Unit 2.D - Major Economic Tools/Solutions

Question 1

What is monetary policy?

Answer 1

Monetary policy is the use of the RBA’s control over the monetary supply (cost + availability of credit) to influence aggregate demand.

Aka when the RBA manages economic growth and inflation with its control of the monetary supply, particularly through the use of the cash rate.

Question 2

What are interest rates?

Answer 2

The price of money in the market for money.

Buyers of money: businesses investing, borrowers.
–> When interest rates are low, the demand is high.
Sellers of money: anyone with excess savings: banks effectively sell your money on your behalf when they loan your savings to investors.

If the RBA didn’t intervene, interest rates would be decided by the price mechanism, as in any other market. E.g in market for loans, price and quantity would be decided by price mechanism.

Question 3

What is the cash rate?

Answer 3

The cash rate is the interest rate that banks pay each other for short-term loans.

The interest rate influences all other interest rates, inc. interest rates on mortgage repayments, home loans, business loans for investment, savings deposits, etc.

Question 4

What are the goals of the RBA?

Answer 4

• Ensuring the stability of Australian currency
• Maintaining full employment
• The economic prosperity and welfare of Australians.

They’ll typically consider unemployment only when inflation is not an issue.
The third is generally achieved through focussing on the first two, and note that often there is a trade off between ensuring stability of the Aussie currency and maintaining full employment, because…

• To raise level of employment the RBA or gov must stimulate AD to increase level of economic growth, BUT increasing economic growth increases the price level, and potentially may cause the level of inflation to exceed the RBA’s target band of 2-3%, so the ‘stability of the Aussie currency’ goal is compromised.
• If AD is increasing such that there is a risk of it exceeding the limits of productive capacity resulting in demand-pull inflation then the RBA must run contractionary monetary policy (raising the cash rate) in order to slow the rate of economic growth, and hence reduce inflationary pressures. This means that there will be less spending on businesses, and as a result of this decreased revenue (and in some ways increased running costs if the business has servicing costs to pay on debt) businesses will produce output, and so hire fewer people, and some will fail, resulting in a higher level of unemployment: the second RBA goal comprised.

Question 5

What are some of the roles of the RBA?

Answer 5

• Set the cash rate
• Banker to the gov.
• All banks must hold account with the RBA
• Produces and distributes banknotes
• Operates interbank payment system
• Holds foreign exchange reserves
• Decides interest rates monthly
• Maintains stability of financial system
• Lender of last resort (buys gov. bonds so investors don’t fear getting stuck with them).

Question 6

What’s the significance of the cash rate?

Answer 6

The cash influences all other interest rates.

Question 7

Why is monetary policy run by the RBA not the gov?

Answer 7

• RBA doesn’t have to get elected every year: there are always winners and losers with monetary policy, yet at the end of the day many of these just have to live with it for the long-term prosperity of the economy, and in the end, they WILL benefit, even if they may lose their job in the short term, for example. The gov. however may be less keen to make unpopular decisions even faced with the fact that in the long-term the economy and society will be better off.

Question 8

What is the transmission mechanism?

Answer 8

The transmission mechanism is the mechanism by which changes in the cash rate translate to changes in AD and the broader economy (and hence in economic growth and the average price level).

Or:

The mechanism by which monetary policy transmits to an effect on the real economy.

Question 9

What’s worse? The uncertainty associated with high levels of inflation or the cure of higher interest rates?

Answer 9

The effects of high inflation are much worse in the long term than the short-term costs of the cure.

Question 10

How do changes in the cash rate affect consumption?

Answer 10

• Cost of home mortage repayments (relates to disposable income)
• No. of home loans
• Cost of consumer loans
• Incentive to save

Question 11

How do changes in the cash rate affect investment?

Answer 11

• Cost of labour
• Cost of business loans

(partic. around property construction + business investment)

Question 12

How do changes in the cash rate affect net exports?

Answer 12

Falling cash rate discourages imports and encourages exports, thus making the balance of net exports more positive:

• -> Falling cash rate makes net exports more positive
• -> Rising cash rate makes net exports more negative.

Question 13

When does the RBA change the cash rate?

Answer 13

The RBA changes the cash rate according to whether the state of the economy is such that there is a movement away from achieving any of the RBA’s key goals; maintaining a stable Aussie dollar, full employment, and the welfare and economic prosperity of the Australian people.

