Topic 4 - Macroeconomic policies Flashcards
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
Are macroeconomic policies effective by itelf to achieve complex policy goals?
No, must be used in conjunction with MER to be effective
What are the main objectives for all policies?
EG, inflation and employment
What are the 4 aims of FP?
To manage eco activity-adjust G and T to influence bs conditions- fine tuning to minimise ST fluctuations and assist govt’s eco objectives of economic growth, internal balance and external balance
To achieve greater efficiency in resource allocation-govts can redirect resources via its spending decisions
To achieve income distribution- Progressive taxation, social security and welfare systems, the govt can redistribute income to achieve more equity in income distribution
To influence the level of national savings and reduce CAD- MT objective to reduce Aus reliance on foreign savings and increase national savings by reducing the govt deficit, FD and debt-servicing obligations thereby reducing CAD
What is gov revenue?
Government revenue or national revenue is money received by a government from taxes and non-tax sources to enable it to undertake public expenditure
Includes direct tax, indirect tax and other revenues
What is gov expenditure?
Gov spending on various aspects of the eco such as social security, health, education etc. typically outlined in the budget
What is FP?
FP is a macroeconomic policy that can influence resource allocation, redistribute income and reduce the fluctuations of the business cycle.
It is essentially the use of gov revenue collection and expenditure to influence a country’s eco
What are the FP instruments?
Its instruments include gov spending and taxation and the budget outcome.
What are the forms of revenue for the gov, and what do they include? (3)
Direct tax (Personal income and company tax)
Indirect tax (such as customs and excise duties and the GST)
Other revenues (such as dividends from public trading enterprises and selling public assets )
What are the 3 possible budget outcomes?
Budget surplus
Budget deficit
Balanced Budget
What is a budget surplus?
A positive balance that occurs when the Commonwealth Gov anticipates that total gov revenue (T) will exceed total expenditure (G) - T > G
What is a budget deficit?
A negative balance that occurs when total gov expenditure exceeds total revenue - T < G
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
WHat
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
What is a balanced budget?
A zero balance that occurs when total government expenditure is equal to total revenue - T = G
What does FP involve?
It involves the use of the Commonwealth Government’s Budget in order to achieve the government’s eco objectives. By varying the amount of gov spending and revenue, the gov can alter the level of eco activity → influences EG, inflation, ue and external indicators in the eco
WHat is the budget?
The Budget is the annual statement from the Aus Gov of its expenditure and income plans for the next financial year. The Budget is the tool of the gov for the exercise of FP. It is typically released in May. The budget includes all forms of revenue received by the gov, including both taxation and other revenue
The other side of the budget is gov expenditure. Major expenditure in the Budget is social welfare, health, education, general public services and defence
WHat are the 4 main measures of the budget outcome?
Underlying cash balance
Headline cash balance
Fiscal balance
Net Operating balance
What is the underlying cash balance? How is it calculated?
It is a cash measure that shows whether the Government has to borrow from financial markets to cover its operating activities and net investments in non-financial assets used in the provision of goods and services. It is the preferred measure of the outcome because it gives an indication of the ST to MT impact of FP on level of eco activity
Calculated by revenue (excluding sales of gov assets) - spending (excluding purchase of gov assets).
It is beneficial as it gets rid of the gov assets which can constantly fluctuate. However, it doesnt distingusih ebtween the type of spending ( for capital or recurrent purposes)
What is the headline cash balance? How is it calculated?
Reflects the underlying cash balance plus the government’s purchase or sale of assets.
Essentially it is calculated by (ALL) revenue - (ALL) spending
It is often billions of dollars higher or lower than the underlying cash balance, either because gov assets have been sold or because new assets have been acquired
WHat is the fiscal balance? How is it calculated?
The fiscal balance (fiscal deficit or fiscal surplus) calculates revenue minus expenses less net capital investment, based on accrual accounting. Accrual accounting measures expenditure and revenues when they are incurred or earned, rather than when a cash transaction occurs
For example, if the gov’s superannuation obligations to public servants increased by $5bn in one year, this would increase a fiscal deficit by $5bn for that year, even if the money is not paid out until next year. This is regarded as more accurate than cash counting
However, fiscal balance doesnt distingusih between spending for capital or recurrent purposes
What is the Net Operating Balance? How is it calculated?
