Economics U4 AOS1
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34 Terms
KK1 - The need for AD policies
To help moderate the severity of instability, the Australian government has used a policy mix involving both AD and AS policies
3 macroeconomic goals
The goal of low and stable inflation (a slow average rise in general consumer prices averaging from 2-3 percent a year over time)
The goal of a strong and sustainable rate of economic growth (the fastest growth in national production - around 3 percent per year rise in GDP that does not accelerate or jeopardise the achievement of other economic and environmental goals)
The goal of full employment (the lowest unemployment rate - around 4.0 - 4.5 % of the labour force that does not accelerate inflation)
KK2 - what is monetary policy
What is monetary policy?
In Australia, monetary policy involves influencing interest rates to affect aggregate demand, employment and inflation in the economy
It is one of the main economic policies used to stabilise business cycles. The reserve bank is responsible for the monetary policy in Australia, and it sets a target for the nations official interest rate, which is referred to as the "cash rate target"
The cash rate target is the conventional tool of monetary policy in Australia
KK2 - The role of the RBA
The role of the RBA
The RBA implements monetary policy involving changes in interest rates designed to influence AD and improve domestic macroeconomic conditions
The RBA is responsible for issuing coins and notes and is custodian of Australia's reserves of foreign currencies
The RBA is the 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.
Keep in mind, the objectives of monetary policy are
Price stability
Economic prosperity and welfare
Full employment
KK3 - How does the RBA target the cash rate
The RBA intervenes in the overnight money market by setting a desirable cash rate target for this market
This is where banks will borrow and lend to each other in order to settle their ES accounts
The RBA intervenes by effectively placing a floor and a ceiling on the interest rate (P) in this market
KK4 - one example of the operation of an unconventional monetary policy tool from the past two years
Unconventional monetary policy
Unconventional monetary policy tools are used by the RBA in conjunction with conventional monetary policy to help achieve the three macroeconomic goals
Unconventional tools are mostly used in extreme situations
Examples include
Asset purchasing, forward guidance, yield targeting.
Forward guidance
Forward guidance involves the RBA providing information about the future course of interest rates and its monetary policy settings
The RBA publishes forward guidance through its monetary policy decision, monetary policy statements and other media releases
Throughout the first half of 2026, the RBA raised the cash rate three times taking it from 3.85% to 4.35% in response to inflation running persistently above target
In its communications the RBA signalled that "monetary policy is well placed to respond to developments" indicating readiness to keep adjusting rates depending on how the inflationary data evolves.
At its June meeting, the RBA held the cash rate at 4.35% but adopted a hawkish tone, explicitly stating it was prepared to consider "increasing the cash rate target further if required"
This forward guidance made clear that, unlike previous periods of cautious "wait and see" messaging, the boards stated conditions for a rate cut was inflation clearly returning towards 2-3% target band, while the condition for a further hike was continued strength in trimmed mean / underlying inflation data.
KK6 - the stance of monetary policy
The stance of monetary policy
How is the RBA using monetary policy to influence the level of AD?
Same concept as BP just a different tool (policy)
The stance of monetary policy
Contractionary = decrease AD = a slowdown in the economy
Restrictive or tightening
Expansionary = increase in AD = speedup the economy
Accommodative or loosening
Monetary policy neutrality
The neutral rate is the interest rate that neither stimulates nor restricts economic activity. At the neutral rate, monetary policy is considered neither expansionary nor contractionary. The neutral rate is consistent with
Inflation remaining sustainable within the RBAs 2-3% range
Economic growth occurring at its long-run sustainable rate
The economy operating close to full employment
The neutral cash rate cannot be directly observed and must be estimated using economic models
Recent RBA estimates suggest a nominal cash rate of approximately 2.7-3% (around 2.9 avg.)
Estimates change over time as economic conditions and productivity growth change.
