Fiscal + Monetary Policy

The Australian government implements a range of policies to try and achieve the four
macroeconomic objectives and ensure the overall welfare of all participants in the
economy. The measures available to economic managers are both macro and
microeconomic. The macroeconomic policies include monetary and fiscal policies which
are designed to shift aggregate demand (AD).

Fiscal policy is the Commonwealth government’s plans and actions to influence

economic activities through government spending and taxation. Fiscal policy is
implemented through the governments annual budget, which is announced in may of each
year. The Budget can have either a surplus or deficit balance. A deficit occurs when
spending exceeds taxation, while a surplus occurs when taxation exceeds expenditure.
The current Liberal government has delivered nine surplus budgets in the past ten years.

Fiscal policy has an impact on AD because government spending is a component of Ad,

which is the aggregate of C+I+G+X-M. Taxation will also effect AD by impacting on C
& I. When a bigger surplus than the previous year is announced, or a smaller deficit,
Fiscal policy is contractionary, thus reducing C and I and shifting Ad to the left.

When the opposite occurs, a smaller surplus or a larger deficit, the budget is said to be
expansionary, where both C and I will increase and AD will shift to the right.

An increase in government expenditure, as seen through an expansionary budget will be

multiplied in effect over time. The initial injection will have a much greater effect on the
economy over time, through the expenditure multiplier. The extent of the multiplier is
determined by the size of leakages.
A reduction or increase in aggregate demand in an economy will have a number of
effects on successfully achieving the macroeconomic objectives. Reduced demand
causes suppliers to drop prices and reduce production, therefore reducing employment.
This result’s in lower inflation but will also reduce economic growth and lead to greater
unemployment. It may also see an improvement in the current account deficit as a
reduction in prices makes Australian goods more desirable, and a reduction in demand
reduces import spending. These effects will occur when a contractionary budget is
announced.

The 2006-07 budget announced in May by Treasurer Peter Costello is set to have an
expansionary on the Australian economy, with a forecast surplus of $10.8 billion down
from $14.8 billion the previous year. This will lead to an increase in AD due to an
increase in government spending, and therefore help achievement of full employment and
economic growth. Another major feature of the coming budget is the significant income
tax reforms and adjustment of the tax brackets. This reform should encourage people to
work more as they will be able to earn more before being heavily taxed, which will
increase AD and assist in achievement of economic growth and full employment.
The 2006-07 budget also announced a new streamlined superannuation package, the
establishment of a future fund, incentives for business to invest in new technology, major
increases in funding for medical research, investment in road, rail and water
infrastructure and increase in defence and national security funding.

Fiscal policy has the limitation of a conflict between achieving the objectives, as
achieving price stability and external balance will conflict with economic growth and full
employment. It is also limited in that it is only released once a year, and may be affected
by political considerations rather than solely economic prosperity of the nation.

Monetary policy is the government’s plans and actions to change interest rates in order to
influence the levels of AD. The policy is decided and implemented by the Reserve Bank
of Australia (RBA) to avoid the conflict of political considerations in policymaking.

The RBA have three objectives in the implementation of monetary policy and
manipulation of interest rates.
• The stability of the currency of Australia;
• The maintenance of full employment in Australia; and
• The economic prosperity and welfare of the people of Australia

The RBA’s definition of stability of currency refers to low inflation, between 2-3%,
which will preserve the value of money. This is how monetary is used on a long-term
basis for growth (3-4%), and thus full employment (5% UE). However, the RBA will not
implement monetary policy with the intention of achieving external balance. When this is
achieved, it could be said Australia is operating at full potential.

The RBA board meet on the first Tuesday on every month to decide the appropriate level
of the cash rate. The cash rate is the interest rate charged on overnight funds between
banks. When the RBA decides to increase the cash rate, they will reduce the supply of
exchange settlement funds (ESF’s) held in the banks exchange settlement accounts
(ESA’s) at the RBA. They do this by selling government securities to the banks (Open
market operations), therefore removing cash from the accounts, affecting the banks
ability to settle transactions between themselves. This will reduce the supply of loanable
funds in the cash market. The banks will then try to borrow more funds from the cash
market, thus bidding up the price of the cash rate. An increase in the cash rate will go
onto affect the entire structure of deposit and lending rates, through a flow on effect.

To reduce interest rates the RBA will implement a reverse policy, thereby increasing the
amount of ESF’s and reducing demand of money in the cash rate, therefore decreasing
the cash rate.

If the RBA decide to increase interest rates, then the level of consumption and investment
spending will be reduced, thus decreasing the level of AD. An increase in interest rates
will lead to a tendency for firms and households to save, having a contractionary effect
on the economy. A reduction of interest rates will have the opposite effect, as households
would rather spend than receive less interest on their money, thereby having an
expansionary effect on the economy, as per the expenditure multiplier.
In August, the RBA voted to increase the cash rate by 0.25% up to 6.00%. This increase
in interest rates will have a contractionary effect on the economy. This was decided in the
face of a marginally increasing CPI, as consumer driven inflation rose to a rate not
expected until a later quarter.

This increase in IR will allow control of inflation, and hence achievement of the price
stability objective. However the reduced economic activity will reduce economic growth
as AD decreases, and will also reduce employment. Despite the fact monetary policy is
not aimed at influencing external balance, as a secondary effect the downward pressure
on prices will make Aus goods more competitive and lead to a decrease in import
spending, possibly improve the CAD. It may also lead to an increase in foreign
investment by placing upward pressure on the exchange rate which will reduce our
international competitiveness. A decrease in IR is expansionary, and will have an inverse
effect on these objectives.

As with fiscal policy, monetary policy also has the limitation of causing conflict between
the objectives. By controlling inflation, there will be a decrease in economic growth and
employment. The RBA are able to overcome this conflict, by possibly reducing interest
rates while the economy is in a recession, or increasing interest rates while the economy
is in a boom. When the economy is in a recess, a reduction in interest rates will lead to a
substantial increase in production and employment as AD shifts outwards, while
producers will not raise prices significantly. When the economy is in a boom, an increase
in interest rates will lead to a sharp reduction in prices, but economic growth and
employment will only be marginally affected.