It is regarded as the best measure of the sustainability of the budget because it shows whether the gov is meeting its day to day obligations from existing revenue. The net operating balance distinguishes between spending for capital or recurrent purposes and it removes spending on capital from the balance
(total rev - total expenses)
What are discretionary changes in FP?
These involve deliverate changes to fiscal policy such as reduced spending or changing taxation rates. If the gov deliberately increased expenditure in order to stimulate D, this would be an example of discretionary FP. Discretionary change influence the structural component of the budget outcome
WHat are non discretionary changes in FP?
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
WHat are non discretionary changes in FP?
The final budget outcome can be influenced by factors other than planned (discretionary) changes to government revenue and expenditure, These non discretionary changes are caused by changes in the level of eco activity. When an eco is in a recession, the budget deficit will increase, whereas during periods of strong EG, the deficit will contract or the budget will shift into surplus. Non discretionary changes influence the cyclical component of the budget outcome
Why might budget outcomes change?
Changes in eco conditions
Changes in gov policy (known as structural or discretionary factors)
WHat are the two components of the budget?
Structural and cyclical
What are automatic stabilisers?
Automatic stabilisers are policy instruments in the gov’s budget that counterbalance eco activity. In a boom period, they decrease eco activity, and in a recession, they increase eco activity. The most common examples are transfer payments and a progressive tax system.
These are changes in the level of gov revenue and expenditure that occur as a result of changes in the level of eco activity
Explain u/e benefits as a automatic stabiliser
When an eco moves into recession, the level of eco activity falls → rise in u/e. An increase in u/e → greater gov expenditure on u/e benefits. Thus, a decline in the level of eco activity automatically leads to an increase in gov expenditure. On the other hand an increase in level of eco activity → decrease in u/e → less gov expenditure on u/e benefits
Explain progressive Y tax system as a automatic stabiliser
means that people with higher incomes pay proportionately more tax than those on lower Y. DUring an eco boom, employment opportunities are increasing and incomes are rising. Rising incomes move workers into higher Y tax brackets and previously unemployed people start paying income tax. Both situations lead to an increase in gov tax revenue. Meanwhile, a decrease in the level of eco activity → Decrease in tax revenue –> greater EG as there is more disposable Y –> greater C and ultimately EG
What are the impacts of FP? (4)
eco activity
Resource use
Income distribution
Impact on savings and ext balance
How does an FP impact eco activity? (expansionary, contractionary and neutral)
Expansionary Stance: Where the gov is planning to increase the level of eco activity in an eco. This can occur through either a reduction in tax revenue and/or an increase in gov expenditure, creating either a smaller surplus or a large deficit than in the previous year. Expansionary FP → multiplied increase in consumption and I and stimulates AD, which will increase level of eco activity
Contractionary Stance: Where the gov plans to decrease the level of eco activity in an economy. This can occur through either an increase in tax revenue and/or a decrease in in gov expenditure, creating either a smaller deficit or a bigger surplus than in the previous year. Contractionary FP leads to a multiplied decrease in consumption and investment, dampening AD, which will decrease eco activity
Neutral Stance: Occurs when the gov plans to maintain the gap between revenue and spending at around the same level as the previous year. A neutral fiscal policy should have no effect on the overall level of eco activity
WHat is the impact of FP on resource use?
Fiscal policy changes can influence the allocation of resources in the economy directly or indirectly
Fiscal policy can affect resource use through gov spending in a particular area of the economy, such as transport infrastructure to boost tourism growth –> increased resource use of tourism resources kinda
The indirect influence of fiscal policy covers tax and spending decisions that make it more or less attractive for resources to be used in a way (e.g. removing taxes from ethanol prod might encourage farmers to use more of their wheat
Govts may use tax and spending policies that lead to changes in resource use that meet the government’s objective.
What is the impact of FP on Y distribution?
