4.1 - Aggregate Demand Policies and Domestic Economic Stability Flashcards
Budgetary (Fiscal) Policy
- The manipulation of the level and composition of Federal Government revenues and expenses, in order assist in the achievement of economic and social goals
- Main aggregate demand management instrument
Government Revenue
- Incoming money that pays for budget outlays
- Includes direct taxes, indirect taxes, revenue from government businesses and the sale of assets
Progressive Tax
- Collects proportionally more from higher income earners compared to lower income earners
- For example - income tax
Proportional Tax
- Collects proportionally identical the same amount from all income earners
- For example - Medicare Levy, company tax
Regressive Tax
- Collects proportionally more from lower incomes earners compared to higher income earners
- For example - Goods and Services Tax
Direct Taxes
- Taxes paid directly to the government and usually paid on income
- Examples: income tax, capital gains tax, Medicare levy, witholding tax, company tax
Indirect Taxes
- Usually taxes on expenditure or consumption
- Examples: excise duty on coal, petrol, tobacco and alcohol; Goods and Services Tax; Customs tariffs
Non Tax Revenue
- Sale of Government assets – for example, Medibank Private in 2014
- Profits from Government businesses – for example, Australia Post
- HECS repayments
Main Government Expenses
- Social security and welfare = 35%
- Health = 17%
- Education = 7%
- Defence = 6%
Government Expenditure (G)
- Government Consumption Expenditure (G1)
o Goods and services that are consumed in the current budget period, and have no ongoing benefits
o For example, wages and supplies for schools and hospitals - Government Investment Expenditure (G2)
o Government capital expenditure designed to increase the productive capacity of the economy
o Includes infrastructure projects - Unemployment benefits are not included in government expenditure as they are transfer payments, and will eventually be included in C or I
Budget Outcomes
- Balanced budget – when revenue = expenditure
- Budget deficit – when revenue < expenditure
- Budget surplus – when revenue > expenditure
Headline Cash Balance
Total cash received by the Government minus total cash paid
Underlying Cash Balance
- Excludes cash flows that do not hare a direct or immediate impact on the economy
- For instance, future fund earnings and proceeds from asset sales are excluded
Underlying Cash Balance as a Proportion of GDP
Shows how expansionary or contractionary the budget is, in comparison to GDP
Fiscal Outcome
Total cash received by the Government minus total cash paid only over the relevant budget period
Actual vs Estimate Budget Figures
- Actual budget figures are for the previous financial year
- Estimate budget figures are predictions for future financial years
Contractionary Budgetary Stance
- Occurs when the budget is in surplus
- Reduced government expenditure (G) → lower aggregate demand
- Reduced transfer payments → reduced C + I → lower aggregate demand
Expansionary Budgetary Stance
- Occurs when the budget is in deficit
- Increased government expenditure (G) → higher aggregate demand
- Increased transfer payments → increased C + I → higher aggregate demand
Bonds
- Issued by the Federal Government with a promise to pay periodic interest and repay the principle on the maturity date
- Sell bonds to - RBA, overseas investors, domestic investors
Selling Bonds to RBA
- Involves the RBA purchasing bonds using assets in their vault or by printing money
- This is the most expansionary and inflationary source of funding
Selling Bonds to Overseas Investors
- Will result in higher net foreign debt and a higher Current Account Deficit due to interest repayments
- Will also appreciate the AUD due to higher demand for it
Selling Bonds to Australian Investors
- Will result in higher interest rates due to higher demand for money
- Will ‘crowd out’ the private sector, as there will be less funds available for consumption or investment expenditure
Consequences of a Budget Deficit
- Cost of repaying bonds – may need higher tax and lower government spending to service
- ‘Crowding out’ of domestic markets
- Impact on credit rating
Implications of a Budget Surplus
- Able to invest into financial markets
- Able to repay debt
- Increases credit ratings
- Able to place into funds – such as the Future Fund → can act as a buffer against future economic decline
- Reduces interest rates so increases private consumption and investment spending
Discretionary Stabilisers
+ Their Operation
- Deliberate changes to the composition or volume of receipts/payments
- Represents the structural component of the budget
- Includes changes to tax rates and infrastructure projects
o Decrease in growth → increased discretionary measures → increased growth and net debt
o Increase in growth → decreased discretionary measures → decreased growth and net debt
Automatic Stabilisers
- Automatic changes to the level of economic activity – government does not have to announce or implement changes to the budget for automatic stabilisers to work
- Operate counter-cyclically
- Represents the cyclical component of the budget
- Includes tax receipts and welfare benefits
o Decrease in growth → decreased tax receipts and increased welfare benefits → increased net debt and increased growth
o Increase in growth → increased tax receipts and decreased welfare benefits → decreased net debt and decreased growth
2023/24 Budet Policy:
Instant Asset Write-Off
- Allows businesses to claim up to a $20k deduction from their tax liability when they purchase new assets, equipment or machinery
- → increased willingness and ability for businesses to purchase → increased private investment expenditure → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
2023/24 Budet Policy:
Child Care Subsidy
- Subsidises childcare for families earning up to $530k p.a.
