The Macro Economic Policies Of Australia

Australian governments over precedent decades have conventionally aimed towards including triangular objectives of financial growth, domestic poise, and external poise within framework of single economy. (DORNBUSCH, Rudiger, 2006) Collectively, these trio set of objectives aim towards sustaining nationalized financial growth while retaining inferior inflation as well as limiting the mass of overseas debts and liabilities. Several researches conducted in concerned field have revealed that there is no consistency in level of economic growth though; it is influenced greatly by fluctuations of international business cycle. (DORNBUSCH, Rudiger, 2006) A governmental macroeconomic management is referred as an attempt to minimize the impact of international business fluctuations by controlling demand to facilitate sustained growth together with inferior inflation and unemployment.

In the last decade macroeconomics policy in Australia has been directed at controlling inflation as it would be associated with macroeconomic stability and growth.

Following on from the GFC’s the government’s main emphasis of macroeconomic policy has been trying to avoid a recession.

Contrast these two phases of policy. Explain how macroeconomic policy objectives, targets and instruments have differed.

Explain how macroeconomic policy objectives, targets and instruments have differed.

Outline the experiences of the Australian Economy over the last 10-15 years making use of macroeconomic aggregates – these may be presented in summaries of tables and/or graphs. Stress should be placed on the challenges facing policy makers at present and likely challenges.

Before the global economic crisis (GFC), the Australian economy has seen significant growth in terms of GDP ignoring various crises that have affected the global economy such as the Asian financial crises (1997-1998) and the United States (US) ‘dot com’ bust (2000) (reference). Throughout this time, Australian macroeconomic policy (MP) has primarily been directed at controlling inflation to maintain stability and growth. MP refers to the structure, performance, behaviour and decision making of a whole economy. (Reference) states that MP is associated with the study of aggregates such as gross domestic product (GDP), price indices and unemployment rates to examine how the economy functions.

Macroeconomic Policy

The continuance of a steady economic environment in Australia post GFC has proven to be a difficult task, with the surfacing of undesired inflation and external account pressures (Treasury, 2008). According to Treasury (2008) acts of policy to tackle such pressures has consistently contributed to short-term downturns and, unavoidably, constrained the prolonging of economic growth. The basis of the issue, however, is the policy failure which permitted the pressures to appear. Nevertheless, the resulting changes in the economic outlook would affect the self-assurance of businesses and consumers and their readiness to engage in the process of structural change. Moreover, disparity in fiscal policy and hesitation about inflation predictions has lead to higher real interest rates, discouraging investment and distorting investment patterns.

In the last few years substantial progress has been made in addressing inflation and to a lesser extent current account deficit constraints (RBA, 2009). The current cycle has been characterised by low inflation, with monetary policy being carried out on a more strategic basis with the desire to keep principal inflation consistent with the Reserve Bank of Australia’s (RBA) average target range of 2 to 3 per cent over a yearly cycle.

Last year the Government introduced a new framework for the conduct of policy, clearly recognising the Reserve Bank’s role and endorsing its inflation objective. The clarification of policy responsibilities, and recognition of their observance in practice over time, together with an accumulating record of low inflation, is likely to have a continuing positive impact on lowering inflation expectations and creating confidence in a sound investment environment.

Australia’s large structural current account deficit reflects both inadequate national saving and inadequate investment returns overall (ABA, 2009). On the saving side, the principal cause is a deficiency in public saving especially at the Commonwealth level. The Government through its fiscal consolidation program is addressing this problem and has put in place a policy framework that will maintain the adequacy of the Commonwealth contribution to public saving. Statements 1 and 2 spell out in detail the fiscal strategy, including improved transparency and accountability practices, and implementation of the strategy in the years ahead. The benefit of a more soundly based fiscal policy is likely to be seen over time in the capacity of the economy to sustain faster rates of growth than would otherwise be the case. While it is too early to be able to point to any concrete results with confidence, the 1997-98 economic outlook presented in Statement 2 suggests that higher saving in prospect next financial year will help to constrain the current account deficit.

Before the global economic crisis of 2007 the Australian economy sustained increased economic growth of approximately 8% per annum – except for the year 1997-1998 (Asian financial crisis) (The Australian Year Book 2008). This resilience reflects on well-timed monetary and fiscal policy responses; strong demand from various major trading partners, such as China; increased population growth that aided demand in the domestic economy; and the robustness of the financial sector (The Australian Year Book 2008). More generally, Australia’s strong economic performance can be commended by decades of economic reform – in economic policy, regulatory frameworks and governance. These have increased the flexibility of the economy, and strengthened its ability to withstand unforeseen circumstances.

