Chapter 4: AD Policies and Domestic Economic Stability Flashcards
What is domestic economic stability?
ideal level of economic activity where simultaneously there is low inflation, a strong and sustainable eco growth and low unemployment.
How are AD policies used?
Aggregate demand policies are used countercyclically to help regulate the level of national spending. This helps achieve Australia’s domestic macroeconomic goals.
What is budgetary policy?
is an AD measure of the government using its forecast level and composition of receipts and outlays for the coming financial year to achieve its economic goals
What are budget revenues?
Involve income gained through direct taxes (e.g. income, company tax) , indirect taxes (e.g. excise, tariffs) and non-tax revenue (e.g. electricity, police services)
What are budget expenses?
Gov. outlays dedicated towards the provision of goods, services and incomes to influence AD and economic activity - mainly by changing levels of C and I.
What is budget outcome?
difference between the government’s total receipts and outlays.
It can be a surplus (receipts exceed outlays) or a deficit (receipts are less than outlays) or balance (receipts and outlays are equal)
What is a budget deficit?
receipts are less than outlays
budget outcome is negative
revenues less than expenses
What is a budget surplus?
receipts exceed outlays
revenues exceed expenses
What is an aggregate demand management policy?
budgetary and monetary policy used to influence spending, economic activity and achievement of key domestic macroeconomic goals.
Why is budgetary policy considered an aggregate demand management policy?
applied counter-cyclically by the gov. to regulate levels of national spending and economic activity
Explain the domestic macroeconomic aims of budgetary policy
Medium-term operational aim: gradually return to a budget surplus with thought and care for the future.
This avoids a rise in public sector debt/borrowing (receipts>expenses → surplus → government doesn’t need to borrow/can pay off debt)
Recently → Australian economy weaker → budgetary policy aiming to promote achievement of key macroeconomic goals + improve living standards
Identify the sources of government budget revenue
Direct taxes
Indirect taxes
Non-tax revenue
What are direct taxes?
Levies on income received by individuals and companies e.g. from wages, salaries, profits, interest, dividends and rent
What percentage of all budget receipts do direct taxes account for?
70%
Provide examples of direct taxes
- personal income tax – paid by individuals who earn income in the form of wages, salaries, rent, interest and dividends
- capital gains tax (CGT) – levied on real profits made from sale of capital assets like land and shared purchased after 1985
- medicare levy - direct tax designed to provide medical insurance than covers basic costs of family health care (about 2% of personal taxable incomes)
- withholding tax - paid by individuals who fail to register their tax file number when receiving income (currently levied at top marginal tax rate of 45%)
- company tax - flat/proportional tax levied on business profits (raises around 20% of all budget revenue)
- fringe benefits tax (FBT) - paid by firms on the value of the ‘perks’ they provide to their employees (47% of taxable benefit)
- petroleum resource rent tax (PRRT) - levied at 40% of profits made from offshore petroleum operations
- superannuation fund - levied at 15% of most premiums, as well as on the interest from fund investments.
Does Australia use progressive rates for personal income tax?
Yes.
Marginal tax rate increases as income rises.
What are indirect taxes?
levies added onto the price of some goods and services at the point of sale
What percentage of all budget receipts do indirect taxes account for?
25%
Provide examples of indirect taxes
- excise duty - an flat rate of tax imposed on selected, locally produced goods e.g. petrol, alcohol, tobacco on a per unit basis (raise about 5% of gov. revenue)
- customs duties or tariffs - levied on certain imported goods to raise revenue and protect local producers from overseas competition (has been significantly reduced since 1970s from about 40% to about 5%)
- goods and services tax (GST) - broad-based indirect tax added to the price of goods and services at the point of sale
Is GST a regressive tax?
Yes.
Tax burden or rate (expressed as a percentage of income level) is greater for low-income earners in comparison to high-income earners.
That’s why ‘necessary’ g/s (e.g. water, childcare, women’s sanitary products etc.) are exempt from GST.
What is non-tax revenue?
comes from sources other than taxation such as profits from operation of government, businesses, fines and interest on loans
What percentage of all budget receipts does non-tax revenue account for?
7%
What are the main sources of non-tax revenue?
