HSC ECONOMICS – TOPIC 4: Economic Policies & Management

7 Economic Objectives

1) Sustainable economic growth (3-4% p.a.) 2) Price stability (RBA: 2-3%) 3) Full employment (~4.5% / NAIRU) 4) External stability (CAD ~3-4% of GDP) 5) Environmental sustainability (ESD) 6) Improved living standards (maximise wellbeing) 7) Equitable distribution of income (reduce inequality)

Sustainable Economic Growth target

3-4% per annum; if too high (>4%): demand-pull inflation, pressure on natural resources, undermines external stability (more imports, worse CAD); government target allows benefits while mitigating the problems of excessive growth

Price Stability target

RBA target of 2-3% inflation over the medium term; below 2% signals low AD → slower improvement in living standards + more unemployment; above 2-3% erodes purchasing power and reduces real incomes; too low risks deflation (slow wage growth)

Full Employment target

~4.5% unemployment (NAIRU); lowest unemployment rate without causing excessive inflation; the lowest sustainable unemployment rate; no cyclical unemployment in the economy

External Stability target

CAD should be low (~3-4% of GDP) so Australia can maintain foreign obligations (repaying servicing costs on loans, buying imports); exchange rate should remain stable; debt servicing ratio (ratio of debt service payments to export earnings) should be low and sustainable

Environmental Sustainability (objective)

Level of economic activity that preserves natural resources for future generations; pacing use of natural resources; government must develop policies promoting economic growth while preserving the natural world; key challenge: global warming, deforestation, biodiversity loss, air pollution

Improved Living Standards (objective)

Aim to maximise wellbeing of the Australian people; quantitative measures: household income, life expectancy, education and literacy; qualitative indicators: happiness, job satisfaction; widely used indicator = HDI (life expectancy, educational attainment, per capita income)

Equitable Distribution of Income (objective)

Government aims to fairly distribute income and wealth across the population by minimising gaps between rich and poor; government only aims to REDUCE inequality (not eliminate it) — eliminating inequality would disincentivise hard work and entrepreneurial risk-taking

Demand-side policies

Increase the level of AD to the point of full employment and price stability; work in the short term; countercyclically regulate the size of fluctuations in the business cycle; include fiscal policy and monetary policy

Supply-side policies

Make the economy more efficient and productive by lowering costs of production; increase AS in the longer term (takes ~10 years); include microeconomic reform; more preferable than demand-side as they ease inflationary pressures

=== CONFLICTS BETWEEN OBJECTIVES ===

Conflict: Inflation & Unemployment

Decreasing unemployment by increasing growth may increase inflation; inverse relationship captured in the Short-Run Phillips Curve (SRPC); key short-run policy trade-off

Conflict: Inflation & Growth

Higher AD levels increase price levels; excessive AD is unsustainable; inflation rises if government implements expansionary macro policy to boost growth; only a genuine conflict when inflation is ALREADY high but growth is still sub-par — then government must prioritise; when AS increases at similar rate to AD, both price stability AND sustainable growth can be achieved simultaneously

Conflict: Environmental Sustainability & Growth

When economic growth increases, production and consumption also increase → more natural resources used (minerals, timber), more pollution and waste, ecosystem damage, climate change; contrastingly, environmental policies (e.g. carbon tax) impose additional costs on firms → higher prices → reduces economic growth; trade-off illustrated on the PPF

Conflict: External Stability & Growth

Higher economic growth → more imports (rising incomes → consumers buy more imports → worse BOGS → worse CAD → threatens external stability); BOP Constraint: when CAD becomes so large that government must reduce economic activity to discourage import spending; also, rapid growth → lots of investment → if insufficient domestic savings → borrow from overseas → more debt

Conflict: Equitable Distribution & Economic Growth

More equal income distribution = less incentive for people to upgrade skills for higher-paying jobs → less productive workforce → less AS and output/growth; but excessive inequality reduces consumption and growth (lower MPC households have less income)

Short-term policy goal

Government responds in the short term through macroeconomic policy to manage growth, inflation and unemployment; aims to keep growth between extremes of boom and recession (countercyclical macro policy)

Long-term policy goal

Aim to 'beat' the inflation-unemployment conflict by achieving lower unemployment while maintaining price stability; increase AS AND lower NAIRU simultaneously; AS increase = more resources and efficiency → more output and AD without inflation; reducing NAIRU: lower structural Ue through retraining/relocation; lower frictional Ue through job search programs