Monetary policy stance
Above 2.9% = contractionary
Less than 2.9% = expansionary
Move closer to neutral = less
Move away from neutral = more
KK3 - convential monetary policy and how it effects interest rates
Banks have ESA accounrs that must be settled each day, the RBA pays banks the floor rate for depositing their money with them and charges banks the ceiling rate to borrow money, banks borrow from the RBA to settle their ESA accounts each day, this is called the overnight money market. (the ceiling and floor is .25 basis ± the cash rate)
KK3 - OMO’s
The use of open market operations to maintain the RBAS chosen cash rate target
Key idea
The demand for cash in the short term money market changes every day
Without intervention, these changes would cause the actual cash rate to move away from the RBA's cash rate target (CRT)
The RBA's solution: open market operations (OMO)
Each day, the RBA adjusts the supply of cash by buying or selling government bonds
Demand for cash rises -> upward pressure on cash rate
RBA pays government bonds from banks
Increases cash in the banking system (liquidity)
Supply of cash rises
Cash rate falls back towards the target
Demand for cash falls -> downward pressure on cash rate
RBA sells government bonds to banks
Withdraws cash from the banking system
Supply of cash falls
Cash rate rises back towards the target
Result
Daily OMO ensures the actual cash rate remains close to the RBA's announced cash rate target, allowing monetary policy to operate effectively.
Simple flow
Change in cash demand -> RBA OMO (buy/sell bonds) -> adjust cash supply -> actual cash rate stays near target
KK3 - RBA changing stance examples (question guidance)
- if the RBA cuts its cash rate target to stimulate AD and economic activity
- if the RBA decides to change the cash rate target and its monetary policy stance due to new economic conditions
If the RBA decides to cut its cash rate target to stimulate AD and economic activity
The RBA board announces a lower cash rate target in response to weak economic conditions
The interest rate corridor shifts down, with both the lending rate and deposit rate falling automatically
Banks are incentivised to borrow and lend within the new lower corridor, causing the actual cash rate to move close to the new target
The RBA then uses open market operations (OMOs) to manage liquidity and keep the actual cash rate near the target, helping lower broader interest rates and stimulate aggregate demand, economic activity, and employment.
If the RBA decides to change the cash rate target and its monetary policy stance due to new economic conditions
The RBA announces a higher cash rate in response to strong economic conditions
The interest rate corridor shifts up, with both the lending rate and deposit rate rising automatically
Banks are disincentivised to borrow and lend within the new lower corridor, causing the actual cash rate to move away from the new target
The RBA then uses OMOs to manage liquidity and keep the actual cash rate near the target, creating higher broader interest rates and stopping AD, economic activity, and employment.
KK4 - one example of the operation of an unconventional monetary policy tool from the past two years
Unconventional monetary policy
DEF: tools used by the RBA in conjunction with conventional monetary policy to achieve the three macroeconomic goals
Tool used
Forward guidance involves the RBA providing information about the future course of interest rates and its monetary policy
The RBA publishes forward guidance through monetary policy decisions, monetary policy statements and media releases
Example (recent times)
Throughout the first half of 2026, the RBA raised the cash rate three times in response to inflation running persistently beyond target
The RBA signalled that “monetary policy is well placed to respond to developments” indicating readiness to keep adjusting rates depending on how responding data was placed
KK5 - Transmission mechanism of monetary policy
Saving and investment channel
Monetary policy typically affects economic activity by changing incentives for saving and consumption.
Lower interest rates on bank deposits reduce incentives for households to save their money, instead there exists an incentive for a household to spend.
Lower lending rates can encourage households to borrow more as they face lower repayments. This will cause more demand for assets, such as housing.
Lower lending rates can increase investment spending by businesses. This is because the cost of borrowing is lower causing increased demand for goods and services. Returns likely become higher as FoP decrease leading to more profit incentive for firms
KK5 - Transmission mechanism of monetary policy
cash flow channel
Monetary policy influences interest rates, which affect decisions of households and businesses by changing the amount of cash they have available to spend on goods and services.
A reduction in lending rates reduces the interest repayments on debt, increasing the amount of cash available for households and businesses to spend on goods and services
At the same time, a reduction in interest rates reduces the amount of income that households and businesses get from deposits, and some may choose to restrict their spending
KK5 - Transmission mechanism of monetary policy
Asset prices and wealth channel
Asset prices and peoples wealth influence how much they can borrow and how much they spend in an economy
Lower interest rates support asset prices by encouraging demand for assets. One reason for this is the present discounted value of future income is higher when interest rates are lower.
Higher asset prices also increases the equity of an asset that is available for banks to lend against. This can make it easier for households and businesses to borrow.
An increase in asset prices increases peoples wealth. This can lead to higher consumption and housing investment as households generally spend some share of any increase in their wealth.
