Reserve Bank of Australia Competition Question: The essay topic for this year is Policy Responses to the Global Financial Crisis. Many countries around the world are responding to the global financial crisis and the associated economic downturn with stimulatory fiscal and monetary policies. Discuss the appropriateness of these policy responses, and the extent to which the exact nature of these responses might matter. Essays should provide an overview of the theoretical arguments and also briefly consider the evidence, including the approaches adopted by different countries in the past.
Introduction This paper is subject to the analysis of the appropriateness of expansionary monetary and budgetary policies adopted by several countries in response to the Global Financial Crisis, as well as the extent to which the responses might matter. In doing so, the Global Financial Crisis is defined, as well as the macroeconomic policies concerned. The reasons for and outcomes of past approaches adopted by several countries during the Asian Financial Crisis will be briefly outlined. Additionally, the short run and long run impact of expansionary monetary and fiscal/budgetary policy on the economy will be illustrated using the Keynesian theory as well as the IS-LM model. This will further assist in verifying the appropriateness of the policies and the extent to which the responses matter.
Background Information The Global Financial Crisis originating in the United States of America was the result of the surge in the liquidity crisis. According to the Board of Governors of the Federal Reserve System in the United States of America (2009), prices of houses diminished sharply in the U.S. causing a reduction in risk taking by investors, as investments were pulled back. As a result “liquidity diminished sharply in the market for interbank funding and structured products more generally” (Board of Governors, 2009, p.6). The performance of subprime mortgage lending was deteriorating as the prices continued to decline in 2008 and an increase in delinquencies in mortgages as well as defaults surged. The Federal Reserve stated that “strains in financial conditions intensified going into the second half of the year” calling upon the need to implement “subsequent monetary policy...and measures thereby taken by the Federal Reserve to bolster the liquidity of financial institutions” (Board of Governors, 2009, p.6). Ultimately, the subprime mortgage financial crisis in the U.S.A resulted in the Global Financial Crisis.
Lesson Learnt The lessons learnt from past financial crises can be used in order to determine the appropriateness of stimulatory macroeconomic policies in response to the global financial crisis. The Asian financial crisis (1997) which spread in economies such as Indonesia, South Korea and Thailand was the result of relatively high levels of interest rates, depreciating exchange rates and relatively high levels of inflation. The International Monetary Fund’s response included “a temporary tightening of monetary policy to stem exchange rate depreciation” in their “immediate effort to re-establish confidence” (IMF, 1999). When the market started to recover from the loss in confidence, an expansionary monetary policy was implemented in order to lower the interest rates. A fiscal tightening occurred in Thailand in the objective of reversing the surge in the previous year’s deficit (IMF, 1999). Contractionary monetary policy was deemed appropriate for the reason that it was effective in “reversing exchange rate pressures and preventing inflationary spirals” (IMF, 2000). The lesson learnt from the Asian financial crisis was that “fiscal policy could have done more to counteract the decline in private demand” and that monetary policy was utmost necessary in responding to a financial crisis (IMF, 2000).