Dungy and Pagan (2007) suggest that aggregate behaviour exists between fiscal policies and is connected

Since 1997/98 the federal budget has been in surplus continually, apart from a very small deficit in one year. The government’s net debt has been retired. Gross debt on issue is maintained at a small size in order to facilitate a functioning bond market so as to allow efficient risk pricing more generally. As with monetary policy, there is a medium-term framework for fiscal policy emphasising balance over the business cycle. There is much less inclination today than there once was to use fiscal policy as a counter-cyclical stabilisation tool.

Significant fiscal challenges in the long-term include health spending and responding to population ageing, as the very important work by officers of the Australian Treasury has made clear.

Macroeconomic policy has a supportive and complementary role in providing a stable economic environment conducive to sound investment decisions by business and to encouraging workers to invest in upgrading their skills to take advantage of new employment opportunities.

Macroeconomic aggregates are:

Aggregate behaviour: relationships between economic aggregates such as national income, government expenditure and aggregate demand. For example, the consumption function is a relationship between aggregate demand for consumption and aggregate disposable income.

Models of aggregate behaviour may be derived from direct observation of the economy, or from models of individual behaviour. Theories of aggregate behaviour are central to macroeconomics.

Aggregate demand: aggregate demand (AD) is the total price for demand for final goods and services in the economy (Y) at a given time and price level [1]. It is the amount of goods and services in the economy that will be purchased at all possible price levels.[2] This is the demand for the gross domestic product of a country when inventory levels are static. It is often called effective demand, though at other times this term is distinguished.

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downward sloping as a result of three distinct effects; Pigou’s wealth effect, the Keynes’ interest rate effect and the Mundell-Fleming exchange-rate effect.

Aggregate expenditure: is a measure of national income. It is a way to measure the GDP or Gross Domestic Product (A measure of the level of economic activity). It is defined as the value of planned goods and services produced in an economy.

GDP is calculated by the formula C + I + G + NX and I = Ip + Iu (planned + unplanned investment), Aggregate Expenditures is defined as C + Ip + G + NX, where:

C = Consumption Expenditure (Also can be written as CE)

I = Investment

G = Government spending

NX = Net exports (Exports-Imports)

Aggregate supply

Aggregation problem

Effective demand:

Saving

Government Macroeconomic goals:

High and stable economic growth rates

Low unemployment

Low inflation

Stable and manageable Balance of Payments

RBA article:

RBA uses short term interest rate as its operating instrument for implementing monetary policy.

RBA sets target level for its cash rate.

RBA has two options

It can target particular level of bank reserves and accept the resulting outcome for short term interest rates

It can seek to achieve a particular target level for short-term and supply whatever quantity of services is demanded at the target rate.

For a given demand curve for reserves the RBA will need to alter the supply of bank reserves to implement a change in the stance of monetary policy.

While banks continue to hold reserves with the RBA these reserves are associated with settlement in the payments system. In addition the RBA pays interest on reserves which is linked to the cash rate.

An important effect on the current operating procedure is the relationship between the quantity of reserves and the level of the policy rate.

Monetary policy operating procedures is based on the supply of and demand for some measure of the money supply.

Systematic changes to the stance of monetary policy need to be implemented by changing the supply of bank reserves.

Central banks can influence the stock of bank reserves by undertaking open market operations either directly with the banking system or with the non-bank public.

A central bank is unable to independently determine both the quantity of bank reserves and their price.

To understand how the RBA achieves its target for the cash rate it is necessary to consider the operation of the payments system in Australia and the overnight cash market.

In Australia the major players in the payments system are the nonbank public (households and firms), the private banks, the RBA and the federal government.

The trend in unemployment in the most recent decade has generally been downward. Following a rise of a percentage point in the economic slowdown in 2001, it has fallen to the lowest levels since the mid 1970s. The long expansion, with occasional temporary pauses, has done a lot to foster lower unemployment. But the changes in labour market arrangements over the past 20 years or so have also been very important. Indeed, I would argue that they are a key contributor, not least because they have facilitated the longer length of economic expansions.

http://www.bis.org/review/r080516b.pdf?noframes=1

Firstly, as is widely accepted, tax systems must be fiscally sustainable across the economic cycle. Secondly, while monetary policy is the principal instrument of macroeconomic management, it is still necessary to remain mindful of the short-run “liquidity” effects of fiscal policy