- Increases disposable income → increased willingness and ability to purchase goods and services → increased private consumption expenditure → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
2023/24 Budet Policy:
Infrastructure Pipeline
- $120bn in spending on infrastructure over the next 10 years
- Increases government investment expenditure (G2) → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
2022/23 Budet Policy:
Low and Middle Income Tax Offset
- Reduces the amount of tax payable for low and middle income earners by an additional $420 p.a. to a total of $1500
- Increases disposable income → increased willingness and ability to purchase goods and services → increased private consumption expenditure → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
2022/23 Budet Policy:
Fuel Excise Reduction
- Reduces the fuel excise by 50%
- Increases disposable income → increased willingness and ability to purchase goods and services → increased private consumption expenditure → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
2022/23 Budet Policy:
Cost of Living Payment
- $250 cash payment for eligible pensioners and welfare recipients to assist with cost of living pressures
- Increases disposable income → increased willingness and ability to purchase goods and services → increased private consumption expenditure → increased aggregate demand →
- Impact on SSEG: increased production → increased economic activity
- Impact on Full Employment: increased production → increased derived demand for labour → lower unemployment
- Impact on Low Inflation: increase demand inflationary pressures → increased inflation
Strengths of Budgetary Policy
- Able to target specific sectors – increase growth in low growth sectors while not causing excessive growth in other sectors
- Short time lag for automatic stabilisers to act
- Short impact lag for policies to have an effect on the economy
- Able to stimulate aggregate demand directly by increasing C, I and G
- Checks and balances prevent poorly designed policies from being implemented
- Public scrutiny increases transparency and accountability so prevents poorly designed policies from being implemented
Weaknesses of Budgetary Policy
- Financial restrictions – government can only introduce so many policies as they wish to prevent increasing debt or taxes
- Can undermine monetary policy
- Some discretionary stabilisers have long time lags, such as infrastructure projects
- Lack flexibility as the budget is only delivered once a year
- Implementation lag as bills take time to pass both houses of parliament and may require cooperation with state governments
- Less effective at restricting aggregate demand during a boom – government is less able to restrict disposable income of consumers
- Political hurdles – bills can be blocked by the Senate
- Political bias – policies may bander to voters or lobby groups
Implementation of Monetary Policy
- Target cash rate set by RBA at board meetings
- RBA manipulation of cash rate allows it to indirectly affect all other interest rates
Overnight Money Market
o A market in which financial institutions borrow from and lend to each other
o RBA controls the supply of cash (liquidity) in the overnight money market
Conventional Monetary Policy
- RBA manipulates the supply of cash in the overnight money market by buying and selling Commonwealth Government Securities
- Increase interest rates: RBA will sell securities to banks, taking cash out of circulation and reducing the supply of cash (reducing liquidity) → upward pressure on interest rates
- Decrease interest rates: RBA will buy securities from banks, putting cash into circulation and increasing the supply of cash (increasing liquidity) → downward pressure on interest rates
Loosening of Monetary Policy
RBA announcing a lower target cash rate → increasing liquidity
Tightening of Monetary Policy
RBA announcing a higher target cash rate → decreasing liquidity
Unconventional Monetary Policy - Foward Guidance
- RBA signals its expectations for monetary policy into the future
- Expected reduced/stable cash rates → increased willingness to borrow
- Expected increased cash rates → decreased willingness to borrow
- For example – 2020, the RBA suggested that the cash rate would not increase for at least 3 years
Expansionary/Accommodative Stance
Achieved through reducing the cash rate (loosening monetary policy) = <3.5%
More Expansionary/Accommodative Stance
Growth is able to continue to increase without a change to interest rates as the rates are low enough already to stimulate growth
Contractionary/Restrictive Stance
Achieved through increasing the cash rate (tightening monetary policy) = >3.5%
More Contractionary/Restrictive Stance
Growth is able to continue to decrease without a change to interest rates as the rates are high enough already to slow growth
Neutral Stance
When the cash rate is neither working to stimulate nor contract the economy = 3.5%
Transmission Mechanism 1:
Savings and Investment
- Interest rates change the incentives for savings and investment
- Increase in the cash rate:
o Consumers are more likely to save → reduced C → decreased AD
o Consumers and businesses are less likely to borrow → reduced C + I → decreased AD - Decrease in the cash rate:
o Consumers are less likely to save → increased C → increased AD
o Consumers and businesses are more likely to borrow → increased C + I → increased AD
Transmission Mechanism 2:
Cash Flow
- Cash flow: cash available for purpose other than paying interest on loans
- Increase in the cash rate → increased proportion of income to pay interest → decreased cash flow → decreased C + I → decreased AD
- Decrease in the cash rate → decreased proportion of income to pay interest → increased cash flow → increased C + I → increased AD
Transmission Mechanism 3:
Exchange Rate
- Higher cash rate → foreign investors more willing to save in Australia due to higher returns → increased demand for AUD → appreciation of AUD → decreased international competitiveness → decreased net exports → decreased AD