For example, if AD is low, they might lower the cash rate to stimulate spending, (which affects all of the components in different ways, remembering that AD = C + I + G + (X-M)) which results in a multiplied increase of GDP, reducing the GDP gap. This is because increasing total spending increases the revenue of businesses so they will employ more people and the average household incomes will increase; this may improve average living standards and general wellbeing; for example, because people will be more able to afford basic necessities and things that improve welfare; more able to afford fresh food, medications, training programs, etc. It will also mean that there is less need for expansionary fiscal policy (gov spending) and so the gov. may save money However, the costs of lowering the cash rate is that there will be less return on loans for lenders: pensioners for example (or anyone else with excess savings) will be disadvantaged.

Question 14

What are some of the problems/limitations of monetary policy?

Answer 14

• A broad brush/blunt instrument: effects all sectors of the economy equally: not so useful in a multi-speed economy.
• Has an effective lower bound: unless RBA decides to delve into unconventional monetary policy they can’t lower cash rate more than 0%, so lowering the cash rate can only stimulate the economy so much: ultimately, changing the cash is a more effective tool for slowing excessive growth rather than stimulating AD.
• Has a time lag: takes up to 18 months for the economy to adjust to changes in the cash rate: if implemented too late, changes may result in reinforcing the phase of the business cycle, rather than working against it. For example, the level of growth is slowing, due to an decrease in investment, and because AD = C + I + G + (X-M) the RBA may try to stimulate the economy by lowering the cash rate, which has an expansionary effect, as it leads to a potential increase in all of the aggregate demand factors, YET, if the economy is already recovering by the time the RBA decides to lower the cash rate, this will essentially build AD to increase and fuel the next boom!
• Confidence of consumers/businesses/investors: if the RBA decides to lower the cash rate, this shows that they think the level of economic activity needs stimulating and hence that the economy isn’t in a very healthy state, which may lead to increased levels of leakages (e.g. consumers saving for a rainy day) and decreased consumption and investment, and because AD = C + I + G + (X-M) changing any of these things will cause a reduction in AD and hence in GDP, leading to slower economic growth and potentially bringing about the very change that consumers/firms/investors were afraid of.
• Affects AD, not AS, and sometimes AS is what needs help more.
• Use of contractionary monetary policy aims to reduce AD, and so there will be less spending on businesses which means that not all will remain profitable, leading to some business closures and businesses hiring fewer people, so unemployment will increase (with all its associated impacts inc…) and people may foreclose on mortages, etc.
• Better at managing high inflation than stimulating economic activity.

Question 15

What is the the fiscal policy?

Answer 15

Fiscal policy is the use of the Commonwealth Government’s Budget to influence AD to achieve its macroeconomic objectives.

Question 16

What are the macroeconomic objectives that the Commonwealth Gov. is trying to achieve using fiscal policy?

Answer 16

• Sustainable economic growth
• Price stability
• Full employment

Question 17

How does the use of the budget affect economic growth?

Answer 17

• In the short term, economic growth is given by the level of GDP, which is given by the level of total spending, which = C + I + G + (X-M). If there is a change in any of the AD factors, there will be a multiplied effect on GDP. The budget plans for the level of gov. spending, ‘G’ and so they can increase G for an expansionary effect on the economy, and they can also change the level of taxation in the economy, which represents leakages, and hence reduces disposable incomes and spending on businesses to have the effect of reducing consumption, ‘C’, another factor of AD.

Question 18

What are some of the other objectives of the budget?

Answer 18

• Balancing budget sustainably: not create a structural deficit/surplus: set the default level of tax too high or spending too high for example.
• Counteracting phase of the business cycle.
• Defence + national security, law + order, property rights.
• Income inequality
• Allocating funds and implementing taxes to address market failures: plans for the provision of goods and services, to subsidise public goods and services, goods with positive externalities, taxes on demerit goods and services and those with negative externalities, managing externalities + common goods problem + abuse of market power.
• Meeting international obligations
• Funding microeconomic reform
• Transfers between states
• Gov. running costs (salaries, admin)
• Polticial agendas (cultural stuff, sports stadiums).

Question 19

What actually is the budget tho

Answer 19

The budget is a plan formed by the treasury to plan the next financial year’s spending, predicting revenue and expenditure, and the break-down of where gov. spending will be directed to.

The treasury communicates with other departments and state authorities to determine where this money is needed, releasing the budget in May.

Question 20

What are the things we consider in analysing a budget?

