investment in the past few years has been a major factor mitigating the effects of fiscal policy on the current account. However, it is unlikely that fiscal policy was the major influence on investment. Australian evidence suggests that profits are the most significant influence on short-run fluctuations in investment. See McKibbin and Siegloff(1988).^[32] This suggests that the rise in profitability, driven by real wage reductions,^[33] since 1983/84 has underpinned the rise in private investment since that time.

Some would find this conclusion unusual in that it implies that the reduction in real wages, by contributing to increased profits and investment, has also contributed to the widening of the current account deficit. A priori, it is not clear why this should be the case since real wage cuts also increase production. The data on absorption and output in Figure 5, show this with the high real unit labour costs of the mid-1970s and early 1980s constraining both output and expenditure and vice versa for the real wage reduction in the second-half of the 1980s. Corden(1986) noted that the current account response to real wages depends on the relative magnitude of the expenditure and output effects. In the short-run, however, the expenditure response probably dominates since the cycle in investment is much larger than that in output.

One issue that has attracted considerable attention of late is the effect of inflation and distortions in the tax system on savings and investment decisions. Macfarlane(1989) and McKibbin and Morling(1989) have argued that the interaction of high inflation and the tax system in Australia has influenced the savings-investment balance. Edey and Britten-Jones(1990) consider this issue in detail and they conclude that these factors may encourage capital importing into Australia.

(iii) Capital Flows

The integration of financial markets across the world that began in the early 1970s has been associated with wider rather than narrower external imbalances. It is certainly the case that the widening of the current account deficit in Australia has occurred during a period in which Australia's domestic financial markets and foreign exchange markets have been deregulated.

In December 1983 the Australian dollar was floated and the bulk of exchange controls were removed. Up to that point Australia had a “crawling peg” exchange rate system underpinned by a range of exchange controls.^[34] Controls were placed on both the inflow and outflow of capital. Generally, controls on outflows were more restrictive. During the 1950s and 1960s, an “open door” policy on capital inflow meant that inflows were readily permitted.^[35] In the 1970s various constraints were imposed when there were large inflows of capital. For example, an embargo on short-term borrowing was periodically introduced;^[36] at the time this was supported by a variable deposit requirement (VDR) which increased the cost of borrowing. These measures sought to prevent or discourage firms from undertaking foreign borrowing.^[37] By the end of 1978, these controls had been lifted. The removal of these particular restrictions preceeded a sharp rise in portfolio borrowing. (Figure 15).

Has deregulation been a factor in explaining the behaviour of the current account and net foreign debt? There are a number of channels through which these changes may influence the external accounts. First, the removal of exchange controls coupled with the development of offshore $A securities markets (to be discussed later) has increased the mobility of capital and given domestic residents' greater access to foreign saving. Shocks will therefore have a larger impact on capital flows, the exchange rate and therefore the current account than previously. Section II provided a discussion of this. At the same time, capital inflow (and the current account deficit) may have risen as potential investors, previously constrained by funding shortages, were now able to finance their projects. Second, deregulation has altered the portfolio investment decisions of corporations and the way those investments are financed. An example of this has been a large rise in equity investment abroad that has been financed by foreign borrowing.

To illustrate the second effect it will be useful to examine developments in the capital account in the 1980s. Figure 14 shows gross capital flows as a proportion of GDP. Both outflows and inflows of capital have increased relative to GDP in the 1980s. Capital inflows averaged 6–1/2 per cent of GDP in the 1980s – more than double the averages of the 1960s and 1970s. Capital outflows grew steadily during the decade, averaging 2–1/2 per cent of GDP in the 1980s compared with less than one per cent in both the 1960s and 1970s.

Capital Inflows

Prior to the 1980s, equity investment in Australia was the predominant form of capital inflow. Almost all borrowing was of a direct nature; for example, between an overseas parent company and its domestic subsidiary. Portfolio borrowing of a short-term nature was insignificant relative to these sources of finance (Figure 15).^[38] The nature of capital inflows changed dramatically in the 1980s. While equity investment remains an important source of finance, it has been surpassed by short-term portfolio borrowing. This increased from around 3/4 of one per cent of GDP in 1979/80 to 4–1/4 per cent of GDP in 1981/82. It has since fluctuated around this level.