- profits gained through government businesses enterprises (e.g. Australia post) that sell g/s
- receipts for asset sales when government business assets are privatised (e.g. Medibank Private in 2014) - only included in headline budget outcome, not underlying budget outcome
- interest, petroleum royalties, the repayment of loans by state and local governments, HECS loan repayment by students, GST administration costs and property rentals
Identify other important features of the budget’s tax system
tax mix
tax base
tax burden
what is meant by tax mix?
refers to the balance between direct and indirect taxes as sources of revenue
what is meant by tax base?
refers to how broadly the particular tax is applied
e.g. GST exempts most necessities
What happens when a tax base is widened?
more revenue raised
what is meant by tax burden?
relates to the rates of direct/indirect tax as a percentage of income.
e.g. with progressive income taxes, the tax burden increases with income
what happens to tax burden income and inflation rises?
increases
The problem of bracket creep/fiscal drag emerges
What is bracket creep/fiscal drag?
when in order to protect real wages during high inflation, nominal wage increases however this pushes workers into a higher tax bracket which deteriorates their average pay (as each unit of income is worth less) and raises their tax burden
How can bracket creep/fiscal drag be avoided?
deliberate cuts in tax rates
changes in tax brackets
In what ways can government expenses/payments be classified?
- the specific functions they serve
- their general nature or type
Provide examples of how government budget expenses are classified according to their function
- social security/ welfare outlays
- heath spending
- defence
- education spending
- transport
- housing and community amenities
- general public services outlays
- public debt interest
- net payments to other governments
- mining, manufacturing and construction outlays
Provide examples of how government budget expenses can be classified by their general type
- government consumption/current spending (G1)
- government capital spending (G2)
- government transfer payments
What is government current/consumption spending G1?
Involve public sector spending (i.e. on defence, health, education etc.) and day-to-day operating expenses, including the wages for federal government employees, that must be paid.
in 2019-20, 90% of all government spending
What is government capital/investment spending (G2)?
Involves budget outlays on national, social and economic infrastructure e.g. building schools, universities, roads and highways, airports, reservoirs and water supply.
In 2019-20 budget 10% of all government spending
What is the main purpose of government capital spending?
- grow productive capacity by improving conditions for businesses to operate
- boost households’ living standards
What are government transfer payments?
Involve budget outlays on welfare benefits, as well as grants and industry assistance.
36% of total BUDGET EXPENSES
How are government transfer payments expected to change in the coming years?
expected to increase due to ageing population
Are transfer payments regarded as government spending? (G1 or G2)?
No.
Bcos the recipient of the transfer payments actually spends the money.
Identify three types of budget outcomes
budget balance
budget deficit
budget surplus
What is a balanced budget?
Where the total value of government receipts exactly equals the total value of outlays
What effect does a balanced budget have on the level of AD and economic activity?
Neither expansionary/contractionary
Little effect
‘Neutral Stance’
In what ways can a budget deficit be financed?
- borrowing from overseas
- borrowing from the RBA/creating money
- borrowing from the Australian public or financial sector
What does borrowing from overseas entail? Discuss the effects of this
Gov. can borrow from overseas e.g. by selling Australian government bonds. This helps finance budget deficits and can stimulate AD and economic activity.
BUT
Australia owes more money (increased liabilities) = increased Net Foreign Debt (NFD)
+
Increased demand for Australian dollar (relative to supply) = higher exchange rate in short-term = decreased net exports = slowing AD and economic activity.
+
Increased interest repayments = increased (primary income) debits relative to credits = increased CAD
What does borrowing from the RBA or creating money entail?
- Gov can use up any saving balances it has accumulated through budget surpluses
- Gov can sell bonds to to the RBA or IOUs (where they repay debt + interest at later date)
Why is borrowing money from the RBA seen as a very expansionary way of financing a budget deficit?
Adds directly to the volume of money in circulation and the level of spending
What does borrowing from the Australian public or financial sector entail? Discuss this approach for financing a budget deficit.
Gov can sell bonds or treasury notes to the public and financial sector.
(+) Good bcos money withdrawn from the private sector is returned when the government uses it to finance budget outlays = ends up in o.g. place.
(-) Gov. competing with the private sector for limited savings = higher demand for money to be borrowed = driving up domestic interest rates.