Answer 20

• How sustainable is it? You can’t run deficits forever. E.g. does it create a structural budget deficit/surplus, will the gov. be able to pay for it, is now a good time to be taking on debt?
• Winners + losers? Does it unfairly take away from or favour any one party? What is the impact on income inequality, the environment? For example, does it give tax cuts to big companies more than small ones, does it prioritise health of veterans over health of pensioners, does it ignore people who need it? Incentives for high income earners.
• Impact on the wider economy? Is it strengthening AD or softening the blow to AD (and magnfied effect on GDP) of a recession? Will it help fund microeconomic reforms for future sustainable growth/
• Assumptions: in order to make guesses about the amount of spending and taxation the gov. must estimate the health of the economy and the phase of the business cycle: do they predict increasing unemployment, slowing AD, increasing wages growth, level of company profitability, etc, to determine how much revenue will come in and so how much they will have to spend. Also, is it a contractionary budget that relies on running a debt to be paid for by future generations, with the assumption that the economy will be growing strongly enough to repay the debt in 10 years time. For example, this year, the gov. was unable to make quite so reliable predictions about the state of unemployment and economic growth, so delayed the budget until they could get a clearer picture of measures needed.

Question 21

What is the budget outcome?

Answer 21

The budget outcome is whether taxation or revenue are equal or if either is greater: if there is a…

• Surplus: when taxation exceeds revenue.
• -> Sucking money out of economy.
• Deficit: when revenue exceeds taxation.
• -> Pumping money into the economy.
• Balanced budget: when revenue = taxation.

Question 22

What is a stance?

Answer 22

The stance of the budget describes the change in budget outcome relative to the previous year: whether the outcome is becoming more negative, or more positive.

• Contractionary: increasing size of surplus, decreasing size of deficit, slowing growth of AD.
• Expansionary: increasing size of deficit, decreasing size of surplus, increasing growth of AD (or reducing the rate at which it falls.

Question 23

How can a budget be in deficit?

Answer 23

Deficits must be paid for with surpluses from previous or future years: either by tapping into saved money from previous surpluses, or by contributing to a debt, to be paid back later when the economy is doing better again: this is a drag on future growth, and relies on the assumption when time comes to pay back this deficit, the economy will be growing strongly enough to make this possible, although the burden will be on future generations/governments.

Question 24

Will the gov run a contractionary or expansionary budget?

Answer 24

• Most usually the budget will work in a counter-cyclical fashion: if the economy is experiencing an upswing in economic growth the budget

SOMETIMES HOWEVER, the gov. will run a contractionary budget when the economy is in a downturn in order to pay back a debt. If the downturn is subtle enough that it can be adressed well enough by monetary policy alone then this might be an acceptable situation, but it becomes problematic when the govn has to run contractionary fiscal policy when the economy is in a serious downturn.

So combination of trying to balance the budget for the sake of sustainable management and trying to pay back debt or set aside funds for future deficits.

Question 25

Is a deficit inherently expansionary? Is a surplus inherently contractionary?

Answer 25

The whole point of budget stance is that its a CHANGE relative to the previous year: by itself, there’s no way of knowing the effect relative to the past.

Question 26

How do we reduce the size of the deficit?

Answer 26

To reduce the size of the deficit (must be done gradually to reduce shocks to the economy) the gov. must run contractionary fiscal policy, so the excess tax revenue that isn’t re-spent can be used to pay back debt. To do this, the gov. must either raise the level of taxes to increase revenue or decrease the level of spending.

Question 27

What are the key features fiscal policy?

Answer 27

• Discretionary measures (e.g. directing spending towards a microeconomic reform, towards health, local infrastructure, etc).
• Automatic stabilisers (e.g. progressive tax system, welfare system).

Question 28

What are the pros of automatic stabilisers?

Answer 28

• No need for gov. action: saves gov. time
• Not subject to political interference
• Always work in a counter-cyclical fashion
• Always kick in exactly at the right time bc they’re automatic.

Question 29

What are the limitations of automatic stabilisers?

Answer 29

• Not usually powerful enough to prevent a recession by themselves; they just reduce severity.
• Won’t get rid of a structural budget deficit

Question 30

What are the pros of discretionary measures?

Answer 30

• Powerful enough to prevent or more significantly reduce the severity of a downturn or recession.
• Can be targeted to areas that face different issues in the event of a multi-speed economy.
• Can be implemented as needed for unusual events (e.g. coronavirus)
• Can be more gradually implemented

Question 31

What are the cons of discretionary measures?