Australia uses a progressive income tax system designed to create a more equal distribution of Y. - people with higher Y pay higher rates of Y tax, allowing gov to use this money for transfer payments
Changes to tax arrangements can affect income distribution significantly. For example, a reduction in tax rates at the upper end of the Y scale would make the system less progressive and may create a less equal distribution of income (i.e. recent tax changes with the abolishing of 37% tax rate)
What is the impact of FP on savings and ext balance?
What are the methods of financing a deficit?
Borrowing from the private sector
Borrowing from overseas
Borrowing from RBA (monetary financing)
Selling Assets
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
Explain how borrowing from the private sector can finance a deficit
Main form of deficit financing is through borrowing from the private sector by selling Treasury Bonds domestically under a tender system. Under this system, the gov sets the value of bonds to be sold (determined by the size of the deficit to be financed).
Prospective purchasers tender to buy a certain quantity at a particular rate of interest. The gov then accepts the tenders, starting with those offering to buy at the lowest i/r, through to the highest, unti all bonds are sold.
What are the advantages of borrowing from the private sector?
The gov can be always certain that it will fully finance its deficit
Market will set the i/r on these newly issued bonds
Explain how borrowing from overseas can finance a deficit
Gov may decide to borrow from overseas financial markets to minimise the crowding out effect, while sill stimulating growth.
However, when govt borrows from overseas, it directly adds to Aus foreign debt with interest repayments recorded as debits on the NPY account of the BOP
Explain how borrowing from the RBA can finance a deficit
The GOv could just simply borrow from the RBA to finance the deficit.
This could be referred to as ‘monetary financing’ or ‘monetising the deficit’
This amounts to the gov printing money in order to finance its expenditure.
However, since 1982, with the deregulation of the financial sector, the gov has not engaged in this kind of deficit financing
Gov avoided monetary financing to ensure it does not increase the money supply and add to inflation.
Explain how selling assets can finance a deficit
An alternative method to find a deficit is to sell gov assets. Selling assets, such as Commonwealth land or the COmmonwealth’s share in businesses such as Medibank Private or Australia Post does not reduce the level of such underlying cash deficit or the net operating deficit because these are adjusted to reflect transactions like asset sales.
In cash terms, from year to year, a gov can create a headline budget surplus by selling assets
How can the gov use a budget surplus? (3)
Depositing it with the RBA
Using it to pay off public sector debt
Placing the money in a specially established, gov owned investment fund
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
What is the crowding out effect?
However, the crowding out effect describes how a budget deficit will soak up funds in Australia’s domestic savings pool, putting upward pressure on i/r and leading to a reduction in private sector spending and Investment. Thus, the private sector is ‘crowded out’ of the domestic market by government borrowing, since lenders prefer to lend money to the gov.
However, in an era of globalised financial markets, the crowding effect is much weaker since many of the financial institutions that buy bonds on domestic financial markets are from overseas
What is the crowding out effect?
However, the crowding out effect describes how a budget deficit will soak up funds in Australia’s domestic savings pool, putting upward pressure on i/r and leading to a reduction in private sector spending and Investment. Thus, the private sector is ‘crowded out’ of the domestic market by government borrowing, since lenders prefer to lend money to the gov.
However, in an era of globalised financial markets, the crowding effect is much weaker since many of the financial institutions that buy bonds on domestic financial markets are from overseas
What is MP?
MP refers to actions by the RBA, AUs’s central bank to influence the cost and availability of credit in the Aus economy.
MP is a macroeconomic policy in the fact that like FP, it can smooth fluctuations in the business cycle and influence the level of eco activity employment and prices
What is contractionary Mp
Contractionary MP is when the RBA tries to increase i/r in the economy, which reduces the amount that households with mortgages have available for consumption and makes business I more expensive → lowers eco activity → reducing employment growth and inflationary pressures
WHat is expansionary MP?
Expansionary MP is when the RBA tries to lower i/r → higher consumption and investment, eco activity, employment growth and inflation
What are the effects of contractionary MP?