The rapid rise in short-term borrowing has been due to a number of factors. Deregulation has been important. The removal of short-term borrowing restrictions and the need to finance large-scale resource projects during the resources boom contributed to the growth of portfolio borrowing at that time.

At the beginning of the decade most of this lending was done by foreign banks. Since the removal of exchange controls in 1983 most of the funds are raised through issues of securities in offshore capital markets. An important source of funds in recent years has been the Euro-$A bond market.

Outstandings in this market now amount to $37 billion (compared with $50 billion in the domestic government bond market and $66 billion in the bank bill market). In the second half of the 1980s the flows originating in this market were extremely large. They were large enough, in principle, to fund the whole current account deficit (Figure 16).

There have been numerous factors underpinning the growth in this market. Taxation and regulatory considerations have meant that Australian issuers face lower borrowing costs offshore.^[39] Also, relatively high interest rates in Australia have encouraged a retail investor base in Europe. A feature of this market is that non-residents have been the predominant issuer since 1985. The growth of non-resident issues has been encouraged by an active swap market in Australia. Non-resident borrowers typically swap the fixed-rate Australian dollar proceeds to an Australian entity and in return receive, directly or indirectly, a floating rate liability in the currency of their preference. This has allowed residents to tap the large European retail funds market.

Another factor underpinning the growth of portfolio borrowing has been a shift in the demand for debt relative to equity. The 1980s have witnessed a marked increase in the gearing of the corporate sector. (For a discussion see Macfarlane(1989)).

Capital Outflows

Non-official outflows of capital were negligible until the early 1980s but have grown quickly since the beginning of the decade, largely due to a rise in Australian equity investment abroad. This averaged 1/2 of one per cent of GDP in the first half of the 1980s but rose to an average of 2–1/2 per cent of GDP in the second half of the decade. These developments followed the relaxation of restrictions on portfolio investment overseas and equity and real estate investment overseas in March 1980 and July 1981.

The stock of direct equity investment overseas has risen from 3 per cent of GDP in June 1980 to 9–3/4 per cent of GDP in September 1989. The stock of portfolio equity investment has risen from less than 1/4 of one per cent of GDP in June 1980 to 4 per cent of GDP in September 1989. (Robertson(1990) gives a fuller account of these developments).

This increase in equity investment abroad must, like the current account deficit, be financed by increased gross capital inflow. Consequently, in every year of the 1980s the gross capital inflow has exceeded the current account deficit. (Figure 17). Equity outflow has largely been financed by foreign borrowing. Thus, the increase in external indebtedness has not been entirely due to the persistently high current account deficits. If this Australian equity investment abroad had not occured then, other things equal, Australia's net foreign debt would be around $40 billion lower. See Robertson(1990).

Clearly, there have been dramatic changes in the nature and volume of capital flows as a result of deregulation. These changes have directly contributed to the accumulation of foreign debt by altering the portfolio investment and financing behaviour of the corporate sector. They have also given Australians greater recourse to foreign savings.

Turning to the issue of capital mobility, there is ample evidence that short-term capital is perfectly mobile and arbitrages riskless profit opportunities^[40] but that expected rates of return are not equalized.^[41],^[42] Feldstein and Horioka(1980) proposed an alternative test of capital mobility. They argued that if capital was perfectly mobile then domestic saving and investment would be uncorrelated. Domestic saving would be allocated around the world depending on relative rates of return. Domestic investment opportunities would compete for funds from the world pool of savings. Feldstein and Horioka found that there was a high degree of correlation between domestic saving and domestic investment. They concluded, therefore, that capital was not mobile.