The challenges associated with an aging population identified in the Intergenerational Report have prompted the Howard Government to establish a long-term strategy to put fiscal policy on a more sustainable footing. Central here was the creation of an independently managed “Future Fund” in 2006 to help meet the costs associated with Australia’s aging population. The primary goal of the Future Fund is to accumulate adequate capital to meet the Commonwealth’s unfunded $91 billion superannuation liability so that it does not burden future generations. The Future Fund has been capitalised from a number of sources including asset sales, special seed funding (designed in part to preserve sovereign debt markets) and budget surpluses from the government’s cash account. While the Future Fund is primarily about fiscal sustainability rather than stabilisation per se, it is important to note that the structure of the Future Fund and the allocation of surpluses to it do have some important implications for the stabilisation debate. The significant point here is that the Future Fund represents an innovative vehicle in which cash surpluses can be invested without stimulating short-run consumption.

Overall recent Australian fiscal policy has been consistent with the objectives set out in the Charter, in that fiscal policy is clearly being conducted on a sustainable basis with significant financial resources now being invested in the Future Fund.

What is less clear, however, is the impact of this policy on the goal of macroeconomic stabilisation and whether the challenges currently confronting the Australian economy may require more careful consideration of the impact of fiscal policy on short-run economic activity.

Given the political sensitivity of the issue and the RBA’s understandable reluctance to speak outside its official mandate, the central bank has not been willing to provide the government with explicit advice on fiscal policy. Indeed the new RBA Governor, Glenn Stevens, attempted to down-play the issue at a February 2007 Parliamentary Committee hearing when he stated that it was unlikely any election spending spree would have enough short-term impact to enter into the RBA’s interest rate calculations (Wood 2007).

Activist fiscal policy of the Keynesian “golden age” may well have passed, with monetary policy now established as the primary instrument of macroeconomic management. Yet this does not mean that we can completely ignore the stabilisation function of fiscal policy which Musgrave described almost half a century ago. This is especially so when, as in the case in Australia at present, key sectors of an economy are running at close to full capacity and inflationary risks are building. Under these circumstances fiscal policy must not only be sustainable, it must also be sensitive to its potential to stimulate demand in the short-run. Fortunately, for the Australian economy it seems that there is an awareness of the need to exercise a degree of fiscal restraint in the prevailing conditions with both major parties.

http://eprints.utas.edu.au/3970/1/3970.pdf

Challenges:

Australia’s population is projected to reach nearly 36 million by 2050 – an increase of around 14 million

The first challenge is that an ageing population implies slower economic growth. As the proportion of the population that is of traditional working age falls, the labour force participation rate is projected to fall (from above 65 per cent today, to below 61 per cent over the next 40 years), dampening workforce growth.

Population dynamics explain one-half of the 0.4 percentage point gap between annual growth in GDP per capita over the next 40 years relative to the past 40 years – the other half being due to a technical assumption relating to productivity growth.

The second challenge is that working Australians will need to support an ageing population that, in part due to continuing technological advancements, is likely to be living longer. Men aged 60 in 2050 are projected to live an average of 5.8 years longer than someone aged 60 today, while women aged 60 in 2050 are projected to live an average of 4.8 years longer.

This is great news for Generation Y, but a sobering statistic for future budgets.

The greater publicly funded health, aged care and related expenditures to support Generations X and Y in their retirement years will need to come from a relatively smaller number of workers than we have today. On a “no policy change” basis, a significant fiscal gap is projected.

The intergenerational report shows how the Government’s fiscal strategy to constrain real expenditure growth contributes to reducing, without wholly eliminating, the projected fiscal gap.

The third challenge identified in the intergenerational report concerns the impact of climate change on ecosystems, water resources, agricultural production and weather patterns.

Against these challenges, there are three topics I want to say something about today:

Promoting economic growth by improving productivity and workforce participation;

The implications of a growing population, particularly for infrastructure investment; and

Medium-term prospects for capital flows required to finance national investment.

For obvious reasons, I won’t be saying anything about climate change on this occasion.

Discuss the concept of instruments and targets in macroeconomic policy and assess how this concept of instruments and targets in macroeconomic policy and assess how this concept might be applied to the current policy framework in Australia.

A number of people have asked me for clarification on instruments and targets as referred to in assignment 2. Here is what I mean:

These refer to macroeconomic policy.

INSTITUTIONS make policy. Examples would be the Reserve Bank of Australia and the Treasury.

