domestic macroeconomic goals and living standards

4.9.2 The weaknesses of using budgetary policy to achieve Australia’s domestic macroeconomic goals

Table 4.8 summarises some of the key weaknesses of using budgetary policy to help promote the achievement of domestic macroeconomic goals and livings standards.

TABLE 4.8 Some possible weaknesses of using budgetary policy to promote the achievement of domestic macroeconomic goals and living standards

Possible weakness Description of weakness 1. Some discretionary budget stabilisers can become procyclical due to their long time lags between recognition of a problem in economic activity and the impact of the corrective policy

There are often long time lags associated with the recognition, implementation and impact of some discretionary budgetary policies like spending on large transport, power and telecommunications infrastructure projects. Because of delays in planning, starting and completing these projects, and spending the money, there is a real risk they can become procyclical rather than countercyclical, possibly increasing instability in AD. This can mean that changing discretionary budget stabilisersare of limited use in correcting shortterm or cyclical instability like a recession. Their full impact on the level of AD and economic activity can take 3–8 years or even longer and so are often more suited to promoting medium- to long-term stability. In the opposite situation where there is a boom, the same sort of pro-cyclical risk applies. For example, if there were discretionary cuts in infrastructure to limit AD, the policy may do little to slow inflation in the short-term, and instead gain traction when inflation has passed and the economy is in recession. However, as noted, some discretionary budget stabilisers can work quite quickly to help stimulate AD (e.g. a rise in the payment rate for welfare or a cash bonus paid to households).

2. Financial constraints and the creation of a structural budget deficits can limit budget options during a slowdown

Like individuals, governments face financial constraints where there is limited money available for spending without increasing unpopular taxes or adding to already high levels of government debt. For instance, during a slowdown like in 2020 and 2021, the government may want to make big discretionary cuts in tax rates, increase outlays and run expansionary budget deficits to help stimulate AD and economic activity. However, the benefits of such action would have to be balanced against the repayment burden that this action would place on future generations and potentially, the negative impacts on Australia's AAA credit rating. In other words, concern over the impact of huge deficits on the government's long-term financial position, is likely to mean that the strength of stimulus budget measures may be less than that actually needed for promoting a significant recovery. This weakens the policy's effectiveness.

3. Budgetary policy can undermine the effectiveness of monetary policy through the problems of crowding out or crowding in

Budgetary policy used as a stabiliser can sometimes undermine the effectiveness of monetary policy. For instance, when the economy is in recession and the government decides to run large budget deficits to stimulate AD financed by borrowing through the sale of government bonds domestically, this can increase the demand for credit in local financial markets. As an unintended result, this puts upward pressure on local interest rates at a time when it would be better to have lower interest rates to boost spending. In turn, higher interest rates can lead to the problem of crowding-out private sector C and I spending, unfortunately slowing the economy. In reverse, when there are budget surpluses during a boom designed to slow AD and economic activity and the government decides to repay previous debt, this can cause lower interest rates and lead to the problem of crowding-in by borrowers, adding to spending, inflationary pressures and instability. UNCORRECTED PAGE PROOFS

Possible weakness Description of weakness 4. Constraints due to tradeoffs in pursuing government economic, social and environmental goals

Some fiscal policies cannot be used to pursue one particular government economic goal because they can involve trade-offs. Here they can conflict with, or prevent the achievement of another goal. For example, although a less expansionary budget like that in 2018–19 helped to slow inflation, it also reduced economic growth and increased unemployment. In reverse, expansionary budget deficits, which are designed to boost economic growth and create jobs, can sometimes accelerate inflation if there is little spare capacity available. Additionally, while slowing welfare or government spending on services such as health, public transport and education may help with fiscal consolidation and return the budget to surplus, the trade-off is that they are also likely to reduce equity in the distribution of income and undermine living standards. Furthermore, expansionary budgets designed to strengthen economic growth can potentially weaken environmental outcomes and make the growth in GDP less sustainable.