=== FISCAL POLICY ===

Fiscal Policy (definition)

A macroeconomic tool of government that utilises the annual federal budget to adjust taxation and expenditure to affect sustainable economic growth, resource allocation and income distribution

Three goals of Fiscal Policy

1) Redistribute income (make economy more equitable through income taxation and transfer payments) 2) Reallocate resources (redirect resources to address market failures; fund public and merit goods; discourage demerit goods) 3) Reduce fluctuations in the business cycle for sustainable growth

The Budget

An annual statement from the government of all planned income and expenditure for the forthcoming financial year; announced every second Tuesday in May; shows whether government forecasts a deficit or surplus at end of fiscal year

Budget Revenue sources

Direct and indirect taxes; selling public assets; operation of government enterprises

Budget Expenditure categories

Welfare system, health, education, transport, defence etc.

Headline Cash / Headline Budget Balance

All cash in and cash out for the government — what newspapers report in headlines; includes ALL government cash transactions; Revenue − Spending; measured on a cash basis

Underlying Cash / Underlying Budget Balance

Cash in and out for the government EXCLUDING major asset sales and one-off transactions from revenue; the preferred measure used by economists and government; measured on a cash basis

Fiscal Budget Balance

Measured on an accruals basis — financial obligations to pay and financial entitlements to revenue DURING the period (not when cash changes hands)

Budget Surplus

Occurs when T > G (tax revenue exceeds government spending); contractionary effect — removes money from the economy

Budget Deficit

Occurs when T < G (government spending exceeds tax revenue); expansionary effect — injects money into the economy

Contractionary Fiscal Policy

Fiscal policy resulting in a reduction in economic activity; involves increasing taxation AND decreasing spending; aims to contract economy; creates a smaller deficit or bigger surplus; dampens AD

Expansionary Fiscal Policy

Fiscal policy resulting in an increase in economic activity; involves reducing taxation AND increasing spending; aims to expand economy; creates a smaller surplus or bigger deficit; stimulates AD through the multiplier

Government Deficit vs Government Debt

Deficit = amount government spends annually in excess of taxation revenue (a FLOW); Debt = total amount a government owes, made up of all accumulated borrowing including to cover past deficits (a STOCK)

Discretionary Fiscal Policy

Planned spending and revenue measures deliberately decided on by the government and recorded in the budget; intentionally formulated; e.g. if slow EG is predicted, government boosts AD by increasing G and lowering T

Non-Discretionary Fiscal Policy (Automatic Stabilisers)

Changes in expenditure and revenue that arise automatically due to changes in the business cycle WITHOUT any change in policy; features of FP that act to offset changes in economic activity; act counter-cyclically

Automatic Stabilisers — Taxation system

Lower GDP → lower household income → lower income tax receipts → lower company profits → lower company tax → government revenue falls automatically; Higher GDP → higher progressive income tax receipts → more government revenue automatically

Automatic Stabilisers — Transfer system

Lower GDP → lower household income → more reliance on welfare → more government spending; Higher GDP and household income → lower welfare payments → less government spending; result: during growth, less G + more T contracts economy; during contractions, more G + less T expands economy

Structural vs Cyclical Budget Components

Structural component: changes to budget outcome due to DISCRETIONARY policy changes; Cyclical component: changes to budget outcome due to AUTOMATIC stabilisers (the business cycle)

=== FISCAL POLICY — REDISTRIBUTION & RESOURCE ALLOCATION ===

Fiscal Policy — Redistribution of Income

Goal of creating a fairer (more equitable) distribution of income and wealth; main tools: progressive tax system, transfer payments, social wage; reduces gap between high and low income earners

Progressive Tax System

As income increases, you move into a higher tax bracket and pay more tax as a proportion of income; richest 40% pay 90% of Australia's total $252bn in income tax; there is a tax-free threshold (no tax on first $18,200); REDUCES income inequality

How to increase progressivity of tax system

Increase the tax-free threshold; increase marginal tax rates of the highest income bracket; reduce marginal tax rates of lower income brackets; change where tax band thresholds/boundaries sit

Regressive Tax System

A tax that impacts lower-income earners more significantly as it makes up a greater proportion of their income; e.g. GST (10% on all G&S) and excise taxes; WORSENS income inequality

