Macroeconomic policy in Australia

Introduction

A strong economy displays characteristics of maximizing growth as well as internal and external balance whilst minimising inflation, foreign debts and liabilities.

There are various policies in Australia governing the macroeconomics including Fiscal and Monetary policies. Both these policies influence the economy through altering aggregate demand. In the last three years, since the onset of Global Financial Crisis, Australia has applied both expansionary monetary and fiscal policies to increase aggregate demand. There seems to be a general agreement amongst the economists with regards to the success of the monetary policy implemented. However the only general consensus with regards to the effectiveness of the fiscal policy is that there is no consensus.

Key macroeconomic indicators

Australia’s macroeconomic health same as the rest of the world is governed by factors of Gross Domestic Product(GDP),unemployment, price fluctuations, total nation’s income per year, interest rates, inflation, government spending, tax system, exchange rates, Consumer Price Index(CPI), consumer credit, foreign trades and value of currency. As oppose to Microeconomics, Macroeconomics deals with totals or aggregates.

Gross Domestic Product

Gross Domestic Product (GDP), is the single best measure of a nation’s economic wellbeing. It measures the total value of goods and services produced in a country in one single year (Liu,EC 5103 lecture notes,2009).

GDP = Consumption + Investment + Government Spending + Net export.

There are three approaches to calculating GDP

• Expenditure approach – calculates the final spending on goods and services.
• Product approach – calculates the market value of goods and services.
• Income approach – sums the income received by all producers in the country.

Problems with using GDP alone as a measure of economic wellbeing is that by itself, GDP does not give any information on income distribution in the country nor takes into account the effect of negative externalities on economic growth such as pollution or the effect of positive externalities such as health and education( Trading Economist, n.d).

Taxes and interest rates influence GDP over time. Non economical factors influencing GDP include war, drought, natural and man made disasters.

Consumer Price Index

The best price index measure is the Consumer Price Index (CPI). CPI is used to calculate the inflation rate and is also a measure of the change in cost of living over time.

Business Cycle

Fluctuations in economic activity over a period of time are reflected in the business cycle.

The growth rate of Real Gross Domestic Product is used for measuring the fluctuations in the business cycle.

Economists argue that higher interest rates can motivate the households for savings, and supply more loanable funds in the market, in form of bank deposits. Increased savings results in reducing foreign dependence which in turn accelerates economic growth due to higher investments. McKinnon (1973) and Shaw (1973) cited in Shrestha, M. B., & Chowdhury, K. 2005, further assert that higher real interest rate also helps channel the capital to the most efficient industries and help development and technological advancement leading to economic growth.

The aforementioned reiterates the fact that both fiscal and monetary policies are used to smooth out the business cycle.

Commodity Prices and Trade

One of the key contributors to Australia’s economic condition is the international economic activities in particular the commodity prices which is reflected in the Terms of Trade i.e. ratio of exports to imports prices (White, 1994). Since Australia’s export of commodities is large and the import is relatively stable, the world economy trades more with Australia hence strong Term of Trade is one of the key reasons for an increase in standard of living in Australia. The recent rise in global commodity prices due to increase demand in China and a drop in the price of imports mainly from China has allowed Australia to achieve a higher Term of Trade above its average.

In 2005 Australia entered into an agreement with the US on Free Trade (Australian – US free Trade Agreement- AUSFTA). Other countries that have FTA with Australia include New Zealand, Singapore, China, Japan, Malaysia and South Korea (Travel Document System, n.d).

Farm output

Farm output also appears to be a key determinant of the economic activity of Australia. This is influenced by factors such as drought. For instance, the major drought of 1980’s was one of the key contributors to the disparities between the growth in the Organisation for Economic Co-operation and Development (OECD) countries and Australia (White, 1994).

Government spending

Government spending in infrastructure such as water, transport, telecommunication, education and health are aimed to expand Australia’s supply capacity such as plans to improve irrigation infrastructure and buy back unused water allocation along the Murray-Darling river.

Environment: climate change

Climate change must also be mentioned in this context. A report commissioned by the former Howard government recommended a domestic carbon emission scheme emphasizing that Australia should have an active role in developing a global carbon emissions trading scheme. The Rudd government aims to introduce a carbon trading system by 2011 and reduce emissions by 5% by 2020 (from 2000 levels).

Interest Rates

Interest rate is defined as the percentage rate per annum that a borrower pays to the lender or the cash rate which is the rate charged on overnight loans between the financial intermediaries. Interest rate has a negative effect on the money demand as shown below.