KK5 - Transmission mechanism of monetary policy
Exchange rate channel
The exchange rate can have an important influence on economic activity and inflation in a small open economy such as Australia
If the reserve bank lowers the cash rate target it means that interest rates in Australia have fallen compared with interest rates in the rest of the world
Lower interest rates reduce the returns investors earn from assets in Australia. Lower returns reduce demand for assets in Australia with investors shifting their funds to foreign assets instead.
A reduction in interest rates typically results in lower exchange rates, making foreign goods and services more expensive compared to those produced in Australia. This leads to an increase in exports and domestic activity. A lower exchange rate also adds to inflation because imports become more expensive in Australian dollars.
KK5 - transmission mechanism of monetary policy
Model response
Asset price (wealth) channel:
The asset price channel is the transmission channel that is responsible for the effects induced by monetary policy decisions that affect the prices of assets. For example, when monetary policy is tightened, the demand for major assets like housing and shares should decrease. This is likely to result in a decrease in the price of these assets. As these prices fall, consumers may experience a negative ‘wealth effect’, whereby they feel relatively poorer and less able to spend (on consumption and investment) because of their decreased ‘paper’ wealth (that is, how much assets can be sold for). This decreases aggregate demand and economic growth. Looser monetary policy has the opposite effect, whereby rising asset prices and a heightened ‘wealth effect’ encourage spending, production and employment.
KK6 - the stance of monetry policy
The stance of monetary policy
How is the RBA using monetary policy to influence the level of AD?
Same concept as BP just a different tool (policy)
The stance of monetary policy
Contractionary = decrease AD = a slowdown in the economy
Restrictive or tightening
Expansionary = increase in AD = speedup the economy
Accommodative or loosening
Monetary policy neutrality
The neutral rate is the interest rate that neither stimulates nor restricts economic activity. At the neutral rate, monetary policy is considered neither expansionary nor contractionary. The neutral rate is consistent with
Inflation remaining sustainable within the RBAs 2-3% range
Economic growth occurring at its long-run sustainable rate
The economy operating close to full employment
The neutral cash rate cannot be directly observed and must be estimated using economic models
Recent RBA estimates suggest a nominal cash rate of approximately 2.7-3% (around 2.9 avg.)
Estimates change over time as economic conditions and productivity growth change.
Monetary policy stance
Above 2.9% = contractionary
Less than 2.9% = expansionary
Move closer to neutral = less
Move away from neutral = more
KK7 - the stance of monetary policy over the past two years and its likely effect on the achievement of the domestic macroeconomic goals and living standards
2024
Cash rate remained at 4.35%
Well above the estimated neutral cash rate
Monetary policy was contractionary / restrictive
Intended to slow AD and reduce inflationary pressures
2025
RBA gradually reduced the cash rate from 4.35% to 3.60%
Monetary policy became less restrictive
Inflation pressures eased but remained a concern
Stance remained mildly contractionary as rates stayed above neutral
2026
Inflationary pressures re-emerged
RBA increased the cash rate from 3.60% to 3.45%
Monetary policy has became more restrictive
Current cash rate remains well above the estimated neutral rate (2.9%)
This is clearly a contractionary / restrictive stance
From the RBA
Over the past two years monetary policy has generally maintained a contractionary stance with the cash rate remaining above the estimated neutral rate. While this has helped reduce inflationary pressure and supported price stability, it has also constrained aggregate demand, economic growth and, to some extent, employment outcomes.