Transfer/Social Welfare Payments

Government redistributes income collected in the tax system to lower income earners; increases their disposable income (Yd); reduces difference in income levels; e.g. JobSeeker unemployment benefit; accounts for ~35% of government expenditure

Social Wage

In-kind benefits provided by government: public health, housing, community services, education; effectively boosts real income of lower quintiles; IMPROVES income inequality

Fiscal Policy — Resource Allocation

Government uses taxation and direct expenditure to direct resources to areas of the economy needing them; directs resources TOWARDS public and merit goods (under-provisioned by private sector); directs resources AWAY from demerit goods (through high taxes); can use direct spending or indirect taxes on harmful goods (e.g. tobacco, carbon)

=== USE OF BUDGET SURPLUS ===

Use of a Budget Surplus — Pay off debt

Domestic: more money available in domestic banks → more C + I; Overseas: Australia's financial liabilities fall → eases CAD → improves external stability; Howard/Costello government used successive surpluses to pay back principal on existing government debt

Use of a Budget Surplus — Special Wealth Fund

Investing surplus into a fund for future use; e.g. Future Fund (2006): deposits money to pay superannuation of retired public servants; Building Australia Fund (2009): finances investment in transport, communications and utility infrastructure

=== METHODS OF FINANCING DEFICITS ===

Monetary Financing (Borrow from RBA)

RBA prints money to cover shortfall in government revenue; governments became wary of this approach as monetarism (accepted in the 1980s) showed that increasing money supply causes long-term inflationary pressures

Debt Financing (Borrow from domestic private sector)

Current method — government sells Commonwealth Government Securities (CGS/treasury bonds) to financial institutions and superannuation funds under a tender system (lowest bidders first); money borrowed is eventually returned without increasing foreign debt

Crowding Out Effect

The disadvantage of debt financing; government removes money from the domestic savings pool → reduces supply of money available for private loans → puts upward pressure on domestic interest rates → private sector investors (firms) are 'crowded out' of domestic market and may have to borrow overseas at higher rates → could decrease I and AD

Borrow Overseas

Government issues CGS to overseas markets; accumulates both government debt AND net foreign debt → worsens external stability; however, avoids crowding out the domestic private sector; Australia's AAA credit rating allows relatively low funding costs compared to high-risk nations (e.g. Greece)

Sell Assets

Howard government sold 75 assets to finance significant deficit (e.g. Telstra, Sydney Airport); allows relatively quick acquisition of funds; however, represents a loss of public ownership; privatisation of assets often unpopular with the public; NOTE: selling Commonwealth assets is NOT a method of financing the UNDERLYING cash deficit — it reduces the headline deficit or creates a larger headline surplus

=== BENEFITS & LIMITATIONS OF FISCAL POLICY ===

Benefits of Fiscal Policy — Specific Targeting

FP can target specific areas of the economy; different states, industries and sectors experience different situations; a blanket policy may do more harm than good; FP is a versatile and precise instrument able to target specific sectors

Benefits of Fiscal Policy — Supply-side effects

Policies can have long-term benefits for AS; e.g. cutting company tax: ST = boost growth; LT = increased investment in capital, productive capacity and AS; spending on infrastructure: ST = employment and growth; LT = better transport → goods traded faster → more AS

Limitations of Fiscal Policy — Time Lags

Medium implementation lag: budget is only announced annually and must pass through Parliament before taking effect; however, FP has a relatively SHORT IMPACT lag once implemented → makes FP the most effective macro policy in response to sharp economic shocks/downturns; also, policy may be inappropriate when effects finally emerge

Limitations of Fiscal Policy — Political Considerations

New laws need a majority of votes in Parliament — recent governments have struggled to achieve majority; governments are often reluctant to introduce long-term policies with negative short-term effects (can lose votes); e.g. cutting trade protection boosts LT growth but causes short-term Ue

Limitations of Fiscal Policy — Global Considerations

Expectations of global financial markets and investors can hinder what government wants to do (e.g. pressure for lower government spending and lower company taxes); integration of international business cycle means some issues are out of government control; policy stances need to align with other advanced economies (e.g. trade-related, environmental policies); low global growth limits the impact of any expansionary FP