Monetary Policy In response to the Global Financial Crisis, the Australian central banks as well as the U.S.A and Chinese central banks have adopted stimulatory macroeconomic monetary policies in order to fight the downturn in economic activity, employment and equity. Australia’s central bank, the Reserve Bank of Australia possesses the following functions: “1. the banker to the government and other banks; 2. Implementer of monetary policy and; 3.Lender of ‘last resort’ to the banks” (Morris, 2004, pg.342). The monetary policy is one of the major categories “of government economic policy. It is implemented by the RBA and is designed to influence the cost, availability and demand for credit and money” in the economy (Morris, 2004, pg.330). In response to the global financial crisis, the RBA took two steps in the implementation of monetary policy. The first stage was the announcement of the reduction in the cash rate target by 25 basis points on the 3rd of September 2008. This had a significant psychological impact on financial institutions and the overall financial market. Additionally, the RBA used ‘persuasion’ (a monetary policy tool) in order to emphasize the cash rate and the interest rates that the financial intermediaries charge, which affect household and business decisions on expenditure (Campbell, 2001). Additionally, the second step involved the RBA undertaking open market operations in their objective of bringing the free forces of demand and supply into equilibrium at the desired cash rate target. The free forces of demand and supply determine the actual cash rate. However, demand is determined by the demand derived from the settlement of deposits and the supply is determined by the RBA’s “supply of cash via its domestic market operations” and for the reason that the RBA is the monopoly supplier of exchange settlement (ES) funds it has the market power to determine the target of the cash rate (Campbell, 2001). Similarly to the Federal Reserve and the People’s Bank of China, the RBA implemented an expansionary loosening of monetary policy, intervening in the short term money market using market operations in order to influence the economy’s cash rate target and ultimately reduce the interest rate. The RBA, as stated under the Reserve Bank Act 1959 “is required to conduct monetary policy in a way that will best contribute to the [government macroeconomic] objectives of..” the stability of the currency in Australia (2-3% per annum Page.4/10
over the business cycle), the maintenance of full employment in Australia (at approximately 5% per annum) and “the economic prosperity and welfare of the people of Australia” (Crane, Fraser & Martin, 2009, p50). In response to the financial crisis, the RBA decreased the cash rate target in its objective of stimulating aggregate demand and economic activity. Moreover, when the RBA increased the money supply relative to the quantity of money demanded, an excess of supply resulted. This surplus ultimately decreased the real interest rate. Due to the theory of sticky prices, for the reason that the price level in the short run is fixed, the increase in money supply increases real money balances. The theory of liquidity preference states that “for any given level of income, an increase in real money balances leads to a decrease in interest rates” (Mankiw, 2007, pg.306). For this reason, the level of national income is increased. Additionally, given that the quantity of money that people hold is more than they want to at the existing interest rate, when the money supply is increased by the RBA the amount of deposits in banks or bonds are increased. Furthermore, “the rate falls until people are willing to hold all extra money that the Federal has created”, bringing the money market into a new equilibrium (Mankiw, 2007, p.307). The diagram below illustrates the decrease in interest rates increases planned investment and in turn increases planned expenditure, production and the level of income. However, in the long run, national income returns back to its original point at point C. The LM curve shifts back to the left, putting interest rates back to its original level at r1, as illustrated in the two diagrams below:
Overall, a decrease in interest rates by the RBA increases national income and output in the short run and increases the price level in the long run. The six cuts by the RBA in the cash rate target totalled a reduction of 425 basis points over the period of eight months, where the cash rate target fell from 7 percent on the 3rd of September 2008 to 3 percent on the 8th of April 2009 (RBA, 2009). In contrast, the U.S. Federal Reserve also undertook open market operations as they implemented an expansionary monetary policy cutting the Intended Federal Funds rate on the 18th of September 2003 for the first time since the year 2003 to 4.75 percent in response to the financial crisis. During the period 2007-2008 the Intended Federal Funds rate was slashed ten times down to 0-0.25 percent on the 16th of December 2008, from the 4.75 percent in September 2007, reducing the cost of credit by approximately 500-525 basis points as the Federal Reserve attempted to stimulate the U.S. economy (FRB, 2009). In order to further determine the appropriateness and the exact extent to which this expansionary monetary policy might matter in respect to responding to global financial crisis, the transmission mechanism resulting from the loosening of monetary policy will be outlined.