These institutions set policy TARGETS. An example of such a target would be an annual inflation rate of no more than 3%.

Policymakers then use policy INSTRUMENTS to meet the targets. Typical instruments include the RBA cash rate or government spending.

Show how the economic theory you have learnt can be used to explain current macroeconomic policy.

How is inflation measured?

GDP Deflator

Consumer Price Index: an average of the prices of the goods and services purchased by the typical urban family of four.

Producer Price Index: An average of the prices received by producers of goods and services at all stages of the production process

fiscal and monetary policy

The tools the Australian government controls to smooth short-run fluctuations in the economy

inflation, unemployment and external trade

The causes and effects of inflation, the link between inflation and unemployment, Australian trade with the rest of the world

Fiscal policy:

Fiscal policy” is the government operation of government spending (G) and taxes (T).

Typically we consider the problem of how the government can manipulate G and T so as to control economic variables such as output, inflation, interest rates, etc.

Issues: how fiscal policy can “stabilize” the economy? what about government borrowing and public debt?

Budget deficit: the budget deficit is the extent of overspending by the government

Budget deficit = G – T

Expansionary fiscal policy: increasing the budget deficit (G↑ or T↓) usually in a recession.

Contractionary fiscal policy: decreasing the budget deficit (G↓ or T ↑) usually in an economic boom.

Budget deficits and surpluses

If the government spends more than it brings in in taxes, what happens? (G > T)

The money has to come from somewhere. For developed countries, this means borrowing (issuing government debt or “public debt”) from domestic residents or foreigners.

If the government is spending less than it brings in in taxes, the government can reduce public debt. The Australian government has followed this policy in the last 10 years.

Types of fiscal policy

We differentiate two types of fiscal policy:

Discretionary fiscal policy: This is fiscal policy that comes about from planned changes in G and T that the government brings in response to the economic situation.

Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes.

Non-discretionary fiscal policy

Certain parts of our spending and taxes automatically increase demand in a recession (when AD < potential GDP) and decrease demand in a boom (when AD > potential GDP).

Welfare spending and unemployment benefits are part of G and increase in a recession and decrease in a boom.

Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession.

These act as “automatic stabilizers” on the economy, reducing the variability of the economy.

Cyclically-adjusted budget deficits

The automatic stabilizers raise the budget deficit in a recession and lower the budget deficit in a boom.

This fact means that we can not just look at the budget deficit to determine whether the government is “overspending”, we also have to take into account where we are in the business cycle.

Adjusting the budget deficit for the point we are in the business cycle is called “cyclically adjusting”. We would expect even a “sensible” government to be in a deficit in a recession.

Discretionary fiscal policy

Discretionary fiscal policy is the manipulation of G and T by government officials typically to reduce the severity of shocks to the economy.

It sounds like a good idea, but how does it work in reality?

There are many problems and limitations to the use of fiscal policy to reduce recessions and booms.

Problems with discretion

Scenario: Imagine a train driver that has only one control- an accelerator/brake that he or she can push or pull on to control the train. This is exactly the same situation as the government faces with fiscal policy.

Now what limitations can the train driver face?

Problems with discretion

Limitations:

Correctness of data: Is the train driver seeing the tracks correctly? Or Does the government get the right data about where the economy is?

Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything?

Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy?

Problems with discretion

Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made.

Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy.

So even the best-designed fiscal policies can go wrong if they are in response to the wrong data or if they take too long to affect the economy.

Political considerations

There are further concerns we might have about the operation of fiscal policy.

Politicians have to remain popular. No one likes taxes, and everyone likes new spending on themselves. Will a politician make an unpopular decision that may result in them losing the election if it is the best decision for the economy.

Electoral cycles: Governments have to be re-elected every 3-4 years. So a politician would love to engineer a boom right before his or her election.

Crowding out

Another problem with fiscal policy is that an increase in G may increase output but at the expense of other components of aggregate expenditure.

Y = C + I + G + NX

Since the economy returns to potential GDP over the long-run, an increase in G must come at the expense of either C, I or NX or all 3.

If an increase in G reduces investment spending over the long-run, this could lead to lower future growth in the economy.

Crowding out

How can this happen?

An increase in G shifts the AD curve to the right.

This results in higher Y and higher P.

The increased government borrowing in the market for savings raises the interest rate.

Higher interest rates lead to lower investment spending so I drops, shifting AD left.

Higher interest rates leads to an appreciation of the A$ (as foreign investors put their money in Australia), so NX drops, shifting AD left.