Australia is a price-taker in global capital markets, so the Australian interest rates move with the global financial market trends. Interest rates are generally higher in Australia and New Zealand compared to the international standards largely due to strong fiscal policies relative to other developed countries (Kirchner, 2007, p. 11-15).

In Australia, the Reserve Bank (RBA) determines the interest rate. It does so by changing the amount of money supplied, in other words by altering the equilibrium quantity of money supplied and money demanded. Australia’s interest rate is currently at 4.0 percent according to the data published by the Trading Economics in March 2010.

Unemployment rate

Unemployment rate refers to the % labour force that are unemployed and actively pursuing a job. The unemployment rate is negatively related to the real GDP i.e. falling GDP results in an increase in unemployment and vice versa. As at January 2010 based on data published by Trading Economics the unemployment rate is 5.30 percent.

Inflation rate

Inflation rate refers to the % rate of increase in the average level of prices measured against a standard level of purchasing in the economy. According to the latest figures published by the Trading Economics the Inflation rate was 2.10 percent in December 2009. Inflation rate is best reflected in the CPI or the GDP deflator.

Consumer Credit

One of the major contributing factors that led to the recent Global Financial Crisis was the lack of regulation with relation to consumer credit originating in the United States. Money for institutions to borrow and lend was easily accessible which eventuated in sub-prime mortgages and what has come to be known as NINJA loans (No Income No Job or Assets). This toxic debt was then sold globally through various hedge funds. Although affected by the rest of the world through the freezing of credit markets, Australia has managed to remain in relatively stable position in comparison to the rest of the major economies. This, in part, can be attributed to the regulations enforced through the Consumer Credit Code (Appendix 1). Constant reviews and amendments of macroeconomic policy in relation to consumer credit regulation have contributed to Australia’s robust financial system in comparison to the majority of other developed nations[1].

Gold and Foreign Currency reserves

The Reserve bank of Australia (RBA) has the responsibility of owning and managing the foreign currency and reserves for Australia[2]. “On average, countries hold 10 per cent of their reserves in gold, although the proportion varies widely from one country to another. The Reserve Bank of Australia holds just 80 tones of gold, or 6 per cent of its total foreign reserves. The bank sold down its gold holdings in 1997 and its reserves are now largely held in US Treasuries and other government bonds. The reserves are used, when required, to keep the Australian dollar steady in times of volatility”. (Bourlioufas,N. 2008).

Several reasons exist for the reduction in gold holdings for Australia such as:

• Lack of income that it produces
• The cost of storage/security
• Inability to put value behind the Australian Dollar.

Appendix 2 displays the RBA’s current reserve holdings for 2009/2010. The amounts are displayed in Australian dollars and are subject to movement based on current exchange rates.

Taxation (GST)

One of the many aspects in taxation is the Goods and Services Tax (GST), which is a value added tax on the supply of goods and services in Australia. Until the introduction of the GST, Australia operated a Wholesale Sales Tax (WST), which imposed a tax on wholesale of goods. The GST was introduced to bridge the unfair tax gaps between service based businesses and suppliers of goods (GST Australia, 2009). In Australia the GST is levied at a flat 10%, which is collected from the buyer, which shifts the demand curve downward by the size of the tax, which effectively means both buyers and sellers share the burden of the tax (Mankiw, 2008).

National income and output

Measures of national income and output are used as an estimate of total economic activity by including Gross domestic profit, gross national product, and net national income. Each of these aspects is in relation with the total amount of goods and services within a country. The National income and output values are of importance for a variety of users such as the Reserve bank, academics, and private as well as the Australian government to allow the government to make interventions into the economy based off current and accurate information, as well. (Australia Bureau of Statistics, 2008)

Macroeconomic Policies in Australia

The goals of economic policy makers are:

1. Maintaining real GDP growth constant and positive
2. Maintaining unemployment rate low
3. Minimising inflation

The most important contributor to the economic growth is aggregate demand (effecting GDP). Both monetary and fiscal policies effect aggregate demand. How is this game being played? Should RBA consider a looser fiscal policy when determining interest rates? Or should the government consider the possibility of a rate cut when deciding on fiscal stimulus?