High IR causes reduction in consumer spending – consumers face higher costs for mortgages and consumer loans
Business investment will decline – high interest rates makes borrowing more expensive, businesses borrow in order to purchase capital equipment
Overall effect will be a fall in aggregate demand and lower economic activity.
Results in an increase in u/e
What are the effects of expansionary MP?
Lower IR increases consumer spending due to lower costs associated with borrowing
Similarly, business investment will increase as purchasing new capital equipment becomes more affordable
Overall effect will be a boost in aggregate demand as consumer spending and business investment increases.
Reduction in u/e
What are the objectives of the RBA’s MP?
Stability of Aus’s currency
Maintenance of full employment in Aus
Promotion of the eco prosperity and welfare of the people of Aus
What is the inflation target?
Since the early 1990s, RBA has set a target range for inflation and then operated independently of the govt in determining the IR movements necessary to keep inflation in the range. This target is typically in the 2-3% inflation range.
However, inflation target is flexible and doesnt require inflation to be in that range at all times and at all costs
Why might inflation occur?
Inflation can occur due to shocks and events outside of the RBA’s control- such fluctuations should be accepted as long as inflation is kept within the target over the course of the BS
What indicators of financial conditions and eco performance of the Aus eco are considered by the RBA when making decisions on the future movements of ir? (10)
Inflation rate
Inflationary expectations
Wage growth
Rate of u/e
Rate of EG
I/r
e/r
Commodity prices
ToT
Global EG
What is the Cash rate?
It is the main tool used to implement MP by the RBA
The CRis the i/r in a financial market called the overnight money market (OMM)
What is the overnight money market?
the market for very ST loans between banks, where loans are made for overnight use in many cases
How can CR be explained?
Exchange settlement accounts
Policy Interest rate corridor
Domestic market operations
What are exchange settlement accounts?
Commercial banks need to hold a certain proportion of their funds with the RBA in exchange settlement accounts (ES accounts) in order to settle payments with other banks and the RBA
I.e. interbank payments such as funds from Commonwealth bank of Aus to NAB. These payments are made by transferring funds between banks’ ES accounts.
What happens for banks which dont have enough funds in their ES accounts to satisfy all interbank payments?
May need to borrow –> overnight money market, where banks that have a shortage of ES funds can borrow money from banks that have an excess of ES funds beyond what they need
Explain the policy rate corridor (floor and ceiling)
When the cash rate is set, two things happen in the policy rate corridor. The RBA first establishes an interest rate to banks on funds held in ES accounts that is 0.25% below the cash rate target. This means that banks with excess ES balances are not given an incentive to lend funds to the other banks if the actual CR is less than 0.25% below the target. The banks could earn greater returns by simply leaving their extra funds in their ES account and ignoring the overnight money market. Thus, the RBA’s deposit rate creates a floor or minimum value for the CR
The other thing that happens is that the RBA is always willing to lend ES balances directly to banks outside of the overnight market. For this, the RBA sets an i/r on these loans equal to 0.25% above the CR. Thus, banks that need to borrow ES balances dont want to pay a rate higher than the RBA’s lending rate in the overnight money market. This is because if the CR is higher than the RBA’s lending rate, banks would just borrow ES funds directly from the RBA. This thus creates a ceiling or maximum value for the CR
What happens as a result of the floor and ceiling in the policy rate corridor?
The floor and the ceiling created by the RBA’s lending rate together form the policy rate corridor for the cash rate. No banks, whether they have a surplus or shortage of ES funds, have an incentive to complete transactions in the overnight money market outside of this corridor
What are Domestic Market Operations (DMOs)?
Refers to actions by the RBA in the ST money market to buy and sell second hand Commonwealth gov securities to influence the supply of exchange settlement balances in order to keep actual CR at the policy rate
What happens in DMOs if ES fundss increases?
If the demand for ES funds increases, the RBA would need to increase the supply of ES funds to keep the CR stable, all else being equal
To do so, the RBA would buy financial secruies of banks and in exchange withdraw funds that were sitting in their exchange settlement accounts → decreases supply of ES funds down to the lower level of Demand
What are the main forms of i/r?