Crowding out- I and NX

Government debt

One problem that economic commentators always point to is the level of government debt- “Our debt is too high.”

How do we evaluate the level of government debt? How do we know is it is “too high”.

Government debt is like any other form of debt. You evaluate the debt relative to the income/wealth of the person incurring the debt.

A $500,000 debt might be high to you and me, but it might mean nothing to Kerry Packer.

Government debt

So we need to evaluate government debt relative to “government income”. But what is the appropriate form of “government income”, as the government doesn’t earn or produce anything.

Generally we use the income of the country as the comparison, since the government is free to tax or claim any part of GDP.

Government debt

So our criterion for “too much” is debt (B, since typically government debt is issued in government bonds) over GDP (Y):

B / Y

Banks would make much the same calculation when considering whether to issue someone a home loan.

In general debt is growing at the rate of interest each year, r, while GDP is growing at the growth rate of the economy, g.

Monetary policy

Firstly, monetary policy uses the level of interest rates to influence the economy in the short to medium term. Its major goals are to stabilise demand and inflation in the medium term and inflationary expectations and to achieve the government’s objectives of sustainable growth with underlying inflation of about 2-3%.

Source: Chapter 12 of the book plus second part of Module 3.

“Monetary policy” is the government operation of the money supply and interest rates.

Typically we consider the problem of how the government can manipulate monetary policy so as to control economic variables such as output, inflation, interest rates, etc.

Issues: how monetary policy can “stabilize” the economy? how will monetary policy affect interest rates or exchange rates?

Who operates monetary policy?

The Reserve Bank of Australia (RBA) is responsible for monetary policy.

The RBA was given 3 goals when it was created:

Maintain low inflation

Maintain low unemployment

Maintain value of the A$

The RBA was only given one policy tool- the money supply to achieve 3 goals. In the mid 1990s, the RBA was simply told to have one aim:

Maintain low inflation.

Definitions

The RBA implements monetary policy through its control of the cash rate.

Cash rate: The cash rate is the rate the RBA charges bank for loans within the RBA reserves system. The cash rate is the base interest rate for the economy, and all other interest rates are derived from it.

Easy monetary policy: When the RBA lowers the cash rate to stimulate AD.

Tight monetary policy: When the RBA raises the cash rate to cut off AD.

Interest rates

As we saw in the Investment section, the profitability of investment projects depends on the nominal interest rate.

The lower are interest rates, the more projects will be profitable, so the higher will be investment spending.

Since the RBA controls the cash rate, and since all interest rates depend on the cash rate, the RBA controls I, and so can shift the AD curve.

How monetary policy works

Cause-Effect Chain of Monetary Policy:

Money supply impacts interest rates

Interest rates affect investment

Investment is a component of AD

Equilibrium GDP is changed

Monetary policy and the open economy

Net Export Effect

Changes in interest rate affect the value of the exchange rate under floating exchange rate.

An increase in interest rate appreciates the currency, resulting in lower net exports

A decrease in interest rate leads to currency depreciation and a rise in net exports

So an easy monetary policy is enhanced by the net export effect.

Quantity theory of money

There is a nice, simple model of money which explains many features of money supply and demand. This model is called the quantity theory of money.

If we imagine that money is needed for all of the purchases made each year, then demand for money is the vale of purchases: PY.

The supply of money for purchases is the amount of cash in the economy.

But each piece of money in the economy can be used multiple times during a year in transactions. We call the number of transactions the velocity of money “v”.

Quantity theory of money

So the total supply of money for transactions in a year is v times M: vM.

So demand equals supply requires that:

PY = vM

So if Y goes up, but nothing else does, then average level of prices must fall.

The QTM is good to use for thinking about money and inflation.

Unemployment

A person becomes unemployed:

Job loser

Job leaver

New entrant or re-entrant into the labour force

He or she is no longer unemployed:

Hired or recalled

Withdraws from the labour force

Labour force participation rate

Unemployment rate

Types of unemployment

Three main types of unemployment:

Cyclical unemployment

Frictional unemployment

Structural unemployment

Cyclical unemployment

Associated with the ups and downs of the business cycle

Takes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve.

High during recessions and low during booms.

Fiscal and monetary policies can reduce cyclical unemployment – policies are relevant.

Frictional unemployment

Associated with the period of time in which people are searching for jobs, being interviewed and waiting to commence duties.

It is inevitable and always exist

Fiscal and monetary policies can not reduce frictional unemployment – macroeconomic policies are irrelevant.