Aggregate Demand (AD= C+I+G+NX) is effected by factors such as:

1. Capital investment boom
2. Rise/fall of exchange rate
3. Consumer boom in a country that Australia has trade agreement with
4. A boom in housing market
5. A share price slump
6. Unexpected cut/rise in interest rate

Monetary policy

Monetary Policy through the effect of the exchange rate influences the economy. Exchange rates also influence the inflation which in turn affects the trade (export and import).

Exchange rates are influenced by factors such as commodity prices and interest rates. This reiterates how the determinants of macroeconomics are intertwined.

Monetary policy is set by the Reserve Bank of Australia (RBA) to influence the supply (availability) of money and credit within the economy in an effort to stimulate growth and stabilise the financial system. Monetary policy influences the interest rates through purchasing and selling of government bonds.

When RBA purchases government bonds to increase liquidity, it results a lower interest rate and lower unemployment. During the periods of high inflation, RBA sells government bonds resulting in an increase in interest rates. Effects of monetary policies are:

1. In short term, a tight monetary policy results in a decrease in the prices of Goods and Services as well as higher disposable incomes hence an increase in the household’s demands.
2. In long term, household demands decrease due to reduced income and increased unemployment.
3. Reserve Bank Act 1959 establishes the objectives of the monetary policies[3].

Fiscal Policy:

Fiscal policy targets both consumption and capital spending. It influences economic activities through government budget. The budget is announced yearly in May stating the government Revenue (T) and Expenditure (G). By varying the amount of spending, a fiscal policy may achieve one of the following:

1. Fiscal surplus- when G<T- enables the government to increase national saving and reduce debts.
2. Fiscal deficit- when T<G- the government must borrow funds from other sectors of the economy
3. Balanced budget- when T=G

When government wishes to stimulate economic growth, it applies an expansionary fiscal policy through increase in government spending and tax cuts which in turn increase consumption and investment. On the contrary, if government decides to slow down the economy, it applies a contractionary fiscal policy.

Global Financial Crisis and Australia’s Response

Deteriorating housing market in the US was the trigger to the onset of GFC in the world. Banks tightened lending policies; credit became more expensive and this led to a restrained aggregate demand resulting in weakness in world economic activity.

The policies of governments around the world in response to GFC were aimed to address these weaknesses. Since the onset of GFC in 2007 Australia has responded by conducting monetary and fiscal policies. Both Short term and long term implications of these policies have to be considered to determine their effectiveness

Analysis of Australia’s Monetary Policy in response to GFC

During the GFC, expansionary monetary policies were implemented in Australia in response to the contraction in aggregate demand. RBA increased liquidity through multiple purchases of government bonds resulting in a decrease in interest rate through shifting the LM curve down and IS curve left.

Analysis of Australia’s Fiscal Policy in response to GFC

The $42 billion economic stimulus plan of Rudd government between December 2008 and February 2009was intended to stimulate aggregate demand (Treasury, 2009). The focus of this package was mostly on investment in infrastructure which was predicted to have a larger effect on the economy in long run than in short run (Australian Government, 2010). It also provided incentives to housing as well as cash bonuses to stimulate consumption in short run.

The inherent weakness of such cash bonuses is where people save their bonuses instead of spending it. Figures published by ABS demonstrate that immediately after the stimulus payments were made, there was a massive hit on spending by Australian’s households but this slowed down after 3 months (Insider retailing, 2010).

According to the latest figures published by Trading Economics on 03.03.2010 and ABS, Australia’s economy grew at the fastest pace in the last quarter in almost 2 years. Table 2 demonstrates some of these figures published in this report.

Economists believe that the underlying reason for Australia’s Economic performance is Rudd’s Government stimulus package as well as increase in export however the widened account deficit of 19% in December 2009 figures is mainly due to an increase in imports. One of the consequences of this is expected to be a 1.3% decrease in Australia’s GDP therefore the recovery period is going to be weak (Market watch, 2010).

The unemployment rate has dropped by 5.3% and the number of people employed has increased by 52700. This will put more pressure on RBA to increase interest (The Australian, n.d).

Treasury secretary Ken Henry warns of the adverse shocks to financial markets despite the fact that GFC seems to have passed. Further more he explains that “fiscal circumstances improve as the economy strengthens. As the economy strengthens, other things being equal, there is increasing upward pressure on prices and monetary responses to that (The Australian, n.d).