Limitations of Fiscal Policy — Conflicting Objectives

Natural conflicts between goals mean FP cannot achieve all objectives simultaneously; sustained budget deficit worsens CAD and foreign debt (via crowding out → domestic investors borrow overseas → NPY debits increase → CAD worsens; OR if borrowed directly from overseas → NPY debits add to CAD)

Policy Coordination (FP and MP)

If monetary policy and fiscal policy work in OPPOSITE directions, this hinders the ability of each policy to achieve its intended goal; they should ideally work in the same direction; recent example: FP was somewhat expansionary (cost of living support) while MP was contractionary (raising OCR to fight inflation) — opposing stances

=== MONETARY POLICY ===

Monetary Policy (definition)

The management of interest rates by the RBA in order to influence economic activity; all actions taken by the RBA to influence the cost and availability of money and credit in the economy; RBA meets every month (except January) to increase, maintain or lower the cash rate

Expansionary (Loosening) Monetary Policy

Involves REDUCING the cash rate (OCR); used to stimulate growth in the economy; increases demand through the transmission mechanism; e.g. cutting OCR → cheaper borrowing → more C and I → higher AD

Contractionary (Tightening) Monetary Policy

Involves INCREASING the cash rate (OCR); used to dampen growth in the economy; decreases demand through the transmission mechanism; e.g. raising OCR → more expensive borrowing → less C and I → lower AD → reduces inflation

RBA Objectives

1) Price Stability: maintain inflation at 2-3% over the business cycle 2) Full Employment: avoid cyclical unemployment, operate at NAIRU 3) Economic Welfare: encourage a sustained level of economic growth

Why does the RBA target 2-3% inflation?

Tracks success with a clear numerical range; provides a clear goal for RBA decisions; anchors inflationary expectations (consumers and businesses plan around this range); underpins job creation; protects savings; preserves value of currency; workers less keen to make excessive wage demands; managers less inclined to raise wages unnecessarily

=== MONETARY POLICY IMPLEMENTATION ===

Exchange Settlement Accounts (ESA)

Each financial institution has an ESA held with the RBA; daily transactions between banks and between banks and the RBA are 'settled' via these accounts; banks must maintain sufficient funds in their ESA

Cash Rate (OCR — Official Cash Rate)

The interest rate within the short-term money market (market for overnight loans between financial institutions); RBA influences this rate to move it toward its monetary policy target; foundation for all other interest rates in the economy

Policy Interest Rate Corridor

A range of potential rates with an upper bound (lending rate) and lower bound (deposit rate) around the target cash rate; after an RBA decision, the corridor shifts to reflect the new OCR target

Corridor — Lending Rate

The rate at which the RBA will lend funds to banks that need to fund a shortfall in their ESA balance; banks have no incentive to borrow from another bank at a higher rate because they can just borrow from the RBA at this rate → sets the ceiling

Corridor — Deposit Rate

The rate the RBA will pay on deposits made by banks with surplus funds in their ESA; banks have no incentive to lend surplus funds to other banks at a lower rate because they earn more through the RBA → sets the floor

Domestic Market Operations (DMO)

The RBA's main mechanism for implementing monetary policy; RBA buys/sells Commonwealth Government Securities (CGS) to/from financial institutions to change the level of funds in banks' ESA balances; 'Buy to boom, sell to slow'

DMO — Buying CGS

RBA BUYS CGS from banks → money flows INTO banks' ESA accounts → money supply INCREASES → cash rate DECREASES → expansionary MP → used to stimulate economic activity

DMO — Selling CGS

RBA SELLS CGS to banks → money flows OUT OF banks' ESA accounts → money supply DECREASES → cash rate INCREASES → contractionary MP → used to dampen economic activity

How OCR translates to broader interest rates

Banks follow movements in OCR when setting their own rates; Higher OCR → banks pay more to borrow → to maintain profit margins, banks raise interest rates for households and firms; Lower OCR → cheaper for banks to borrow → banks lower interest rates to remain competitive

Transmission Mechanism

The 6-18 month process by which a change in monetary policy (cash rate) impacts AD and the level of inflation in the economy; has both internal mechanisms (affecting C and I) and external mechanisms (affecting X and M)

=== MP CHANNELS ===

Savings & Investment Channel

Increase in OCR → higher returns on savings → incentive to save more / borrow less → less C and less I (higher mortgage repayments lower housing demand); Decrease in OCR → encourages borrowing → more C; lower rates → cheaper loans for firms → more I (capital investment); NOTE: currently limited empirical correlation — more FP influence on investment