(-) Crowding out;
(PRIVATE SECTOR) lends money to the government and may face higher interests rates = disincentivised to spend due to higher cost of borrowing = private consumption and investment spending falls = depress AD and eco activity
(EXTERNAL SECTOR) local borrowers seek out relatively lower interest rates overseas = increases capital inflow into Australia = higher demand for AUD = appreciating the AUD = decreasing net exports = depress AD and eco activity
THEREFORE decreases the expansionary nature of the budget deficit, which was designed to originally stimulate AD
Define crowding out
What occurs when the government finances a budget deficit by borrowing from the Australian public/financial sector, thus driving up domestic interest rates and pushing out private sector borrowers.
(This keeps monetary policy from being effective in stimulating a recovery from a recession)??? idk why this says monetary policy
Identify and Outline the problems associated with budget deficits
LOSS OF GOOD CREDIT RATING
Budget deficits normally add to public sector debt. If this builds up, credit rating lowered = $$$ to borrow due to higher interest rates reflecting higher risk for lenders.
INTEREST PAYMENTS TAKE MONEY FROM PROVIDING COMMUNITY SERVICES
Deficits financed by borrowing money, involving interest payments = opportunity cost. Diverting money away from other uses e.g. edu, health etc.
LESS ABLE TO DEAL WITH ECONOMIC CRISES
Persistent budget deficits and large debts detract from the government’s cash reserves, weakening ability to deal with crises like recessions (e.g. make it harder to increase borrowing).
UNSUSTAINABLE & A BURDEN ON FUTURE GENERATIONS
Persistent budget deficits are unsustainable and eventually need to be covered by higher taxes and reduced government outlays, hindering future living standards.
When does a budget surplus typically occur?
Pace of eco activity is too strong, causing inflationary pressures
In what ways may a budget surplus be used?
- reduce debt
- save with the RBA
- Add to investment balances in special savings funds
How can the government use a budget surplus to reduce debt?
The government uses surplus to pay for local/overseas debt.
If local debt is being repaid, there is increased liquidity = lowering interest rates + stimulating spending = counteracting initial contractionary effects of surplus and solving the problem of crowding out by encouraging crowding in (when private sector investors are enticed by lower domestic interest rates)
This is one of the reasons why the gov. aims to have a fiscal balance by running surpluses.
How can the government use a budget surplus to save with the RBA?
The government’s savings balances with the RBA could be built up as a ‘fighting fund’ for a rainy day (perhaps for use during a future recession or another financial crisis) when there is a need to finance deficit budgets.
How can the government use a budget surplus to add to investment balances in special savings funds?
Budget surplus may be put into nation-building funds that generate returns and improve gov. wealth. Can enhance current and future living standards e.g. in Australian and international shares, cash and infrastructure projects
What are the advantages in being able to run a budget surplus?
- can offset deficits and avoid debt (can finance deficits without having to borrow $)
- create a fighting fund for bad times (cash reserves for economic crises)
- protect international AAA credit rating (leads to cheaper interests rates; freeing up capital to spend elsewhere)
- generate confidence (supports international confidence among investors)
- sustainable and not burdensome for future generations
What has the operational aim of recent budgetary policy been?
return to a budget surplus at an appropriate rate over the medium-term
- reduce debt over the medium term
Identify key forecasts used by the federal treasurer to estimate budget outcome
- forecast rate of growth of GDP
- forecast global rate of eco growth
- forecast wages growth
- forecast unemployment and participation rates
- forecast level of commodity prices and tot
- unexpected changed is hh confidence
- unforeseen disasters
- political obstacles and numbers in the parliament
How does the forecast rate of growth in GDP influence estimates of budget outcome?
High forecast rate = indicates fast rise in incomes and profits = high value of tax receipts from income tax + less welfare outlays for unemployed = may estimate strong budget outcome (surplus or small deficit)
Low forecast rate = indicates opposite
How does the forecast global rate of economic growth influence estimates of budget outcome?
Strong global rate = suggests higher demand for exports = net exports increase = increased profits for exporting companies = increased value of budget receipts = may estimate strong budget outcome (surplus or small deficit)
Weak global rate = indicates opposite
How does the forecast wages growth influence estimates of budget outcome?