Monetary policy stance between 24-25
Inflation remained above the target range through most of 2024 though gradually easing from its peak
The RBA maintained a contractionary / restrictive stance, holding the cash rate at 4.35% throughout 2024 to continue reducing inflationary pressure
The RBA cut the cash rate three times in 2025 taking it from 4.35 to 3.60%
The shift reflected a contractionary stance
Monetary policy stance between 25-26
After cutting interest rates three times in 2025, inflation began picking up materially in the second half of the year
This reflected stronger-than-expected growth in aggregate demand and renewed pressure on productive capacity
The RBA therefore reversed course, shifting back to an increasingly contractionary / restrictive stance to rein in renewed inflationary pressure
The RBA raised the cash rate three times in 2026, taking it from 3.60% back to 4.35% fully reversing the 2025 cuts
The RBA held the rate steady at 4.35% at its June 2026 meeting as cost inflation took hold following the war in the middle east
The impact of the RBA's monetary policy stances
It could be argued that the RBA's contractionary policy stance was relatively successful in getting inflation to target in 2025
Rate cuts in 2025 also enabled economic growth to pick up
But it could be argued that they underestimated how quickly AD could pick up following rate cuts in 2025
Their rate cuts directly contributed to the higher AD which brought upon a rise inflation in the second half of 2025 - in a way, they we're responsible for the very inflation they are now trying to bring down
Unemployment and the RBA's monetary stance: 2024-2025
Unemployment remained low throughout this period, sitting around 4.0% in mid 2024 and falling further to aroudn3.5% by late 2024/ early 2025
A tight labour market placed continued upward pressure on wages, which risked feeding into demand-pull inflation through higher household income spending
This encouraged the RBA to maintain a contractionary stance
Toward mid-2025, unemployment began edging back up toward 4%, suggesting some easing in labour market tightness
Unemployment and the RBA's monetary stance: 2025-2026
With a mostly contractionary stance, unemployment rose steadily over this period, climbing from 3.6% in mid-2025 to roughly 4.3-4.4% by mid-2026
Despite rising unemployment, the RBA continued to believe that labour market tightness was continuing to contribute to rising inflation, although the labour market was easing
Concern with labour market tightness and rising inflation meant that the RBA adopted a largely contractionary period in this time
Summary
KK8 - the strengths and weaknesses of using monetary policy to affect AD and influence the achievement of domestic macroeconomic goals and living standards
Strengths
The strengths of monetary policy (compared to budgetary policy)
No political bias/constraints
The RBA is not elected by the public and has no political affiliation
They make decisions purely based on economic factors (not political factors)
This gives them the freedom to make economically sound but politically unpopular decisions
MP is most effective at controlling inflation
Many economists will argue that MP is much more effective at controlling inflation caused by excessive demand compared to promoting a recovery from a recession or downturn in economic activity
It can be difficult to encourage spending (wanting more borrowing and consumption/investment) as opposed to the more focused nature of stopping spending (i.e. via the cash flow channel)
Short implantation lag
The RBA meets nearly every month to make a choice about the cash rate target
This gives them the flexibility to wait and see
They can wait for key economic data before making decisions because they meet 8 times a year
No financial constraints
Unlike budgetary policy, the RBA does not have financial constraints
It can purchase as many bonds or change the CRT without limitations, as necessary, in order to meet the domestic macroeconomic goals
KK8 - the strengths and weaknesses of using monetary policy to affect AD and influence the achievement of domestic macroeconomic goals and living standards
Weakness
Weaknesses of MP (compared to BP)
Long impact lag
Monetary policy has long and variable lags
E.g. it takes time for changes in the CRT to make its way through the transmission mechanisms and into the economy.
Some households have fixed mortgage rates (they are not immediately impacted)
Savings buffer
Because of this lag, the RBA run the risk of their stances becoming pro-cyclical
E.g. having a contractionary MP stance where the impact is felt most during an economic downturn
Long impact lag (continued)
For instance, one estimate suggested that a 1 percent change in interest rates ultimately alters GDP by about 0.7%, but that only
40% of this impact will be felt after 12 months
With 80% felt after two years and
100% felt after three years
Because of this lag, the RBA run the risk of their stances becoming pro-cyclical
Policy reversal exposes the lag risk
2024: the cash rate stayed at 4.35% while earlier tightening continued to work
2025: three cuts followed the return of inflation to target; by September, consumption and housing were strengthening
Late 2025: inflation picked up more than forecast and earlier cuts had not yet flowed through fully
2026: three hikes reversed the easing. The timing error created a risk of the policy becoming pro-cyclical
Monetary policy is blunt
Changes in interest rates by the RBA affect the overall levels of savings, consumption, investment, and net exports
Because the economic impacts of the policy are so widespread, the policy cannot precisely target particular areas of concern
Less effective in a recession - to stimulate AD
The key strength of monetary policy is its effectiveness to restrict AD during an expansion or periods of excess demand.
MP is not as strong at stabilising and encouraging growth in a downturn:
Small cuts are less effective
2020 borrowers already had higher levels of debt -> encourage households to take on more debt was unlikely. Some households/businesses also struggled to meet existing loan criteria
Confidence in both C and I was weak in 20/21 with reluctance to borrow
FX channel was ineffective because other central banks cut by more
Some households were fixed in at higher rates than what was available over 20/21
Can be undermined by BP
If budgetary policy aims to stimulate economic activity this may require additional government borrowings
Governments will borrow through financial markets and create additional demand for debt and thus lead to higher domestic interest rates (and thus not the intention of the RBA if they have similar expansionary MP setting). Higher IRs contract the level of economic activity.
