ECON1001 Introductory Microeconomics

Introduction

The report focuses on the impact of the economic policy uncertainty on the investment in the Australian and worldwide perspective. The report is presented from the point of view of an economic advisor of the government of Australia. The report will take into account different issues regarding uncertainty such as what type of uncertainty a firm can face, measurement of uncertainty, process of taking investment decisions under uncertainty. This will be followed by a brief discussion of the economic policy uncertainty. Initially the economic policy uncertainty will be discussed in a bigger picture from the worldwide level. After the discussion at the international level, the case of economic policy uncertainty will be discussed from the Australian perspective. The economic policy uncertainty and the rate of investment with the help of capital formation will be shown. All the analysis will be performed based on appropriate data and graphs. It will also be studied whether Covid-19 pandemic contributed to the uncertainty.

What is uncertainty in economics?

Uncertainty is an important concept of economics. It refers to the cognitive situations that can arise due to unknown, imperfect and incomplete information. It applies mainly to the forecasts to future incidents to the physical indicators that have already been made (Kohn, 2017). Situations of uncertainty arises in unpredictable and partially recognizable situations. Uncertainty also involves risk where some possible consequences can have undesirable outcome or a considerable loss (Renn, 2017). Uncertainty simply refers to the lack of sureness to an incident. Uncertainty in economics implies that the future perspective for an economy can not be forecasted. When people talk about uncertainty in economics, they simply implies likelihood of high occurrence of negative effects. This can include predictions regarding rate of inflation and unemployment.

What kind of uncertainty a firm can face?

In business and organizations, lot of individuals put in lot of effort to reduce the level of uncertainty. This is mainly because people do not understand uncertainty in a proper manner and secondly profitable scope is mainly observed in uncertain outcomes (Roper & Tapinos, 2016). Frank Knight wrote about uncertainty of a firm in his book “Risk, Uncertainty and Profit” in the year 1921. Normal people who are not the most rational decision-takers drive the activities of firms (Emmett, 2020).

Firms can deal with situations that are unique such as any  statistical tabulations for guidance. Firms estimate the validity and dependability of their opinion that can lead to lot of confusion. When firms think that every action they take is a risk, there is a high chance of failure. Uncertainty can arise in a firm when they stay in delusion of happiness. Firms need to understand that they do not have the actual information about the future and they also did not have proper information regarding the past.

The uncertainties that firms can face are regarding monetary problems, disruption in the supply chain, productivity, management of resource, legal issues and unpreparedness for normal world. Uncertainty also involves business risks that involves monetary risk, functional risk, strategic risk regulatory and compliance risk (Bui & De Villiers, 2017). There can be uncertainties in a firms that involves risks in environment, uncertainties regarding economic and political instability, risks regarding safety and health, commercial risks that includes failure of important buyers and sellers.  Firms can face uncertainties regarding sufficient number of employees, safety of the employees and up-to-date skills (Sadgrove, 2016).

How do we measure uncertainty?

Uncertainty is measured mainly with the use of risk. Measures of uncertainty in economics helps the investors to track a fear of complacency and fear for the purpose of strategies of trading. Different methods are used to measure uncertainties such as volatility in equity market, economic forecasting, dispersion regarding the forecasts of earning, policy uncertainty graphs, formation of capital as a proportion of the Gross Domestic Product. Uncertainties can be measured with the help of news-based measures of the uncertainty of economic policy (Frankel & Kamenica, 2019).

The economic forecast disagreement dependent measures of uncertainty takes into account the forecast dispersion of Consumer Price Index and forecasts of Gross Domestic Product. Uncertainty in the economy can also be measured based on major historical events occurring in the worldwide economy (Carriero et al., 2018). Monetary uncertainty can be measured with the help of equity volatility based uncertainty, measures of volatility in the stock market and forecast of analyst’s earning (Konstantinidi & Pope, 2016). Uncertainty with the indicator of risk is measured with the help of statistical tools such as deviation and standard deviation. If a particular option has higher rate of standard deviation, there is a lot of risk involved with the choice ,hence the rate of uncertainty is also high in such case.

How do firms make decision under uncertainty?

Firms make decisions under uncertainty with the help of different steps such as acknowledging uncertainty, considering more options, taking more chances, expecting to be wrong and learning. Firms make decision under uncertainty initially by acknowledging it. This is a constant step that has increased importance of the high level of uncertainty. Firms must consider more choices with the help of huge number of forecasts. Widening the scope can increase the odd of making a proper decision.

Under the situation of uncertainty, firms can try to take more chances by expanding the chance that a single option will prove to be a fruitful one. For the development of a new product that is expensive and has a less rate of success, the firms can consider to take the chance by involving more ideas. During the peak period of uncertainty, firms can expect themselves to go wrong. If the firms are always looking for methods to avoid errors, they can miss some of the most powerful and fruitful opportunities. The best thing that a firm can do to take decision during times of uncertainty is to learn by examining their works and experimenting with them. This can improve the future profits of the firm and their share in the stock market.

Economic policy uncertainty at international level

The graph shows the index of Economic Policy uncertainty at an international level from January 1997 to October 2020. The graph is constructed by the Gross Domestic Product-weighted mean of indices of the countrywide Economic Policy Uncertainty for 21 countries that includes Brazil, Australia, Chile, Canada, Colombia, China, Germany, France, India, Greece, Ireland, India, Japan, Italy, Netherlands, Mexico, South Korea, Russia, Sweden, Spain, the United States and the United Kingdom. The country wide economic policy uncertainties portrays the relative frequency of the newspaper articles of the respective countries that contains the three main terms – Economy, Policy and Uncertainty.