There are a number of problems with this approach. These are outlined in Appendix 1 which also reports the results of similar tests for Australia. The results show that while there is a significant correlation between savings and investment, that correlation declines over the period which covers the removal of exchange controls and the development of offshore securities markets. This result is not inconsistent with the hypothesis that capital flows are now more mobile as a result of Australia's more complete integration into world financial markets.

Unfortunately, there are a number of competing hypotheses consistent with these results. The first is that capital mobility, and Australian access to foreign savings, has increased and that this facilitated the widening in the current account deficit. A second possibility is that the apparent change in the savings-investment relationship was due to fiscal policy becoming more lax, particularly early in the decade, with less emphasis being placed on its implications for the current account. The correct interpretation probably lies somewhere between these two. Corden(1989) essentially makes this point when he argues that the fiscal expansion of 1982/83 was made possible by increased access to international capital markets. That is, while this increased access may not have, in itself, directly affected the current account, it permitted the government and subsequently the corporate sector to run larger savings-investment imbalances. Frankel(1989) draws a similar conclusion for the U.S. and argues that “financial liberalisation in Japan, the UK and other countries, and continued innovation in the Euromarkets … have resulted in a higher degree of capital mobility, and thereby facilitated the record flow of capital to the United States in the 1980s” with the magnitude of the flow being determined by the decline in national saving.^[43]

One possible weak test that might disentangle this is to examine real interest differentials between Australia and overseas. Long-term real interest differentials are shown in Figure 18. If the investment-savings imbalance in Australia had been constrained by restricted access to international financial markets, we might expect to see real rates higher in Australia than overseas, with this premium disappearing as access was opened up. No such pattern can be seen in the data. However, the regulation of nominal rates in the 1970s clouds this interpretation because, as Carmichael(1990) shows, real rates were driven by inflation at that time. It is interesting to note that, on average, the real interest differential was closer to zero in the 1980s than previously. This is consistent with increased capital mobility.

It is also difficult to establish to what extent the rise in capital flows was induced (i.e. a response to changes in expected returns) or autonomous – resulting from, say, shifts in the preferences of international investors.^[44] It may be that the distinction between autonomous and induced capital flows is, in any case, unhelpful. The Euro $A market, for instance, developed because of the interest differential. If exchange controls had been in place to prevent capital inflows, the exchange rate would have been lower (i.e. more depreciated) and the current account would have been smaller by definition. To sort chicken-from-egg in this interaction may not only be impossible, but not very useful.

(iv) Monetary policy

The current account response to monetary policy is ambiguous, at least in the short-run.^[45] A monetary expansion leads to an exchange rate depreciation, but the beneficial effect of the relative price change on the current account will be countered by higher demand. In the longer run, this excess demand will raise domestic prices, leaving the real exchange rate (and the current account) unchanged. The two crucial links in the short-term response – from lower interest rates to a lower exchange rate and from lower interest rates to increased expenditure – are both clear enough in principle, but very difficult to establish empirically. Australian empirical evidence suggests, at best, that interest rates lead expenditure, but there is little evidence on the magnitude and lag structure of the relationship. See Bullock, Morris and Stevens(1989).^[46] Macfarlane and Tease(1989) find that policy reaction to exchange rate changes makes it difficult to quantify the relationship between domestic interest rates and the exchange rate. Given these problems in estimating the expenditure and exchange rate responses to monetary policy it is difficult to determine the short-run effect of monetary policy on the current account.

The period from April 1988 to January 1990 presents an interesting example of the interaction of tight monetary policy, terms of trade shocks and the current account. There can be little doubt that the tight monetary policy of that period was one of the factors causing and maintaining the appreciation of the exchange rate. This was acknowledged in the RBA Annual Report: “in the short run, there may be perverse effects on the balance of payments if higher interest rates produce an exchange rate appreciation”. But tight policy was not the only factor in the appreciation: the rise in the terms of trade, of itself, required a real appreciation. Domestic expenditure was increasing at an excessive rate and threatening inflation objectives. Had policy been easier through this period then some adjustment of the real exchange rate would have been achieved through higher domestic inflation rather than by nominal appreciation. Blundell-Wignall and Gregory(1989) have shown that, in most cases, the appropriate response to terms of trade disturbances is to allow the nominal exchange rate to adjust. Monetary policy should not attempt to offset this.