In his book ” The Great Crash of 2008″, the economic advisor Ross Garnaut, warns Kevin Rudd of hard times ahead in terms of lower living standards and economic wellbeing as a result of stimulus response to GFC (The Australian, October2009). Garnaut’s point of view is also shared by many other economists who consider the stimulus package a “dangerous revival of a discredited Keynesianism” which focuses on the short term aggregate spending as the source of growth in the economy. Some point out that fiscal policies result in an interest rate rise which has a crowding out effect on the expansion due to export and import. Hence they argue the ineffectiveness of Australia’s fiscal policy. The supporters of Stimulus package on the other hand argue that the spending avoided further economic contraction at the right time boosting consumer’s and business’s confidence and hence avoiding a recession. They also argue back with regards to trade issue pointed above, in the sense that Australia’s trade share is 47% of GDP which is less than the 60% quoted in previous studies as a benchmark of ineffectiveness of fiscal stimulus. They therefore argue that because of the lower trade share the fiscal stimulus has been effective in Australia (The Australian, n.d).

Irving Fischer, the renowned American economist contributed to the economics in many ways one of which is his theory of “Inter-Temporal Choice”, which describes that through time savings, interest rates and investments are related(The Australian, n.d.). His theory highlights that present economic decisions have to have the future in mind[4].

Discussion

There has been increasing concern amongst the economists in Australia about the sustainability of the fiscal policy in particular with regards to a solution for the current government deficit of $17.459 billion (Table 1).

Australia has had challenging times in maintaining a stable economic condition. The recent Global Financial Crisis (GFC) that started in 2007 imposed great pressure on the economy. Nevertheless implementation of the fiscal and monetary policies achieved a better than expected performance by the economy (Budget, 2009-10), with forecasts of stronger growth and lower unemployment.

Rudd’s Stimulus package through its fiscal expansionary characteristics seems to have been an appropriate response to the GFC in stabilizing the output levels however there is great concerns regarding the future of the economy.

Did our politicians throw in a Keynesian based fiscal stimulus package without consideration of future consequences of it? Was there any vote buying elements incorporated in the design of it?

There is a general consensus amongst the economists on the effectiveness of lowering interest rates as a monetary response to GFC by RBA which was also assisted by a depreciated exchange rate.

On the other hand the fiscal policy has generated a lot of debate amongst the economists with no consensus on it’s effectiveness in sight. This is mainly due to the long lasting effect of the fiscal stimulus as oppose to short term, temporary and more reversible effect of the monetary stimulus.

Kevin Rudd’s Fiscal stimulation concentrated on aggregate spending in short term to boost economic growth as per the Keynesian model. This has been proven to be the case in Australia however the unproductiveness of this large scale spending and the deficit resulting from it is far from a perfect economic condition.

Does Kevin Rudd share the thought with John Maynard Keynes of “in the long run we are all dead”? If so are we, the Australian people supposed to suffer the consequences of his 17 billion dollars debt through our taxes, higher interest rates and higher inflation? If Irving Fisher was alive and if he was with Kevin Rudd when he was signing on the stimulus package, perhaps he would have reminded the prime minister that although his short term fiscal stimulus policy would increase public spending, it would show no regards to achieving long term high standard of living for Australian people. The side effects of the fiscal cash out include:

1. Increasing future taxes to pay for the debts
2. Higher interest
3. Likelihood of inflation (as history shows us that the easiest way out of public debt has traditionally involved money creation).

So was Kevin Rudd’s big night out worth the next day’s hangover of a budget deficit that adds to public debts which would further drain the economy? Or has the government designed an appropriate fiscal rebalancing strategy that it hasn’t shared with Australian public yet?

1. The passage of the National Consumer Credit Protection Amendment Bill brings Australia closer to having a single, standard national credit regulatory regime. (Australian Government Treasury. 2010)
2. One important consideration for the RBA is the need to identify a desired range for the level of reserves within which they feel that they can achieve their nominated objectives. When determining the optimal size of a reserves portfolio consideration is given to a number of factors including the size of the central bank’s balance sheet, the opportunity costs of maintaining an unhedged portfolio of foreign assets, the relative depth of the domestic and foreign exchange markets, the size and openness of the domestic economy and the extent to which an economy is reliant on external sources of short-term funding. (RBA. 2010)

• Inflation at the targeted rate of 2%-3% in other words achieve stability of the currency of Australia
• The full employment at the NAIRU( the non accelerated inflation rate of unemployment between 5%and 7% in other words maintenance of the full employment in Australia
• Economic growth between 3% and 4% to sustain the living standards and welfare of the people of Australia