This is called crowding out
This can also work in reverse too - crowding in
Creates asset 'bubbles' and high household debt
There is a strong correlation between interest rates and asset prices. Prior to this tightening cycle the RBA cut interest rates over a 10 year period which drove share and house price accumulation
Asset 'bubbles' can be created in times of expansionary monetary policy
KK8 - the strengths and weaknesses of using monetary policy to affect AD and influence the achievement of domestic macroeconomic goals and living standards
Answering a question
Answering a question
The best responses
Identified and explained one or more factor that made monetary policy relatively potent over 2020 in terms of its ability to reduce unemployment
E.g.
Lower implementation lag
Flexibility of monetary policy
Balanced this against the monetary policy weakness evident in the past
Prioritised arguments with an overall conclusion
KK9 - sources of goverment revenue, including direct and indirect taxation; progressive, regressive and proportional taxes; and revenue from goverment businesses and the sale of goverment assets
Budgetary (fiscal) policy: estimated changes in the level of composition of federal government revenue (receipts or incoming money) and expenses (outlays or outgoing money) for the year ahead
Purpose: cyclical instability can be reduced by the government applying AD policies in a counter-cyclical way
Budget receipts and outlays are estimated does not equal closing budget numbers
Classification of taxes
Type | Definition | Example |
Progressive | Proportion of tax paid out of total income increases as income rises | PAYG tax |
Proportional | Proportion of tax paid out of total income is constant amongst all taxpayers | General company tax rate 30% |
Regressive | Proportion of tax paid out of total income decreases as a person's income rises | GST, excise duties, carbon tax |
Other features of the tax system
Tax mix: balance between direct and indirect taxes as sources of revenue
Tax base: how broadly the particular tax is applied (e.g. GST exempts most necessities)
Tax burden: rates of direct or indirect tax applied. Progressive personal income tax: tax burden increases as income increases (bracket creep)
Direct taxation
Direct tax: levies on the incomes received by individuals and companies (wages, salaries, interest, dividends and rent)
Tax | Definition |
Personal income tax | Paid by individuals who earn incomes in the form of wages, salaries, rent, interest and dividends (progressive tax)
|
Capital gains tax (CGT) | Levied on the real profits made from the sale of capital assets such as land and shares |
Medicare levy | Income-earning individuals pay 2% of their personal taxable income to fund the health system |
Company tax | Flat or proportional tax levied directly on business profits (reducing over time) (27.5% / 30%) |
Fringe benefits tax | Paid by firms on the value of 'perks' provided by businesses to their employees (47% of the taxable benefit) |
Superannuation fund tax | 15% of most premiums, as well as on the interest from fund investments |
Petroleum resource rent tax (PRRT) | Tax on profits generated generally from the sale of oil and gas products |
Bracket creep (fiscal drag): inflation encourages workers to 'bid up' wages + real wages may only increase by little -> push up income into the next bracket -> increase tax burden -> government can adjust the tax bracket in line with inflation; or receive more tax receipts
Total personal income tax revenue received increases -> reducing deficit -> cyclical component of the budget (relies of changes in inflation rate, not rate of economic growth)
Higher tax on nominal wage -> a decline in real disposable income -> reduces after tax and inflation wage -> reduces purchasing power -> slowing rate of spending + reduce incentives to work
Indirect taxation
Indirect tax: levies placed on g/s at the point of sale and are added onto the price of items being purchased
Tax | Definition |
Excise duty | Imposed on selected, locally produced goods (tobacco, alcohol, petrol - ~30% of the price of each litre of unleaded petrol) |
Tariffs (custom duties) | Paid on certain imports (generally 5%, but not all) |
GST | 10% of the selling price of g/s (exc. Unprocessed foods, charities, exports, health care, etc.) |
Non-tax Revenue
Source (7%) | Example |
Government business enterprises (GBE) | AusPost |
Receipts from asset sales when GBEs are privatised (only included in the headline budget outcome, not the underlying) | Medibank Private Telstra |
Interest, petroleum royalties, repayment of loans by state and local government, HECS loan repayments, GST administration costs and property rentals | |
Spending
Classifying government budget expenses by their functions
Function | Benefit |
Social security and welfare (36%) | Transfer payments to the neediest groups who meet the means and assets test (aged, unemployed job seekers, patients, carers, students, disabled and war veterans)
|
Health (16%) | Running expenses (drugs, staff salaries) + capital infrastructure (hospitals) + medical subsidies paid for doctors' services and some medicines |
Education (7%) | Running expenses (teachers) + capital infrastructure (schools) for universities, VET, state and non-government schools |
Other purposes (20%) |
|
Transport, communications, housing and community amenities, defence and general public services | |
Classifying government budget expenses by general type
Function | Benefit |
Current spending (G1) | Payment of wages and salaries for federal government employees in the public sector (health, education, defence, etc.)