Footnotes

Gruen(1986) discusses Australia's long term economic performance in detail. [17]

This has, in part, contributed to the decline in the terms of trade by increasing the supply of agricultural commodities. [18]

EPAC(1986) note that the rise in the current account deficit between 1983/84 and 1985/86 can be attributed to valuation effects of the depreciation of the Australian dollar and the decline in the terms of trade. [19]

This data is taken directly from Figure 3 in Edey and Britten-Jones(1990). [20]

MacTaggert and Rogers(1989) have noted an apparent strong secular relationship between the terms of trade and the household saving ratio. This relationship is, probably spurious because, as Edey and Britten-jones(1990) show, when private saving is adjusted for inflation there is no trend in the private sector savings ratio. Furthermore, the suggestion that the trend decline in the terms of trade is manifest in a trend decline in private saving and therefore the current account deficit is theoretically weak. [21]

The methodolgy can be found in Reserve Bank Bulletin April(1986). The volume effect is calculated by holding import and export prices constant between each quarter and calculating the change in the deficit due to changes in trade volumes. The terms of trade effect is calculated by holding volumes constant between each quarter and obtaining the change in the deficit due to changes in the terms of trade. [22]

They argue, however, that the easing in monetary policy in 1987 limited the rise in the nominal exchange rate and resulted in part of the adjustment coming through higher inflation. [23]

Examples include the United States, the United Kingdom, Canada, Belgium, Sweden and New Zealand. [24]

See Alesina, Gruen and Jones(1990) for a discussion of the cross-country experiences. [25]

Most of the literature has focussed on the relationship between the public sector deficit and the current account deficit. More recently, a number of authors have examined how the composition of the public sector's accounts and the structure of the tax system influence the current account. See, e.g. Genberg(1988), McKibbin and Morling(1989) and Alesina, Gruen and Jones(1990). [26]

To a certain extent the movements of the PSBR have been cyclical. However, the broad trends in the PSBR reflect structural changes in fiscal policy. Nevile(1989) has shown that after running structural surpluses in the first half of the 1970s Australia experienced structural deficits in the second half of the decade. Fiscal policy was tightened in a structural sense in the early 1980s then it became very expansionary after 1982/83 before being subsequently tightened. [27]

The widening of the current account in 1973/74 reflected a “return to normality” after the terms of trade change the year before. It was not related to, and preceeded, the subsequent fiscal expansion. [28]

The rise in investment does not, in an accounting sense, completely explain the offset to fiscal policy. Since 1983/84 the PSBR has been reduced by a little under 8 per cent of GDP yet the current account deficit is about 1–1/2 per cent of GDP wider than in 1983/84. The bulk of the offset was due to private investment which rose by 5–1/2 per cent of GDP. Private saving has fallen by around 1–1/2 per cent of GDP. The rest of the offset was accounted for by a rise in the statistical discrepancy of 2–1/2 per cent of GDP. [29]

There have been a number of attempts to assess the relationship between the PSBR and the current account with the aid of macroeconometric models. In these models, an expansion of fiscal policy does lead to a rise in the current account deficit. However, the extent of the rise in the current account deficit varies between the models.

Kouparitsas, Pearce and Simes(1989), using a version of the NIF88 model, find that a bond-financed rise in government spending results in a rise in the current account deficit of about half the size of the fiscal impulse. Some of the public sector dissaving is offset by private sector net saving.