Policies that make it easier to find new jobs will affect frictional unemployment.

Structural unemployment

Associated with wider structural or technological changes in the economy that may make some jobs redundant.

It is inevitable and always exist

Lasts longer than frictional unemployment

Fiscal and monetary policies can not reduce structural unemployment – macroeconomic policies are irrelevant.

Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.

“Full” employment

Full employment means when all productive resources in the economy are in full use – implies no cyclical unemployment – still frictional and structural unemployment exist – they can be low – but can never be zero.

The full-employment rate of unemployment is called the “natural rate of unemployment”.

Domestic output consistent with the natural rate of unemployment is “potential output” or “full employment level of GDP”.

Classical employment theory

Economy always operates under full employment – it is automatic and self sustaining – if there is any unemployment that is only temporary.

Price-wage flexibility

the assumption that all prices, including wages and interest rates, are flexible and will, rapidly adjust to remove disequilibria

Classical theory and laissez faire

the price system ensured that price-wage flexibility and fluctuations in the interest rate was capable of maintaining full employment

Classical theory

Keynesian employment theory

Full employment is not automatic – unemployment exists for longer periods – the Great Depression of the 1930s – sticky wages and prices.

Horizontal aggregate supply curve during recession – ‘recessionary’ or ‘Keynesian’ range.

Change in AD impacts on unemployment – not on price level.

Once the full employment level is reached – vertical AS curve – change in AD affects price level only.

Unstable aggregate demand – especially investment, so that demand management and stabilisation policies by the government are essential.

Keynesian theory

Measuring inflation

We measure the general price level through a price index such as the Consumer Price Index (CPI)

Inflation is a continuous rise in the general price level. We measure inflation:

Inflation in Australia, 1970-2004

Two types of inflation

We can differentiate two different sources of inflation in an economy:

Demand-Pull Inflation

Occurs when an increase in AD pulls up the price level.

Cost-Push Inflation

Occurs when an increase in the cost of production at each price level shifts the AS curve leftward resulting in increased prices.

Demand-pull inflation

Short-run: There is an increase in demand, such as an increase in consumer spending, so AD shifts rightward. AS does not change in the short run, and we have a movement along the AS curve. Price level and GDP increases..

Long run: Workers will realise their real wages have fallen and will demand and receive increased nominal wages. As costs rise, supply decreases and the AS to shift to the left. Price level increases, and GDP declines.

May be caused by expansionary fiscal and monetary policies – can be countered by contractionary policies by the government.

Demand-pull inflation- SR and LR

Cost-push inflation

Short-run: Increased prices and decreased real output (and more unemployment). Causes can be:

Wage push : increase in wage rate – power of trade unions

Supply shocks – increase in prices of major raw materials – oil etc.

Profit push : increase in profit requirement of large monopoly businesses.

The AS curve shifts to the left/up as prices and costs rise, and firms cut back on output.

Cost-push inflation

Long-run: There are two scenarios.

Government intervention ( shift in AD): If government intervenes to increase AD, prices and output will rise, moving us back to the natural rate of output.

No Government intervention (no shift in AD): If government does not intervene to increase AD, a severe recession will result. However nominal wages will eventually decline and will restore AS to its original position, moving us back to the natural rate of output.

Cost-push inflation- SR and LR

Phillips curve

Suggests an inverse relationship (or a trade-off) between inflation and the unemployment rate

Named after A W Phillips who originally discovered the relationship between unemployment and nominal wages, using British data in 1950s.

In general, inflation is associated with economic expansion, and unemployment with economic recession.

During expansion : the greater the rate of growth of AD – inflation is high, and unemployment is low.

During recession : the slower the rate of growth of AD – inflation is low, and unemployment is high.

Phillips curve

Policy implications of Phillips curve

Trade-off suggests : a rise in inflation should lead to a decline in unemployment, and vice versa.

In general, both can not be brought down to the minimum level.

The society must make a choice between low inflation and low unemployment.

Phillips curve in Australia

Stagflation

Simultaneous experience of high and increasing unemployment and inflation – cost-push inflation.

Caused by :

Aggregate supply shocks such as severe increases in fuel costs, and devaluations;

Productivity declines; or

Inflationary expectations and wages – expectations about the likely future path and rate of increase of the general price level.

Stagflation in Australia

1973-74 : Cost push – caused by international oil price rise.

1979 : cost-push – caused by international oil price rise.

1981-82 : cost push – caused by rapidly rising wages.