|
Capital spending (G2) | National social and economics infrastructure (e.g. building of schools and universities, roads and highways, NBNs)
|
Transfer payments | Welfare benefits, grants and industry assistance (e.g. for the aged, unemployed, supporting parents, students, disabled, etc.) Not classified as government spending (G1 or G2) as it is the recipient of transfer payments who actually spends the money |
KK10 - types of government expenses, including current government current and capital expenditure and transfer payments
Current spending (G1)
Day to day operational spending by the government (ongoing costs of running government)
Have a current benefit
E.g. maintenance, cleaning, repairs, staff
Capital spending (G2)
Investment spending by the government into physical assets
Have a future benefit
E.g. infrastructure, schools, roads, hospitals
Transfer payments
One way payment (not in exchange for anything)
Redistribution
Aged pension
Youth allowance
Jobseeker
KK11 - the budget outcome: balanced, deficit, or surplus
The budget outcome
Measured over the financial year from, July 1st - June June 30th
Total revenues (receipts)
Minus
Total expenses (payments)
= Budget outcome
Budget outcome
Surplus = (revenues > expenses) e.g. $5B
Deficit = expenses > revenues) e.g. - $30B
Balanced = outlays = revenues e.g. $0 (break even)
KK12 - The underlying cash balance (budget outcome), including as a proportion of GDP
The underlying cash balance
Headline = all revenues and expenses on a cash accounting basis
Underlying = removes 'Net cash flows from investments in financial assets for policy purposes'
Removes both receipts and payments relating to investments in financial assets (these are non-recurring)
E.g. investments in the NBN, repayment of a loan
Underlying cash balance / GDP
It also makes sense to measure the size of the deficit as a proportion of GDP (size of the economy)
A $20B deficit for a $40B economy = 50%
A $20B deficit for a $1t economy = 2%
Underlying cash balance / GDP
Key takeaways:
If the deficit grows in line with GDP = neutral
If the deficit grows at a slower pace than GDP = 'good'
If the deficit grows faster than GDP = 'bad'
KK13 - methods of financing a deficit or utilising a surplus
Financing a deficit
The government cant/wont go back and increase revenue or decrease outlays
Financing is a keyword: borrowing
The government borrows by selling bonds
A bond
A bond is an "I owe you"
The government sells bonds to fund/finance its deficits
The investor who buys the bond from the government receives interest and their money back at a certain date
Selling bonds
Selling bonds to local investors
Most common form of budget financing over recent years
Least expansionary as funds are taken from private sectors but returned when the government uses the money for budgetary purposes
Can lead to the crowding out affect -> government takes a big chunk of lenders funds away from other options that would otherwise be used for private sector borrowing
Selling bonds to overseas investors
Less common form of financing
Generates upward pressure on value of AUD (OS demand for AUD increases), occurs when overseas investors demand more AUD to get currency needed for bonds
Higher AUD creates less demand for export demand (X) -> impacts AD adversely
Means greater debit interest payments -> grows current account debt or lowers current account surplus
Selling bonds to the RBA
Most expansionary impact on the economy -> increases volume and spending
Most inflationary way to finance a deficit as it lowers the value of each unit of currency and bids prices of goods and services higher (creating inflation)
KK14 - The role of automatic stabilisers (cyclical component of the budget) in influencing aggregate demand and stabilising the business cycle
Automatic (cyclical) stabilisers
The budget has an "in-built" stabilisation mechanism
These stabilisers
Speed up the economy when economic growth is too slow
Slows down economic growth when the economy is growing too fast
Automatic stabilisers work without government intervention
2 key automatic stabilisers
Revenues (tax collection)
Outlays (payments)
Automatic stabilisers on the business cycle (AD)
In an expansion (tax collection)
Tax revenue collected will increase (due to the progressive nature of our income tax system)
This increases leakages out of the circular flow models (e.g. slows AD growth)
In an expansion (payments)
Welfare payments will decrease as lower UE rate means less people qualify for payments like JobSeeker
This decreases injections into the circular flow models (e.g. slows AD growth)
In a contraction (tax collection)
Tax revenue collected will decrease
This decreases leakages out of the circular flow models
E.g. slows drop in AD
In a contraction (payments)
Welfare outlays will increase
This increases injections into the circular flow models
E.g. slows drop in AD
KK15 - The role of discretionary stabilisers in influencing aggregate demand and stabilising the business cycle
Discretionary stabilisers (structural)
Any time the government makes a deliberate change to the structure or composition of the budget this is known as a discretionary stabiliser
E.g. removing a tax bracket or decreasing spending on infrastructure
Discretionary stabilisers
In theory the government should use these stabilisers to smooth out the business cycle.
