Fiscal And Monetary Essay Example 6ea2x

Fiscal + Monetary Policy The Australian government implements a range of policies to try and achieve the four macroeconomic objectives and ensure the overall welfare of all participants in the economy. The measures available to economic managers are both macro and microeconomic. The macroeconomic policies include monetary and fiscal policies which are designed to shift aggregate demand (AD). Fiscal policy is the Commonwealth government’s plans and actions to influence economic activities through government spending and taxation. Fiscal policy is implemented through the governments annual budget, which is announced in may of each year. The Budget can have either a surplus or deficit balance. A deficit occurs when spending exceeds taxation, while a surplus occurs when taxation exceeds expenditure. The current Liberal government has delivered nine surplus budgets in the past ten years. Fiscal policy has an impact on AD because government spending is a component of Ad, which is the aggregate of C+I+G+X-M. Taxation will also effect AD by impacting on C & I. When a bigger surplus than the previous year is announced, or a smaller deficit, Fiscal policy is contractionary, thus reducing C and I and shifting Ad to the left.

When the opposite occurs, a smaller surplus or a larger deficit, the budget is said to be expansionary, where both C and I will increase and AD will shift to the right.

An increase in government expenditure, as seen through an expansionary budget will be multiplied in effect over time. The initial injection will have a much greater effect on the economy over time, through the expenditure multiplier. The extent of the multiplier is determined by the size of leakages.

A reduction or increase in aggregate demand in an economy will have a number of effects on successfully achieving the macroeconomic objectives. Reduced demand causes suppliers to drop prices and reduce production, therefore reducing employment. This result’s in lower inflation but will also reduce economic growth and lead to greater unemployment. It may also see an improvement in the current deficit as a reduction in prices makes Australian goods more desirable, and a reduction in demand reduces import spending. These effects will occur when a contractionary budget is announced. The 2006-07 budget announced in May by Treasurer Peter Costello is set to have an expansionary on the Australian economy, with a forecast surplus of $10.8 billion down from $14.8 billion the previous year. This will lead to an increase in AD due to an increase in government spending, and therefore help achievement of full employment and economic growth. Another major feature of the coming budget is the significant income tax reforms and adjustment of the tax brackets. This reform should encourage people to work more as they will be able to earn more before being heavily taxed, which will increase AD and assist in achievement of economic growth and full employment. The 2006-07 budget also announced a new streamlined superannuation package, the establishment of a future fund, incentives for business to invest in new technology, major increases in funding for medical research, investment in road, rail and water infrastructure and increase in defence and national security funding. Fiscal policy has the limitation of a conflict between achieving the objectives, as achieving price stability and external balance will conflict with economic growth and full employment. It is also limited in that it is only released once a year, and may be affected by political considerations rather than solely economic prosperity of the nation. Monetary policy is the government’s plans and actions to change interest rates in order to influence the levels of AD. The policy is decided and implemented by the Reserve Bank of Australia (RBA) to avoid the conflict of political considerations in policymaking. The RBA have three objectives in the implementation of monetary policy and manipulation of interest rates. • The stability of the currency of Australia; • The maintenance of full employment in Australia; and • The economic prosperity and welfare of the people of Australia The RBA’s definition of stability of currency refers to low inflation, between 2-3%, which will preserve the value of money. This is how monetary is used on a long-term basis for growth (3-4%), and thus full employment (5% UE). However, the RBA will not implement monetary policy with the intention of achieving external balance. When this is achieved, it could be said Australia is operating at full potential. The RBA board meet on the first Tuesday on every month to decide the appropriate level of the cash rate. The cash rate is the interest rate charged on overnight funds between

banks. When the RBA decides to increase the cash rate, they will reduce the supply of exchange settlement funds (ESF’s) held in the banks exchange settlement s (ESA’s) at the RBA. They do this by selling government securities to the banks (Open market operations), therefore removing cash from the s, affecting the banks ability to settle transactions between themselves. This will reduce the supply of loanable funds in the cash market. The banks will then try to borrow more funds from the cash market, thus bidding up the price of the cash rate. An increase in the cash rate will go onto affect the entire structure of deposit and lending rates, through a flow on effect.

To reduce interest rates the RBA will implement a reverse policy, thereby increasing the amount of ESF’s and reducing demand of money in the cash rate, therefore decreasing the cash rate.

If the RBA decide to increase interest rates, then the level of consumption and investment spending will be reduced, thus decreasing the level of AD. An increase in interest rates will lead to a tendency for firms and households to save, having a contractionary effect on the economy. A reduction of interest rates will have the opposite effect, as households would rather spend than receive less interest on their money, thereby having an expansionary effect on the economy, as per the expenditure multiplier.

In August, the RBA voted to increase the cash rate by 0.25% up to 6.00%. This increase in interest rates will have a contractionary effect on the economy. This was decided in the face of a marginally increasing I, as consumer driven inflation rose to a rate not expected until a later quarter. This increase in IR will allow control of inflation, and hence achievement of the price stability objective. However the reduced economic activity will reduce economic growth as AD decreases, and will also reduce employment. Despite the fact monetary policy is not aimed at influencing external balance, as a secondary effect the downward pressure on prices will make Aus goods more competitive and lead to a decrease in import spending, possibly improve the CAD. It may also lead to an increase in foreign investment by placing upward pressure on the exchange rate which will reduce our international competitiveness. A decrease in IR is expansionary, and will have an inverse effect on these objectives. As with fiscal policy, monetary policy also has the limitation of causing conflict between the objectives. By controlling inflation, there will be a decrease in economic growth and employment. The RBA are able to overcome this conflict, by possibly reducing interest rates while the economy is in a recession, or increasing interest rates while the economy is in a boom. When the economy is in a recess, a reduction in interest rates will lead to a substantial increase in production and employment as AD shifts outwards, while producers will not raise prices significantly. When the economy is in a boom, an increase in interest rates will lead to a sharp reduction in prices, but economic growth and employment will only be marginally affected.