Cash Flow Channel

Increase in IRs → higher repayments on EXISTING debt (mortgages) → less disposable income → less C; HOWEVER, also increases returns on savings for some → more disposable income for savers; Decrease in IRs → lower repayments on existing debt → more disposable income → more C

Wealth Effect Channel

Higher IRs → lower demand for housing → lower house prices → less wealth → less C (negative wealth effect); Lower IRs → higher demand for assets (houses) → higher asset prices → households feel wealthier → more C (positive wealth effect)

Exchange Rate Channel

If OCR decreases → lower returns in Aus → foreign investors move money elsewhere → sell AUD → AUD depreciates; If OCR increases → higher returns in Aus → more foreign investment → more AUD demanded → AUD appreciates; Lower OCR → lower AUD → cheaper exports → more X; more expensive imports → less M → net exports rise → more AD

=== BENEFITS & LIMITATIONS OF MONETARY POLICY ===

Benefits of Monetary Policy — Short Implementation Lag

RBA makes monetary policy decisions every month (except January); issues in the economy can be acknowledged and addressed quickly; if low economic growth emerges, RBA can respond faster than the government can through fiscal policy

Benefits of Monetary Policy — Freedom from Political Constraints

RBA acts on behalf of the government but is separate from it (independent central bank); RBA only considers its economic objectives, not political popularity or electoral cycles; this makes MP more credible and consistent

Limitations of Monetary Policy — Blunt Instrument

Growth in certain areas of the economy cannot be specifically stimulated; attempting to target one area may have undesired effects on other sectors; less adaptable and precise than FP (cannot target specific industries or regions)

Limitations of Monetary Policy — Long Impact Lag

Changes to the cash rate take 6-18 months to take full effect due to households and businesses taking time to adjust spending and saving behaviour; difficulties in predicting: policy decisions made now might not be appropriate to economic conditions 6-18 months later

Limitations of Monetary Policy — Global Limitations

Significant external, global shocks to the Australian economy are outside the RBA's control; e.g. COVID (global supply chain constraints, border closures), Russia-Ukraine War (supply chain concerns and higher commodity prices); since inflation targeting began in 1993, average inflation has been 2.6% — demonstrates overall success

Household Debt and Monetary Policy effectiveness

High household debt (currently ~180% of disposable income) may be making MP MORE effective; when rates were low (expansionary), consumers chose to pay off debt rather than consume more; when rates rise (contractionary), higher repayments severely reduce consumption — amplifying the contractionary effect

Opposing MP and FP stances

FP and MP can work in opposite directions; recent example: FP had some expansionary elements (cost-of-living support) while MP was contractionary (raising OCR to fight inflation) — opposing stances reduce overall policy effectiveness

=== MICROECONOMIC POLICIES ===

Productivity (definition)

The ratio of output produced to inputs used; measures how efficiently inputs (e.g. labour, capital) are used to produce outputs; key source of long-term economic growth, business competitiveness and real per capita income growth

Labour Productivity

Ratio of output to input of labour; factors include workers' skills, technological change, management practices, and changes in other inputs (e.g. capital); key driver of wage growth and living standards

Multifactor Productivity (MFP)

Measured on the basis of COMBINED inputs of labour AND capital; gives a broader picture of productivity improvement than labour productivity alone

Technical Efficiency (Productive Efficiency)

The ability to achieve the maximum level of output with a given quantity of inputs; 'highest output for fewest inputs'; can be improved through technological innovation and specialisation; a key goal of microeconomic reform

Allocative Efficiency

Ability of the economy to allocate resources to where it has a comparative advantage; e.g. removal of car industry tariff protection → resources reallocated from the car industry to more efficient industries; resources move to their highest-value use

Dynamic Efficiency

Ability of the economy to reallocate resources in response to changes in consumer demand or market conditions; all about INNOVATION and embracing new technology to produce more for less; the quicker the adaptation, the more dynamically efficient

Effects of Higher Productivity

Higher growth: more outputs per input → more goods produced → GDP rises → AS increases (productive capacity grows); Lower inflation: fewer inputs needed per unit of output → cheaper output prices → eases cost-push inflationary pressures