The transmission mechanism for the monetary policy explains how changes in the interest rates operate to control economic activity and slow inflation (Morris, 2004). The transmission mechanism, for lower interest rates will impact economic activity in three ways. These include the spending effect, the exchange rate effect and the effect on inflationary expectations. The reduction in the cash rate target which has been passed onto the end consumers through banks and financial institutions has encouraged credit based expenditure by the private sector. As private consumption increases, aggregate demand is increased. Ultimately economic activity and production is increased as illustrated in the previous diagram, â€˜short run and long run impact of an expansionary monetary policyâ€™. Additionally, the five cuts in the Australian cash rate target has impacted the real exchange rate to appreciate from AUD$0.6122/USD$1 on the 10th of August 2008 to AUD$0.8427/USD$1 on the 4th of August 2009. As the real interest rate increases, net foreign investment in Australia is reduced which in turn reduces supply in the FOREX market (market for foreign exchange), causing an appreciation in the exchange rate. More to the transmission mechanism and the impact on inflation, the consumer price index (CPI) has Page.6/10
been reduced from 5.0% in September 2008 to 3.7% during December 2008, to 2.5% in March 2009 down to 1.5% during the month of June. This illustrates price stability, whereby the level of inflation is increasing slowly at the desired 2-3%p.a rate over the period of the business cycle.
The global financial crisis witnessed banks being “reluctant to lend to one another” which resulted in “conditions in short-term funding markets continued to be strained" (Monetary Policy Report to the Congress, 2009, p.6). For this reason there was the need for the central banks to implement expansionary monetary policy in order to encourage lending between banks. In Australia, under RTGS (Real Time Gross Settlement), banks are encouraged to trade their exchange settlement funds between one another. The opportunity cost associated with the balances of Exchange Settlement Accounts “might be approximated by the difference between the interest rate banks would earn by investing overnight in the market, and the rate paid on balances held at the Reserve Bank”- the difference being 25 basis points (RBA, 1998, pg.55). Efficient systems enable the minimisation of this liquidity cost and for the reason that a relatively low opportunity cost is associated with ESAs under the efficient RTGS, banks are encouraged to trade their exchange settlement funds when the RBA implements expansionary monetary policy.
Budgetary Policy Furthermore to the policy responses to the global financial crisis, governments around the world have implemented expansionary fiscal/budgetary deficits. Morris (2004) defines the budget as “the government’s estimates of the expected value of its receipts and the expected value of its outlays, usually based on a one year period (p.296). In connection, Black (1997) defines budgetary (fiscal) policy as “the use of taxation and government spending to influence the economy” (p.179). A budget deficit is a situation where the “total value of government outlays exceeds the total value of its receipts for a period of time” (Morris, 2004, p.294). A fiscal deficit can be implemented by increasing government outlays relative to the collection of government revenue. The Australian, Chinese and the U.S. economies have adopted stimulatory budgetary policies for the period 2009-2010.
The Australia government implemented a $60 billion to $70 billion budget deficit in the objective of stimulating the economy (Curtis, 2009). The major focus of the Australian budget deficit is directed at heavy government investments in Nation Building Infrastructure with an emphasis on roads, rail, universities and energy efficiency as illustrated in the table below: The Australian Budget $22 Billion Nation Building Infrastructure $3.4 billion
Ports and Freight Infrastructure
Clean Energy Initiative
Universities and Research
Hospitals and Health Infrastructure
Partnership with the private sector: Building the $43 billion National Broadband Network (Information taken from the Budget at A Glance 2009).