5. Adverse political constraints can limit budget options and effectiveness, especially in a boom

As seen in recent years, there are three types of political constraints that can act as deterrents and reduce the effectiveness of budgetary policy as a stabiliser of economic activity. • The absence of a federal government majority in the Senate. For some parts of the budget to become law, they first need approval in both houses of parliament. In recent years, the Liberal Coalition government has lacked a majority in the Senate, which was controlled by Labor and various minorities. This caused significant aspects of budget receipts and outlays to be rejected, altering the planned budget outcome and its intended impact on AD. • Adverse voter reaction. Some changes in budget receipts and outlays can have significant adverse popularity ramifications, especially in election years. For example, while few voters oppose expansionary budget measures like discretionary tax cuts, or increased outlays on health and education (that increase the structural budget deficit) to stimulate AD in a recession, when the boom is over, most voters object to higher tax rates or cuts to government services, and may take out their anger on unpopular governments at the next election. As a result, the budget has an expansionary bias and structural deficits can easily develop, even if they are not entirely warranted. This undermines the financial sustainability of important budget outlays like welfare and health, and weakens the government’s ability to respond to future economic crises.

6. Psychological constraints can reduce the budget’s effectiveness as a stabiliser

The success and strength of any budget depends partly on the prevailing level of confidence. For instance, reduced consumer and business confidence (e.g. during 2020) would tend to weaken the expansionary effects of budget deficits or tax cuts where people may save the money rather than spend it. In reverse, if confidence is strong, contractionary budgets can be made less effective than expected in slowing the level of AD, thereby reducing the effectiveness of the budget as a stabiliser. 4.9 Activities

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4.9 Exercise

1. Identify and outline two important strengths of using budgetary policy.

2 marks

2. Identify and outline two important weaknesses of using budgetary policy. 2 marks 3. During a recession (e.g. perhaps in 2020 following the COVID pandemic), explain how financial constraints and psychological constraints may reduce the effectiveness of using budgetary policy as a stabiliser of domestic economic activity. 4 marks 4. Explain how the existence of long time lags reduce the effectiveness of using some discretionary budgetary initiatives as a stabiliser of aggregate demand and economic activity during a recession. 4 marks 5. A possible advantage of using budgetary measures is that they can target particular economic problems more precisely. Explain, giving possible examples. 4 marks Fully worked solutions and sample responses are available in your digital formats. UNCORRECTED PAGE PROOFS

PART B Aggregate demand monetary policy and the pursuit of domestic economic stability

4.10 Definition and aims of monetary policy, and the role of the RBA

KEY KNOWLEDGE • the role of the RBA with respect to monetary policy as outlined in its charter. Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission Have you ever wondered what the Reserve Bank of Australia (RBA) actually does and how it helps to manage our economy? Well, we are about to find out. In fact the RBA makes important decisions that influence levels of inflation, economic growth, unemployment and living standards. As we shall see, it does this by implementing monetary policy that involves changing interest rates as a way of influencing the level of spending and economic activity. For example, in the recession of 2020, it cut interest rates to their lowest rate ever, to help stimulate AD, whereas in the boom of 2006–08, it raised interest rates in an attempt to quieten spending and economic activity to more sustainable levels, improving our wellbeing. UNCORRECTED PAGE PROOFS

Monetary policy is an aggregate demand management strategy that is implemented by the Reserve Bank of Australia (RBA). It mainly involves manipulating the actual cash rate of interest, thereby more broadly affecting other interest rates and the level of AD. By changing interest rates in a countercyclical way, the RBA can help to stabilise the level of economic activity and improve the achievement of Australia’s key domestic macroeconomic goals and living standards.