Answer 31

• May be timed incorrectly: end up reinforcing phase of the business cycle rather than working against it.
• Subject to political interference: money may not go to its best use, but rather to kindling political favour instead.
• May be incorrectly timed and end up reinforcing the phase of the business cycle rather than working against it (e.g. if infrastructure projects aiming to increase jobs and investment in an area gets delayed by council approvals and legal challenges, so the expansionary effects only start kicking in when the economy naturally began to recover anyway.
• Temporary measures may become permanent
• Success depends on implementation
• May result in a structural deficit.
• Results in the question of when to take support away?

Question 32

When does a structural budget deficit occur?

Answer 32

When the gov. spends more than it receives even when the economy is in a boom: level of tax set too low, or spending too high.

Question 33

What are the top three sources of revenue in the budget? (+ Breakdown in 2019/2020 predicted budget)

Answer 33

• Income taxation receipts (maybe around 2/3 of total revenue)
• Company tax (maybe a fifth)
• Sales tax (maybe a 6th to a 7th)

Question 34

Top three uses of revenue? (+ Breakdown in 2019/2020 predicted budget)

Answer 34

• Social securty and welfare (maybe about a third, includes pensions, veterans’ assistance, families with children, sick + unemployed benefits)
• “Other purposes” (about a fifth) (of which 2/3-3/4 is revenue assistance to states and territories, up to a fifth is public debt interest, a tenth is nominal superannuation interest).
• Health (sixth to a seventh)

Question 35

What are some of the problems/limitations of fiscal policy?

Answer 35

• Gov. can’t directly make changes to C, I, or (X-M): can only influence decisions of consumers, firms, and investors not control them.
• ‘G’ is only ~ 1/4 of GDP; can be overwhelmed by shocks in other components.
• Interest burden on the debt developed by our deficits: in 2019 we paid $17bn on this. This is money that can’t be used for any useful purpose aka returned to taxpayers in the form of investment for major infrastructure projects or improving healthcare.
• Taking on debt relies on future growth to it pay back.
• Past deficits build debt that make gov. less able to borrow to fund future deficits.
• Repayments of budget deficit a drag on future growth.
• There’s effectively only so much money to spend

Question 36

What is microeconomic policy?

Answer 36

Microeconomic policy refers to a collection of gov. policies that aim to improve efficiency ofmarkets with the ultimate goal of boosting AS and hence enabling long-term economic growth.

Question 37

What are the key ideas underpinning microeconomic policy?

Answer 37

• It’s a tool for increasing GDP via extending productive capacity: unlike increasing GDP via AD, this doesn’t result in increased inflationary pressures, but rather, decreases them.

Key ideas:

• Increase productivity (e.g. uni reform to increase level of education and training).
• Increase efficiency (e.g. automation, remove unnecessary regulations that may be barrier to supply)
• Intergenerational equity/inequality (reforms in housing market to make it easier for first home buyers)
• Short-term cost for long-term gain
• Who are the winners + losers?

ALSO:
- About a greater or better use of resources

• While mol pol and fiscal pol are about getting from below the PPF to on the PPF, microeconomic reform is about actually extending the PPF.
• Reforming and adapting policies and regulations to best suit the market’s needs + best function.
• Sometimes very slow to kick in (e.g. less helpful as relief in a crisis) and provide long-term benefits when short-term costs will be apparent.
• Structural reforms to deal with structural changes in society and the economy; what we buy, how we work. E.g. globalisation, technological state, society following a conflict. Changing things that are no longer relevant.
• When structure of economy changes, boosting AD won’t help, improving AS quality + quality of factors of production and the way we use them does.

E.g. setting rules for energy production so investors know how to proceed.

Question 38

What is efficiency in microeconomic reform?

Answer 38

Greater vol. of outputs with same vol. of inputs.

Question 39

What are some benefits of microeconomic reform?

Answer 39

• No trade-off of managing both economic growth and inflation: boosting AS increases long-term growth and actually reduces inflationary pressures by raising the full employment level of output.
• Might not cost anything to achieve, only requires a little bit of parliament’s time to enact a change in rules.

Question 40

Why might a govt. privatise a company?

Answer 40

• Gov-run businesses don’t need to be competitive: they know they won’t fail regardless of the quality of their product.

Question 41

What are some key types of microeconomic policy?

Answer 41

• Simplifying rules and regulations/deregulation
• Policies to increase competition (ACCC, productivity commission)
• Privatisation of gov. business enterprises
• Labour market changes (e.g. penalty rates changes)
• Trade policy (reduction of protection, trade deals)