McKibbin and Elliot(1989) find that a permanent rise in government spending of one per cent of GDP in the MSG2 model increases the current account deficit by about 1/2 of one per cent of GDP initially and by 3/4 of one per cent of GDP after five years. Murphy(1989), shows that a rise in public sector debt (resulting from tax cuts) is fully reflected in a rise in foreign indebtedness but only after a considerable delay. Results from the ORAN1 model (Freebairn (1989)), which has a different framework to the models mentioned above, are broadly similar. In contrast, the IMP model suggests that the link between fiscal policy and the current account is negligible. (See Hughes(1989)). Parsell, Powell and Wilcoxen (1989) compare some results from the MSG2 and Murphy models.

While it is difficult to compare the results from alternative models some reasonable conclusions can be drawn from the above discussion. First, these models incorporate a tendency for fiscal expansion to lead to a rise in the current account deficit. This adjustment in the current account occurs over the medium to longer term (from two to five years). Second, the “elasticity” of the current account to changes in fiscal policy may be higher than one half but lower than one. The effects of fiscal policy on the current account are offset by a rise in real interest rates and a reduction in private sector wealth (due to the rise in external indebtedness) which constrain private expenditure. [30]

In addition to Australia, these economies were Belgium, Canada, Denmark, Sweden and the United Kingdom. [31]

While this paper is about the current account and therefore savings and investment, a lengthy discussion of investment is not warranted. This is because the persistently large current account deficits in the 1980s cannot be explained by a trend rise in investment. However, sharp fluctuations in investment have had large short-run effects on the current account at the beginning and end of the decade. The determinants of investment are surveyed by Carmichael and Dews(1987) and Edey and Britten-Jones(1990). [32]

See Chapman(1990) for a discussion of the behaviour of real wages in the 1980s. [33]

For a description of the exchange control measures see Argy(1987) and Laker(1988). Also for a discussion of the behaviour of the Reserve Bank since the float see Laker(1988) and Macfarlane and Tease(1989). [34]

During this period and in the 1970s permission from the Reserve bank was required before overseas borrowing could be entered into. [35]

An embargo on borrowing of two years or less was introduced in 1972. The maturity was subsequently reduced to six months in 1974. In 1977 another ban on borrowings with a maturity of two years or less was introduced. All restrictions on short-term borrowing were lifted in 1978 except those for public sector enterprises. For more detail on exchange control measures sec Argy(1987) and Sieper and Fane(1982). [36]

The Australian Financial System Inquiry(1982) and Porter(1982) noted inflows were, to a certain extent, limited by these controls. Sieper and Fane(1982) argued that the VDR may have altered the timing but not necessarily the volume of inflows and discouraged large projects with long planning lead times. [37]

The official sector is defined as the General Government and the RBA and the non-official sector is defined as private and public sector enterprises. [38]

Funds raised offshore by Australian banks, for example, were not subject to the Statutory Reserve Deposit (SRD) ratio, which only applied to domestic deposits. Also, $A Eurobonds can be structured so that they are exempt from interest withholding tax. Decisions taken at the Loan Council/Premiers' Conferences of 1984 and 1985 gave public sector authorities greater access to offshore sources of finance. [39]

That is covered interest parity holds once transactions costs are taken into account. See Turnovsky and Ball(1983) and Levich(1985). [40]

That is uncovered interest parity does not hold. See Hansen and Hodrick(1980), Cumby and Obstfeld(1984) and Frankel and MacArthur(1988) for international studies and Tease(1988) and Smith and Gruen(1989) for Australian evidence. [41]

For an examination of capital mobility in Australia see Macfarlane and Tease(1989). [42]

Frankel(1989) p.12. [43]

Taxation considerations may have been driving some of the flows. There is no withholding lax on some classes of Australian securities and, even where foreign residents pay tax, they will often receive a higher real return than their domestic counterparts (Edey and Britten-Jones(1990) p 74). [44]

In the simplest Mundell-Fleming model, with perfectly elastic supply, monetary policy has powerful effects on output and the current account in the short-run because it alters both the nominal and real exchange rate. Once, realistically, some stickiness is added to the supply side, the current account response to monetary policy is ambiguous. See Sachs(1980). [45]

Stevens and Thorp(1989) do not find any support for this. However, they caution against drawing strong conclusions from their results. [46]