As mentioned, monetary policy is an aggregate demand strategy because as we shall soon see, changes in interest rates can affect the levels of AD, especially household (C), business (I), and even net overseas spending (X–M by influencing the exchange rate). 4.10.2 Role of the Reserve Bank of Australia The RBA is our country’s independent central bank and is accountable to the parliament. Under its charter, it has four main responsibilities or roles: • The RBA implements monetary policy involving changes in interest rates designed to influence AD and improve domestic macroeconomic conditions. This role was outlined in the Reserve Bank Act of 1959: “… to ensure that the monetary and banking policy of the [Reserve] Bank is directed towards the greatest advantage of the people of Australia and that the powers of the Bank … are exercised in such a manner … as will best contribute to the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic welfare and the prosperity of the people of Australia.” Essentially this statement is saying that the RBA has the responsibility to pursue Australia’s key macroeconomic goals and promote better material wellbeing. The phrase, “stability of the currency” is actually referring to the aim of maintaining the purchasing power of money by avoiding rapid inflation and promoting the goal of price stability. • The RBA is responsible for issuing coins and notes and is custodian of Australia’s reserves of foreign currencies. • The RBA is banker to the federal government. For instance, here it might arrange the issue of government bonds to help finance budget deficits. • Finally, the RBA acts as banker to our commercial banks. 4.10.3 The macroeconomic aims of monetary policy The RBA uses monetary policy involving changes in interest rates to pursue three key domestic macroeconomic goals, thereby helping to create optimal conditions for better living standards. The pursuit of the goal of low inflationUNCORRECTED PAGE PROOFS Foremost, the RBA sees the goal of low inflation as its number one priority since this is a precondition for prosperity and better living standards. Inflation targeting (summed up as ‘fighting inflation first’) means achieving an average inflation rate of between 2–3 per cent a year over time. This is the medium-term operational aim of monetary policy. While the RBA uses changes in consumer prices as measured by the headline CPI to help guide policy decisions, it particularly notes trends in the core or underlying inflation rate,

because this excludes price changes caused by one-off, temporary events. The underlying CPI provides a better guide to any emerging inflationary problems.

Hence, when inflationary expectations exist and there are signs that inflation will accelerate to exceed the upper end of the 2–3 per cent target range (and especially when core inflation is up), the RBA will normally tighten its stance (set higher interest rates) in a countercyclical way, to depress inflationary expectations, slow the growth of AD or spending, and curb economic activity to a sustainable rate. Additionally, by slowing AD and economic activity, rises in interest rates help to soften the demand for labour, and hence ease wage pressures that might otherwise cause cost inflation.

The pursuit of the goals of strong and sustainable economic growth and full employment When inflation is not a threat and there is unused productive capacity, the RBA usually turns its attention to other aspects of domestic economic stability such as the pursuit of a strong and sustainable rate of economic growth, full employment and the economic welfare and prosperity of Australians. So when the level of economic activity is too weak and inflation is too low, the RBA typically adopts and expansionary, accommodative or looser monetary policy stance to help stimulate AD, strengthen economic and employment growth, promote prosperity, and boost living standards. The priorities of monetary policy over the last two years As previously noted, the RBA’s charter requires that monetary policy is applied in ways that promote ‘the stability of the currency’ (i.e. low inflation), ‘the maintenance of full employment’, and ‘the general wellbeing and economic prosperity of Australians’. Recently during 2020, 2021 and 2022, the macroeconomic environment was weak. Key goals were not well achieved. On average, inflation was too low. There was a recession in the first half of 2020, the subsequent recovery was uncertain. Following a spike in unemployment in 2020, labour market conditions showed there was unused capacity and wage growth remained slow. Given this, the RBA adopted and maintained record low interest rates of just 0.10 per cent, as it pursued its two key aims: • to strengthen the rate of economic growth • to drive down the rate of unemployment (perhaps as low as 4.0 per cent). As reported in various RBA statements, if the current policy is successful, stronger spending, faster economic growth and lower unemployment, would eventually start to exert some upward pressure on wages, and thus help return inflation to within the desired 2–3 per cent target zone. While there were some positive signs of recovery over 2020–21 with stronger GDP growth and lower unemployment, much uncertainty remained during the latter part of 2021 and into 2022. Indeed, the RBA has recently repeated that it does not expect to raise interest rates till 2023 at the earliest. Resourceseses Resources Weblinks Monetary policy Monetary policy and the Federal Reserve UNCORRECTED PAGE PROOFS TOPIC 4 Aggregate demand policies and domestic economic stability 337