Strong = high wages = greater value of budget receipts from income tax = may estimate strong budget outcome (surplus or small deficit)
Weak = opposite
How does the forecast unemployment and participation rates influence estimates of budget outcome?
High = higher average incomes and less poverty = higher value of budget receipts from income tax and less outlays on welfare payments for the unemployed = may estimate strong budget outcome (surplus or small deficit)
Low = suggests opposite
How do forecast level of commodity prices and terms of trade influence estimates of budget outcome?
Strong TOT and high value of Australia’s commodity prices = increased Aussie company profits + profiting companies may expand & increase demand for labour resources, decreasing unemployment = higher value of budget receipts through company tax and less outlays on welfare payments = may estimate strong budget outcome (surplus or small deficit)
Weak TOT and low value of Australia’s commodity prices = suggests opposite
How can unexpected changes in consumer confidence influence estimates of budget outcome?
Rise = boost C spending = greater value of receipts from sales and excise tax and fewer budget outlays on welfare = may estimate strong budget outcome (surplus or small deficit)
Fall = opposite
How can unforeseen disasters promote influence estimates of budget outcome?
slow down rate of growth in Australia’s GDP = lower value of tax receipts from company tax + increased outlays on repairing infrastructure and welfare support = weaker actual budget outcome
How can political obstacles and numbers in parliament influence estimates of budget outcome?
Harder to pass aspects of budget through both houses of parliament = rises in receipts and cuts in outlays can be delayed = weaker actual budget outcome
Party has the numbers = opposite
What is fiscal balance?
Strong and sustainable financial position for the government’s budget where, over the medium-term, the budget surpluses generated in booms are more than enough to pay for budget deficits in recessions, without needing to borrow or commit future generations to heavy debt repayments.
What measures are included in the reporting system for the budget
- headline balance
- underlying balance
- fiscal balance
What is the budget’s headline balance?
Represents the difference between cash outlays and cash revenues from all sources.
Often makes budget outcome appear stronger due to inclusion of value of one-off events like gov. asset sales and debt repayments received for other governments.
What is the underlying budget outcome?
The difference between cash outlays and cash revenues, excluding the value of volatile, one-off items like asset sales and debt repayments by other governments.
More clearly reflects government’s real financial position.
Can be used to determine whether the gov. overall is running down or adding to national savings and debt.
What is the fiscal outcome?
Like underlying outcome but arrived at through accrual approach
Looks at fiscal balance
Positive = enough savings to finance gov. spending without increasing debt and CAD
Negative = lack of savings to finance gov. spending, leading to increase in debt and upward pressure on CAD (due to income payments abroad)
What is meant by budget stance?
Refers to the intended macroeconomic impact of the budget outcome on AD as either expansionary or contractionary
What are the main stances for budgetary policy?
Contractionary stance
Neutral stance
Expansionary stance
What budget outcome implies a relatively more contractionary budget stance to slow AD?
- rise in size of budget surplus
- fall in size of budget deficit
What budget outcome implies a relatively neutral budget stance?
Balanced budget
What budget outcome implies a relatively more expansionary budget stance to boost AD?
- increase in size of budget deficit
- Decrease in size of budget surplus
What are expansionary budgets?
Those that seek to stimulate AD and economic activity
Include reductions in receipts and/or rises in outlays
Associated with increase in size budget deficit or decrease in size of budget surplus against the previous year
What are contractionary budgets?
Those that seek to slow AD and eco activity.
Typically in response to inflationary threat and involve increase in receipts and fall in outlays
Associated with increase in size of budget surplus or decrease in the size of budget deficit against the previous year.
Can using the size of a budget surplus/deficit as a guide to the direction of the budgetary policy’s stance be misleading?
Yes.
That’s why more info. is needed to be sure.
What additional info. can be used to determine whether the stance of budgetary policy is expansionary or contractionary?
- considering whether changes budget outcome are caused by automatic or discretionary stabilisers (discretionary budget surplus or deficit reveals more about federal treasurer’s true intentions)
- comparing the budget outcome against the changing size of the economy - by expressing it as a ratio or proportion of the GDP or size of the economy (gives a clear picture of how government is contributing to the country’s economy in general)
What are automatic/cyclical stabilisers?
built in aspects of the budget which change in response to economic conditions in a countercyclical way without any deliberate action by the govt.
