Fiscal and Monetary Policy

Analyse the role and implementation of monetary and fiscal policies as tools of macroeconomic management to manage the Australian economy through the current global economic crisis.

How does the government use fiscal and monetary policy to get Australia through the current global financial crisis

Fiscal Policy

- Fiscal policy is implemented through the use of a particular group of variables known as fiscal instruments. The instruments of fiscal policy are the expenditure and revenue variables, which are under the direct control of the government. In the real world, rates of taxation, rates of transfer payments and levels of government expenditure of various types represent them.
- The spending and revenue plans of the government for the fiscal period are announced through the government budget. The budget brings the revenues and spending sides of the government’s finances together and shows whether these finances are in surplus, deficit or balance for the year. The budget balance is measured by the difference between total government revenue and expenditure. The three possible outcomes for the budget are: o Surplus: Revenue exceeds expenditure and the budget balance is positive o Balance: Revenue equals expenditure and the budget balance is zero o Deficit: Expenditure exceeds revenue and the budget balance is negative

The Budget and the Stabalisation of Economic Growth
- Fiscal policy, along with monetary policy, provide the main macroeconomic policy tools the government uses to keep the economy growing at a sustainable pace, with low inflation and low unemployment. They are also the policy tools the government can use to try and shorten recessions and prevent booms in economic activity from becoming excessive. This has traditionally been termed stabilisation policy.
- It is the presence and impact of automatic stabilisers (taxes and transfer payments in particular), which enable fiscal policy to exert a stabilizing force on economic activity. Automatic stabilisers such as income taxes and unemployment benefits respond automatically to expenditure and output gaps in the economy. When GDP declines, income tax collections fall due to the fall in household taxable income while unemployment and other welfare benefits rise. These changes in government spending and tax collections are automatic i.e. they require no explicit action by the government. They serve to increase the level of planned spending during recessions and reduce it during expansions without the delays associated with the legislative procedures that accompany the budget process.

The Budget and the Reallocation of Resources
- Changes in the level and composition of government taxation and expenditure can affect resource allocation in a number of ways: o Expenditure on collective goods and services and welfare financed by taxation serves to shift resources out of private production and into the public sector. o Taxations measures directed at particular goods and services can alter the prices charged and demand patterns of consumers and producers. This in turn can impact on the allocation of resources for the production of goods and services by the private sector o Governments may use selective assistance or incentives to various industries such as subsidies, tariffs, quotas, and tax incentives to encourage or discourage certain types of production thereby encouraging a reallocation of resources within the economy

The budget and the Redistribution of Income
- Fiscal policy can be used to redistribute income, mainly through progressive income taxes and more specifically, changes to income tax thresholds and marginal tax rates. Furthermore, through social security/welfare programs the government has the capacity to influence income distribution. This usually involves direct payments to low-income households. In this context, the government is using the fiscal instruments to influence income distribution after taxes and transfers.
- Government policies aimed at reducing income inequality are primarily designed to redistribute income and wealth in order to reduce the social and economic disadvantage suffered by members of the community. In most advanced economies a system of tax-transfers has been developed to reduce inequality in the distribution of income and wealth. This usually involves the use of progressive income taxes and transfer payments such as pensions and unemployment benefits to support low income earners, families with children on a single income, the unemployed and other disadvantaged groups.

Monetary
- The Reserve Bank of Australia (RBA) is Australia’s central bank and it’s main role is responsibility for overall financial system stability, and the conduct of monetary policy. The RBA is the principal monetary authority of the Commonwealth Government and is banker to the Australian Government. The RBA’s powers and functions are set out in the Reserve Bank Act 1959. The RBA is independent of the Australian government in conducting monetary policy, but there is usually close co-operation and consultation between the RBA board and the Treasurer.
- Under the Reserve Bank Act 1959, the RBA is to conduct monetary policy in achieving 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 main functions of the RBA are the following: Control of note issues; Banker to the banks; Banker to the Australian Government; Custodian of Australia’s holdings of gold and foreign exchange reserves; and the implementation and conduct of monetary policy.
- The role of the RBA in conducting monetary policy is through the use of an inflation target, which is set at keeping CPI or headline inflation between 2% and 3% over the economic cycle. This is seen as necessary to sustain economic growth, secure full employment, and maintain international competitiveness by containing inflationary expectations in the Australian economy.
- The cash rate is the interest rate on overnight loans in the cash market. The RBA will act to raise the cash rate if it believes that monetary policy should be tightened through a higher interest rate structure.
- The RBA uses its market operations of buying or selling Commonwealth Government Securities (CGS) and Repurchase Agreements (RPAs) in the cash market to implement a change in the stance of monetary policy. For example, if the RBA wished to tighten monetary policy, it would sell CGS and RPAs. Their purchase by commercial banks would reduce cash balances in their Exchange Settlement Accounts with the RBA, forcing up the cost of borrowing through a higher cash rate. Conversely if the RBA wished to stimulate economic and employment growth and ease monetary policy, it would use its open market operations to buy CGS and RPAs in the cash market to increase liquidity. The scale of these securities by commercial banks to the RBA would increase their Exchange Settlement Account balances, forcing down the cost of borrowing through a lower cash rate.
- Typically after a rise in the cash rate, other interest rates such as rates on credit cards, mortgage loans, personal loans, commercial bills and business loans, will also rise to reflect the increased cost of borrowing in the cash market.
- Although changes in the stance of monetary policy act with a lag of between six and nine months, the higher cash rate and tighter monetary conditions would be expected to reduce the rate of economic growth in Australia and ease inflationary pressures. The most immediate impacts of a higher term structure of interest rates are on the following variables in Australia: o A reduction in the amount of consumer, business and government spending through a higher cost of borrowing and the servicing of existing levels of debt. Higher interest rates will also reduce the rate of credit growth and raise the returns for saving. o A reduction in the growth of national spending will eventually reduce the growth of GDP. This will lead to lower economic and employment growth and cause the rate of unemployment to rise. o An appreciation of the exchange rate, as the rate of return on capital in Australia is higher than the rest of the world. This will lead to increased capital inflow and put upward pressure on the exchange rate. A higher exchange rate will reduce international competitiveness. o A reduction in the prices of financial assets such as shares, houses and apratments as the cost of borrowing to finance the purchase of such assets rises. Also, the higher cost of servicing debt by existing by borrowers will lead to the forced sale of financial assets and lower asset prices. o A lower rate of inflation in the Australian economy should occur as wage and price setters reduce their inflationary expectations.