In order to determine the appropriateness of this budget deficit and the extent to which the exact nature of this response might matter, the budget deficit is analysed to determine its impact on aggregate demand. As the Australian government injects $22 billion into the economy investing in projects such as road, metro rail, port and freight infrastructure, this investment increases the demand for output, including the demand for labour resources which results in an increase income and production. For the reason that every dollar from government expenditure increases aggregate demand by more than one dollar, a multiplier effect results. The multiplier effect occurs when “additional shifts in aggregate demand result when expansionary fiscal policy increases income” which results in an increase in private consumption and aggregate demand (Mankiw, et.al, 2005, p.749). The multiplier effect continues as private consumption, production and aggregate demand increases as illustrated in the multiplier effect diagram below: The Multiplier Effect Diagram: The Nation Building Infrastructure $22billion Project Price Level The $22billion Nation Building Infrastructure
The Multiplier Effect can increase the shift in aggregate demand (AD). QTY of Output (Y) The increase in government expenditure of $22billion initially increases AD by $22billion
In addition to the budget deficit and its impact on the Australian economy, the short run and the long run impact of an expansionary budgetary policy will be outlined using the leading interpretation of Keyne’s theory, the IS-LM model. The IS-LM model is “a model of aggregate demand that shows what determines aggregate income for a given price level by analysing the interaction between the goods market and the money market” (Morris, 2005, p.559). The budget deficit should stimulate planned expenditure, causing the IS curve- the Page.9/10
curve which illustrates the negative relationship between income that arises in the market for goods and services and the interest rate; to shift to the right as illustrated in the below diagram. Planned expenditure is the amount that the household, private and the government sector would like to spend on goods and services. The increase in planned expenditure resulting from an increase in government expenditure increases production and the level of national income resulting from the multiplier effect. In respect to this policy, the Keynesian cross states that the government purchases multiplier raises the level of income at any given interest rate. The liquidity preference theory states that an increase in the level of total income will increase the quantity of money demanded at every interest rate, given that demand is dependent on income. However, if the money supply has not been altered, a higher level of money demand will cause the real interest rate to increase in the long run, inducing firms to spend relative to save due to the increase in the cost of credit (Mankiw, 2007). Moreover, a decrease in investment â€œoffsets the expansionary effort of the increase in government purchasesâ€? and hence investment becomes unfavourable (Mankiw, 2007, pg.305). These events are illustrated in the diagrams below: Expansionary Budgetary Policy: The Short Run and Long Run impact Real Interest Rate
LM1 Price Level %
B A 3. Increase in the Real Interest Rate
1.Increase in IS by
5. The level of Y returns to its natural rate in the LR P2 SRAS 4. Prices remain the the same (Sticky prices) AD1
Output 2. Increase in Income
Nevertheless, in the long run, national income returns to its natural rate as AD decreases. The interest rate is further increased to R3 and the price level alters and is increased to P3. Consumption returns back to its natural level due to the increase in the price level and the Page.10/10
decrease in the real value of money. Ultimately an increase in the budgetary deficit will increase the price levels and the interest rate in the long run; however in the short run national income and output are increased which is significant in fighting the global financial crisis.
Responses to the Global Financial crisis have taken form in stimulatory macroeconomic policies. The Australian central bank, the RBA; as wells as The U.S.A and the People’s Bank of China have implemented an expansionary loosening of monetary policy as well as an expansionary budgetary/fiscal policy in the objective of stimulating the economy. Theoretically, the extent of these policies matter significantly in the short run as national income and output are increased. However in the long run the economy will experience increases in the consumer price index, as illustrated in the I-S/L-M diagrams. Factoring in John Maynard Keynes statement that “the long run is a misleading guide to current affairs... in the long run we are all dead”, it is important to note the significance of these expansionary monetary and budgetary policies during this period of economic downturn in order to restore confidence and economic activity as needed during the Asian Financial Crisis (1997). The objective of the Australian 2009-2010 Commonwealth Budget is to “support jobs today by investing in the infrastructure Australia needs for tomorrow” which is significant in bringing restoration to full employment. Additionally, current statistics as noted in this paper illustrates improvements in the global economy as “aggressive monetary policy... contributed to some recovery in the financial market” (Federal Reserve Board, 2009, pg.6). Early results also indicate improvements in the domestic economy illustrating an increase in real spending by 2 percent, a slowing in inflation to 1.5 percent to the June quarter in 2009 and a revised forecast in GDP from a decline of approximately 1 percent to an increase in half a per cent (RBA, 2009). For these reasons it is logical to conclude that expansionary monetary and budgetary policies are deemed utmost appropriate in responding to the Global Financial Crisis in the short term to the extent that the government objectives of price stability, full employment and equity in the redistribution of personal income have been better achieved.
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