The main i/r are home loans, credit cards, personal loans and commercial loans
How does CR influence i/r?
It has this influence on i/r because it affects how much it costs financial institutions such as banks to fund themselves
What are the effects of an increase in CR on i/r
An increase in CR → more expensive for financial institutions to obtain funds in the ST money market (and generally other funding markets too). To maintain their profit margins financial institutions generally respond by increasing the i/r that they charge to borrowers such as household mortgages.
What are the effects of a decrease in CR on i/r?
Meanwhile, a reduction in CR → lowers funding costs for banks and other financial institutions (costs less to borrow money), and competition between financial institutions → pass the cost saving onto their customers in the form of lower lending interest rates
What are other factors affecting the main i/r?(4)
Competition in the banking sector
Regulations
Conditions in global and domestic financial markets
Risk assessments relating to eco conditions
What does tightening vs loosening Mp mean in terms of CR?
Tightening –> increases CR
Loosening –> decreases CR
What are unconventional MP?
Unconventional monetary policy occurs when tools other than changing a policy interest rate are used. These tools include: forward guidance. asset purchases. term funding facilities, changing size of corridor
Explain forward guidance
This is when central banks use official communications about the future stance of MP to influence current i/r on LT assets. I.e. Phillip Lowe assuring Aus that the CR at 0.1% was going to remain for a few years (2024), but the condition (reaching 2-3% inflation) was actually met in 2022 → criticism from the community
Explain changing the size of the corridor
The RBA changed the structure of the policy rate corridor system. Instead of paying i/r 0.25% below the CR on ES balances, the RBA decided to set the corridor floor 0.1% below the CR target rate in late 2020 → Allows the RBA to lower the CR target to .1% without worrying about the risks of negative i/r.
Explain asset purchases
RBA purchased gov securities outright in the secondary market from financial institutions and paid for them by depositing newly created ES balances in their accounts (which is why asset purchases are considered quantitative easing or ‘printing money’).
Explain term funding facility/more liquidity
RBA increased size of the DMo compared to normal, and created a new funding facility called the Term Funding Facility (TFF) which provides very cheap additional loans to commercial banks so that they can use it to lend more funds to households and businesses
What is the transmission mechanism?
Transmission mechanism explains how changes in the stance of MP pass through the eco to influence eco objectives such as inflation and EG
What are the 4 channels of the transmission mechanism
Savings and Investment Channel
Cash-Flow Channel
Exchange Rate Channel
Asset Prices and Wealth Channel
Explain the transmission mechanism through the savings and investment channel
Explain the transmission mechanism through the cash-flow channel
Explain the transmission mechanism through the e-r channel
Explain the transmission mechanism through the asset prices and wealth channel
WHat are the limitations of MP? (4)
Time lag
Blunt instrument
Global constraints
Policy Mix
Explain time lag as a limitation of MP
MP has a short implementation time lag but a long impact time lag (6-18 months), although this lag is shorter due to mortgage repayments are a larger proportion of incomes- the cash flow is greater. Affects 30% of households
Explain blunt instrument as a limitation of MP
MP is a blunt instrument to combat inflation. All borrowers are affected. It cannot be fine-tuned- for example, High CR post-GFC increased mortgage repayments, especially in Sydney where 10% of households suffered from mortgage stress
It essentially affects all industries regardless of different levels of growth
Explain global constraints as a limitation of MP
MP can be constrained by global influences if Aus’s IRs become so out of line with overseas IR’s that it produces effects that are contrary to the RBA’s goals. For example, in 2007-08 IR’s were higher than those in the US, using capital inflow, a high $A, slow export growth and high import growth leading to a high CAD. The high import/ slow export result also slows eco growth, which reinforces the goal of MP at that time
Explain policy mix as a limitation of MP
MP is only effective in affecting AD. It cannot deal with supply side issues affecting inflation, such as capacity constraints or petrol prices. MER is needed to tackle these issues and cause structural change
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
What is macroeconomic management?
Macroeconomic management refers to the use of government policies to influence the economy with the aims of reducing large fluctuations in the level of eco activity and achieving certain eco goals