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4.10 Quick quiz 4.10 Exercise 4.10 Exercise 1. Define what is meant by monetary policy. 1 mark 2. Outline the main goals or priorities of the RBA’s monetary policy over the last two years. 2 marks 3. a. Explain what is meant by inflation targeting. 2 marks b. Explain the ways in which monetary policy is regarded as an aggregate demand policy. 2 marks c. Identify and outline the main responsibilities of the RBA, according to its 1959 charter. 1 mark d. If inflation is below the target range, explain the likely aims of RBA monetary policy. 2 marks e. Outline the main priorities of the RBA’s monetary policy during the past two years. 2 marks Fully worked solutions and sample responses are available in your digital formats. 4.11 Conventional monetary policy and how the RBA can affect interest rates KEY KNOWLEDGE • conventional monetary policy (cash rate target) and how it affects interest rates. Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission Interest rates represent the cost or price of borrowing credit and the reward or incentive to save income. They are determined in financial markets by the forces of demand and supply. Standard or conventional monetary policy involves the RBA’s direct guidance of the cash rate of interest that applies in the overnight or short-term money market (abbreviated STMM). In turn, the cash rate acts as a reference rate that indirectly allows the RBA to influence longer-term interest rates (e.g. interest rates on loans to business like overdrafts, interest rates on home loans or mortgages, interest rates on bankcard credit, or interest rates paid on savings accounts). This close connection between short- and longer-term interest rates reflects the fact that there is competition between financial markets. Because the level of interest rates can have a strong effect on AD (C+I+G+X−M), the RBA uses its conventional monetary policy in a countercyclical way to help steer the economy along the narrow path between recession on the one hand, and an inflationary boom on the other. This is illustrated hypothetically in figure 4.17. So, for example, during a recession, the RBA is likely to adopt a looser or perhaps more expansionary monetary policy stance to lift the economy by announcing a cut in the cash rate that it directly controls in the short-term money market. This would then indirectly put downward pressure on other interest rates, making credit cheaperUNCORRECTED PAGE PROOFS and encouraging households and businesses to borrow and spend more, rather than save. Through what we call transmission mechanisms (to be explained shortly), lower interest rates countercyclically help to stimulate AD and economic activity, strengthening domestic macroeconomic conditions.

FIGURE 4.17 Conventional monetary policy involves the RBA changing interest rates in a countercyclical way to help soften or flatten the severity of the business cycle

Economic activity (Annual percentage change)

In an inflationary boom, typically, a tighter monetary policy stance is used involving a rise in the RBA’s cash rate target, to slow AD

–2 4 6 0 In a recession with high unemployment and unused capacity, typically, a looser monetary policy stance is used involving a cut in the cash rate target to lift AD Potential non-inflationary rate of economic growth (perhaps around 3% rise per year). Time in years In reverse, during a boom, the RBA is likely to adopt a tighter or more contractionary stance by lifting the cash rate in the short-term money market. Indirectly, this again puts upward pressure on other interest rates and makes borrowing and spending dearer, while at the same time, rewarding saving. Finally, through various transmission mechanisms, a higher cash rate in a boom helps to countercyclically slow AD and economic activity, improving domestic macroeconomic conditions. This broad outline shows how monetary policy can be applied to help manage the level of aggregate demand. However, we now need to go back to fill in the details of how the RBA can directly control the cash rate of interest in the short-term money market. 4.11.1 The short-term money market and the cash rate target Let’s start by looking at the short-term money market (abbreviated STMM). Essentially, this is the market set up by the RBA, where banks borrow cash from and lend cash to each other, for very short periods of time- perhaps just overnight. This market is important to enable transactions between banks and their customers to be cleared at the end of each day’s trading. To facilitate this, each of our banks is legally required to hold a positive cash balance in its own exchange settlement account (ESA) with the RBA. For instance, a NAB customer may pay a customer of the CBA $1m, so that at the end of the day, NAB will need to shift cash into the CBA’s ESA. If the NAB’s cash balances are insufficient or in deficit, it would need to quickly borrow or demand cash at an agreed interest rate from another bank, perhaps the CBA, that may have a cash surplus and be keen to earn extra interest to grow its profits. This means that at the end of each day, one bank could only have a cash surplus in its ESA if some other bank has a cash deficit. Overall, the total amount of cash circulating in the STMM is normally relatively stable or fixed (if for the time being, we exclude the impacts of changes in government taxation and other receipts, and variations in government welfare payments and other outlays on this cash market). Figure 4.18 illustrates some of the basic features of the STMM. 2 UNCORRECTED PAGE PROOFS