To construct the graph of International Economic Policy Uncertainties three steps were involved. Firstly, each of the country-wide EPUs were normalised to an average of 100 from 1997 to 2015. Secondly, the missing values for certain countries were imputed with the method of regression. Finally, GEPU value for every month based on the weighted mean of GDP was calculated for 21 countries (policyuncertainty.com, 2021). From the graph it can be seen that the economic policy uncertainty during 2020 in the whole world was the highest. This was primarily because of the spread of the Covid-19 pandemic.

Economic Policy Uncertainty in Australia

To construct the graph of Economic Policy Uncertainty of Australia, texts archives from eight different Australian newspaper such as Courier Mail, The Australian, Daily Telegraph, The Advertiser, The Age, Sydney Morning Herald, Mercury and The Herald Sun has been taken from January 1998 to 2021. To get the rates of Economic Policy Uncertainty rate for each of the papers, the researchers have scaled counts of raw EPU by the number of total articles provided in the same newspaper and same month. Firstly, the rate of EPU of each paper is standardised to an unit standard deviation from 1998 to 2012. The units are then rescaled with the average of 100 from the month of January of 1998 to December of 2012 (policyuncertainty.com, 2021). From the graph it can be understood that the economic policy uncertainty was at its peak during 2011, 2016 and 2020.

Economic Policy Uncertainty and Investment

The graph shows the Gross Capital Formation as a percentage of the Gross Domestic Product. The Gross Capital Formation is also known as the rate of Investment. The capital formation includes holding of produced assets that also incorporates second-hand assets, production of the asset by the producer for their own need minus the disposal. Produced assets are those assets that come into existence because the process of production is also included. It can be said that economic policy uncertainty and the investment or the gross capital formation are inversely related to each other (Chow, 2017).

From the graph, it can be seen that the gross capital formation of Australia is higher than the rate of investment of the world as a whole over the years. Firms with high return on the capital that is invested can reduce the impact of economic policy uncertainty. Firms that use more of internal monetary resource can reduce the effect of policy uncertainty. Moreover, the firms that are not owned by the state can reduce the negative impact of economic policy uncertainty. Increase in the economic policy uncertainty can boost the systematic risk and thus the cost of formation of capital in an economy. Thus a high level of economic policy uncertainty reduces the rate of investment mainly because of the irreversal nature of investment.

Did Covid-19 pandemic contribute to uncertainty?

Covid-19 pandemic has created considerable shock in the uncertainty that is larger than that of the Worldwide crisis of 2008-2009. The uncertainty created due to Covid-19 pandemic is quite similar to that of the uncertainty created during the Great Depression of 1929-1933. The rise in uncertainty during the Covid-19 pandemic can be measured with the help of volatility measures of stock market, measures of economic uncertainty based on newspaper article and aggregating the responses to the questions of survey about recognised uncertainty at the business-level (Altig et al., 2020).

Conclusion

The report can conclude that there is an inverse relationship between economic policy uncertainty and the gross capital formation as a measure of investment. The worldwide economic policy uncertainty and the economic policy uncertainty of Australia is mentioned in the report. The world economic policy uncertainty was highest in the year 2020. However, in Australia, the economic policy uncertainty peaked in different years The rate of investment in Australia was higher than that of the level of investment of the world as a whole. The pandemic also has raised the level of economic policy uncertainty due to the restrictions imposed by the government of the countries.

References

Altig, D., Baker, S., Barrero, J. M., Bloom, N., Bunn, P., Chen, S., ... & Thwaites, G. (2020). Economic uncertainty before and during the COVID-19 pandemic. Journal of Public Economics, 191, 104274

Bui, B., & De Villiers, C. (2017). Business strategies and management accounting in response to climate change risk exposure and regulatory uncertainty. The British Accounting Review, 49(1), 4-24.

Carriero, A., Clark, T. E., & Marcellino, M. (2018). Measuring uncertainty and its impact on the economy. Review of Economics and Statistics, 100(5), 799-815.

Chow, G. C. (2017). Capital formation and economic growth in China (pp. 1186-1221). Brill.

Emmett, R. B. (2020). Reconsidering Frank Knight's risk, uncertainty, and profit. The Independent Review, 24(4), 533.

Frankel, A., & Kamenica, E. (2019). Quantifying information and uncertainty. American Economic Review, 109(10), 3650-80.

Köhn, J. (2017). Uncertainty in economics. Contributions to Economics.

Konstantinidi, T., & Pope, P. F. (2016). Forecasting risk in earnings. Contemporary Accounting Research, 33(2), 487-525.

policyuncertainty.com. (2021). Economic Policy Uncertainty Index. Retrieved 13 May 2021, from https://www.policyuncertainty.com/global_monthly.html

policyuncertainty.com. (2021). Economic Policy Uncertainty Index. Retrieved 13 May 2021, from https://www.policyuncertainty.com/australia_monthly.html

Renn, O. (2017). Risk governance: coping with uncertainty in a complex world. Routledge.

Roper, S., & Tapinos, E. (2016). Taking risks in the face of uncertainty: An exploratory analysis of green innovation. Technological Forecasting and Social Change, 112, 357-363.

Sadgrove, K. (2016). The complete guide to business risk management. Routledge.

worldbank.org. (2021). Gross capital formation (% of GDP) - Australia, World |

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