What effect do automatic stabilisers have on budget stance during a business cycle expansion?
automatically, tax receipts increase and welfare outlays fall = contractionary budget surplus = slow down AD and economic activity
What effect do automatic stabilisers have on budget stance during a business cycle contraction?
automatically, tax receipts fall and welfare outlays rise = expansionary budget deficit = boost AD and economic activity
What are discretionary/structural stabilisers?
deliberate actions taken by the treasure to change receipts and outlays in counter cyclical ways to the business cycle
What effect do discretionary stabilisers have on budget stance during a business cycle expansion?
treasurer announces rise in tax rates or cuts in specific outlays = contractionary budget surplus = slow AD and eco activity
What effect do discretionary stabilisers have on budget stance during a business cycle contraction?
Treasurer announces cuts in tax rates and rise in levels of specific outlays = expansionary budget deficit = lift AD and economic activity
Identify and define Australia’s domestic macroeconomic goals
- the goal of low inflation: involves aiming for an average increase in the general price level of 2-3% per annum over the course of the business cycle (typically measured by the CPI) - a rate that is consistent with other government macroeconomic goals.
- the goal of strong and sustainable economic growth: the fastest possible rate of increase in production of G/S (3-3.5% real GDP growth) so as to cause employment growth without leading to inflationary, environmental, or external pressures.
- the goal of full employment: having the lowest rate of unemployment, around 4.5-5% of the labour force, consistent with achieving low inflation and other government economic goals.
What is monetary policy?
AD management strategy applied countercyclically by the RBA that involves changes in interest rates to affect the cost, availability and demand for credit .
Why is monetary policy considered an AD policy?
changes in interest rates can influence levels of spending and therefore influence AD (C, I and X in particular)
What are the RBA’s main responsibilities or roles?
- implement monetary policy - involving changes in interest rates - to regulate AD & improve domestic economic conditions
- issuing coins and notes, acting as custodian of Australia’s reserves of foreign currencies
- banker to fed. gov. e.g. arrange issue of gov. bonds to finance budget deficits
Which goal is the RBA’s top priority?
goal of low inflation
What is inflation targetting?
achieving an average inflation rate of 2-3% per year over the cycle
What is the medium-term operational goal aim of monetary policy?
inflation targetting: achieving an average inflation rate of 2-3% per year over the cycle
Why is the goal of low inflation top priority for the RBA?
- precondition for achieving other gov. dom. macro goals
- e.g. maintains consumer/business confidence (needed for steady rise in spending) , discourages speculative activity & instead attracts resources in productive investments, promotes savings etc.
What is the official cash rate?
- Interest rate target set by RBA
- For short-term money market
- Indicates monetary policy stance
What is the short-term money market?
Specialist financial institution where money is borrowed and lent for short periods.
In this market, RBA market operations affect supply of cash, and thus influence cash rate.
What are open market operations?
RBA’s buying and selling of government securities/bonds, with the aim of increasing/decreasing the cash rate.
What is monetary policy stance?
Whether the RBA’s buying and selling of government bonds and securities is designed to increase or decrease economic activity and AD.
Cash rate above 2.5% = contractionary
Cash rate below 2.5% = expansionary
How can the RBA use OMO to lower interest rates and adopt an expansionary stance?
- Changes to target cash rate announced and reasons why outlined (eg super low inflation)
- RBA repurchase Commonwealth government securities to financial institution at a higher rate, so that banks seeking profit will sell them (higher rate of return)
- In exchange for these securities, the RBA will deposit funds into exchange settlement accounts (accounts held purely for transactions with other banks)
- This increases the supply of funds in the short term money market and the surplus of funds will bring the cash rate down towards the target
- Banks will decrease retail interest rates that they offer to businesses and households via the ripple effect
- General drop in cash rate to below approx. 2.5% makes cost of borrowing cheaper and lowers reward for saving, incentivising borrowing and consumption/investment spending = boost AD and eco activity
How can the RBA use OMO to increase interests and adopt a contractionary stance?