- Lower cash rate → foreign investors less willing to save in Australia due to lower returns → decreased demand for AUD → depreciation of AUD → increased international competitiveness → increased net exports → increased AD
Transmission Mechanism 4:
Asset Prices
- Higher interest rates → lower demand for assets due to reduced willingness to borrow → decreased value of assets → asset owners become less confident to spend → decreased C → decreased AD
- Lower interest rates → higher demand for assets due to increased willingness to borrow → increased value of assets → asset owners become more confident to spend → increased C → increased AD
Goals of RBA
- Stability of the currency
- Maintenance of full employment
- Economic prosperity and welfare
Role of RBA
- RBA is responsible for monetary policy
- Set the cash rate, which influences other interest rates, to control economic activity, employment and inflation
- Uses underlying inflation as the key statistic to forecast future inflation
Implementation of Monetary Policy
- Target cash rate set by RBA at board meetings
- RBA manipulation of cash rate allows it to indirectly affect all other interest rates
Conventional Monetary Policy
- Overnight money market:
o A market in which financial institutions borrow from and lend to each other
o RBA controls the supply of cash (liquidity) in the overnight money market - RBA manipulates the supply of cash in the overnight money market by buying and selling Commonwealth Government Securities
- Increase interest rates: RBA will sell securities to financial institutions, taking cash out of circulation and reducing the supply of cash (reducing liquidity) → upward pressure on interest rates
- Decrease interest rates: RBA will buy securities from financial institutions, putting cash into circulation and increasing the supply of cash (increasing liquidity) → downward pressure on interest rates
Loosening of Monetary Policy
RBA announcing a lower target cash rate → increasing liquidity
Tightening of Monetary Policy
RBA announcing a higher target cash rate → decreasing liquidity
Unconventional Monetary Policy - Forward Guidance
- RBA signals its expectations for monetary policy into the future
- Expected reduced/stable cash rates → increased willingness to borrow
- Expected increased cash rates → decreased willingness to borrow
- For example – 2020, the RBA suggested that the cash rate would not increase for at least 3 years
Stance of Monetary Policy
- Expansionary/accommodative: achieved through reducing the cash rate (loosening monetary policy) = <3.5%
o More accommodative: growth is able to continue to increase without a change to interest rates as the rates are low enough already to stimulate growth - Contractionary/restrictive: achieved through increasing the cash rate (tightening monetary policy) = >3.5%
o More contractionary: growth is able to continue to decrease without a change to interest rates as the rates are high enough already to slow growth - Neutral: when the cash rate is neither working to stimulate nor contract the economy = 3.5%
Transmission Mechanism 1:
Savings and Investment Channel
- Interest rates change the incentives for savings and investment
- Increase in the cash rate:
o Consumers are more likely to save → reduced C → decreased AD
o Consumers and businesses are less likely to borrow → reduced C + I → decreased AD - Decrease in the cash rate:
o Consumers are less likely to save → increased C → increased AD
o Consumers and businesses are more likely to borrow → increased C + I → increased AD
Transmission Mechanism 2:
Cash Flow
- Cash flow: cash available for purpose other than paying interest on loans
- Increase in the cash rate → increased proportion of income to pay interest → decreased cash flow → decreased C + I → decreased AD
- Decrease in the cash rate → decreased proportion of income to pay interest → increased cash flow → increased C + I → increased AD
Transmission Mechanism 3:
Exchange Rates
- Higher cash rate → foreign investors more willing to save in Australia due to higher returns → increased demand for AUD → appreciation of AUD → decreased international competitiveness → decreased net exports → decreased AD
- Lower cash rate → foreign investors less willing to save in Australia due to lower returns → decreased demand for AUD → depreciation of AUD → increased international competitiveness → increased net exports → increased AD
Transmission Mechanism 4:
Asset Prices
- Higher interest rates → lower demand for assets due to reduced willingness to borrow → decreased value of assets → asset owners become less confident to spend → decreased C → decreased AD
- Lower interest rates → higher demand for assets due to increased willingness to borrow → increased value of assets → asset owners become more confident to spend → increased C → increased AD
‘Factors’ Influencing Monetary Policy
- Trends in inflation
- Levels of national spending and confidence
- Labour market conditions
- Budgetary policy stance
- International developments
Strengths of Monetary Policy
- RBA independent from political bias or considerations
- Short implementation lag due to monthly board meetings
- Influences expectations of consumers, investors etc
- Effective at controlling inflation through aggregate demand
Weaknesses of Monetary Policy
- Imprecise/blunt instrument – cannot target certain sectors of the economy
- Long time lag – up to 2 years for impact to take full effect
- No direct control over interest rates – up to banks to determine whether to implement changes to cash rate
- Less effective at increasing AD as consumers/businesses may prefer to reduce debts than increase consumption/investment
- Cannot reduce cost inflation
- Ageing population → increased reliance on interest rates on savings to spend → decrease in interest rates to stimulate spending may have opposite effect
Budget Outcome and Public Debt
- Budget deficit → sell bonds → increase public debt
- Budget surplus → able to repay existing debt → decrease public debt