Changes to target cash rate announced and reasons why outlined (eg high inflation)
RBA sells Commonwealth government securities to financial institution at a lower rate, so that banks seeking profit will purchase them (higher rate of return)
In exchange for these securities, the RBA receives funds from the banks exchange settlement accounts (accounts held purely for transactions with other banks)
This decreases the supply of funds in the short term money market and the shortage of funds will bring the cash rate up to the target
Banks will increase retail interest rates that they offer to businesses and households via the ripple effect
How can the RBA keep interest rates steady, adopting a fairly neutral stance?
RBA’s daily selling and buying back operations will seek to avoid changing the overall supply of cash in the short-term money market, keeping the current cash rate unchanged.
Cash rate held around 2.5%.
Through a ripple effect, this influences other commercial interest rates.
What are transmission mechanisms?
Refer to how changes in interest rates affect different sectors of the economy (AD and economic activity)
Identify five transmission mechanisms or channels
- the cost of and the demand for credit
- cash flow of households and firms
- availability or supply of credit
- exchange rate
- wealth or asset values effect
How does the cost of and demand of credit influence AD and economic activity?
Lower interest rates = cheaper to borrow and less rewarding to save = increasing demand for credit by incentivising borrowing & disincentivising saving = more credit-sensitive consumption and investment spending = boosting AD and eco. activity
Higher interest rates = more $$$ to borrow and more rewarding to save = decreasing demand for credit by disincentivising borrowing & incentivising saving = less credit-sensitive consumption and investment spending = slowing AD and eco. activity
How does the cash flow of households and firms influence AD and economic activity?
Lower interest rates = lower interest repayments = borrowers experience rise in discretionary income = increased consumption/investment spending = boost AD and eco. activity
Higher interest rates = larger interest repayments = fall in discretionary income = lower consumption/investment spending = weaker AD and eco. activity
How does the availability or supply of credit influence AD and economic activity?
Lower interest rates = more firms and households meet the criteria for loans from banks as more are able to repay interest on loans = more lending approvals (higher supply of credit) = increase C + I = boosting AD and eco. activity
Higher interest rates = fewer firms and households meet the criteria for loans from banks as less are able to repay interest on loans = fewer lending approvals (lower supply for credit) = depressing C + I = depressing AD and eco. activity
How does transmission by affecting the exchange rate influence AD and economic activity?
Lower interest rates relative to those abroad = foreign investors have a lower return on investment for saving with Australia banks = rise in capital outflow and a fall in capital inflow (as investors take money out of Australian banks and look to save elsewhere) = increases the supply of AUD, relative to demand in FOREX leading to a depreciation of the dollar = international price competitiveness increases = causing X to rise relative to M which is consistent with a rise in AD
Higher interest rates relative to those abroad = foreign investors have a higher return on investment for saving with Australian banks = fall in capital outflow and rise in capital inflow (as investors keep or move their money into Australian banks) = increases demand for AUD, relative to supply in FOREX leading to appreciation of the dollar = international price competitiveness decreases = causing X to fall relative to M which is consistent with a fall in AD
How does the wealth or asset values effect influence AD and economic activity?
Lower interest rates = cheaper credit = higher demand for property and shares = increased value of assets = owners feel wealthier and those who sell assets make larger capital gains (real increase in their wealth) = increase C = boosting AD and eco. activity
Higher interest rates = dearer credit = lower demand for property and shares = reduced value of assets = owners feel less wealthy and those who sell assets make smaller capital gains (possible loss of wealth) = less C = lowering AD and eco. activity
What is meant by the RBA’s monetary policy stance?
whether the change in cash rate or policy setting is designed to slow, maintain or stimulate AD and the level of economic activity
What are the main stances of monetary policy?
- Fairly neutral stance
- Expansionary stance
- Contractionary stance
What is the aim of an expansionary monetary policy stance?
boost AD and eco. growth
reduce unemployment without adding significantly to inflationary pressures
What is the aim of a contractionary policy stance?
Slow AD and eco. activity
reduce inflation to within the 2-3% range
What is the aim of a neutral monetary policy stance?
Neither stimulate or slow AD and economic activity
keep interest rates at level that brings about full employment and stable inflation over the medium-term