In an expansion the government could:
Increase the income tax rate to decrease disposable income and slow AD
Increase spending on infrastructure projects to increase the (I) component of AD and increase AD overall
In a contraction the government could
Decrease the income tax rate to increase disposable income and increase (C ) and AD overall
Increase spending on infrastructure p
Other discretionary stabilisers
Removal / changing tax brackets
Increasing / decreasing welfare payments
Business tax cuts (write offs)
Easing costs of living pressures
KK16 - the effect of automatic and discretionary changes in the budget on the budget outcome and government (public) debt
The impact of automatic stabilisers on outcome / debt (expansionary) - counter cyclical
During a contraction the automatic (built-in) stabilisers will
Increase the level of welfare spending into the economy (increase govt. expenses)
Decrease the level of income tax collected (decrease govt. revenues)
During a contraction the automatic built in stabilisers will
Increase the deficit
Decrease the surplus
From surplus to deficit
The impact of automatic stabilisers on outcome / debt (contractionary) - counter cyclical
During an expansion the automatic stabilisers will
Decrease the level of welfare spending into the economy decreasing government outlays
Increase the level of income tax collected, increasing government revenues.
During an expansion economic stabilisers will
Increase the surplus
Decrease the deficit
From deficit to surplus
Automatic stabilisers on outcome / debt
Increase the surplus = decrease government debt
Increase the deficit = increase government debt
Reduce the deficit = decrease government debt
Increase the deficit = increase government debt
The impact of discretionary stabilisers
During an expansion the government will use discretionary stabilisers by:
Decreasing the level of (G1+G2) spending in the economy, decreasing government spending
Increase the income tax rate = increasing government revenues
This will either
Decrease the deficit = increase debt
A deficit still exists, therefore it still needs to be financed
Increase the surplus = decrease debt
Surplus that exists can be used to pay off pre-existing debts
Budget deficit
Requires debt
Typically seen as expansionary setting (boosts economic activity)
Budget surplus
Enables governments to repay pre-existing debt
Typically seen as a contractionary setting (temper / slow eco activity)
KK17 - the stance of budgetary policy: expansion or contractionary
The stance
The stance signals the governments intention in relation to the level of economic activity
The stance of BP
How is the government using the budget (as a tool) to impact the level of AD and economic activity in Australia.
Using it to expand AD and activity = expansionary stance
Using It to contract AD and activity = contractionary stance
Stances and outcomes (contracting)
If the budget is contracting the level of AD and the level of activity, the budget outcome must be in surplus or moving from deficit to surplus
E.g. revenues are growing faster than expenses or expenses are decreasing faster than revenues
Surplus = contractionary
Stances and outcomes (expanding)
If the budget is expanding AD and the level of economic activity, the budget outcome is in a deficit or moving from surplus to deficit
E.g. expenses are growing faster than revenues or vice versa
Deficit = expansionary
Stances over time
It makes more sense to compare the change in budget outcome over one financial year to the next to understand the intentions (stance) of the government
E.g. its relative change that is important
A simple rule for budget stances
Surplus = contractionary position / stance = expansionary
If moving towards balanced (e.g. from surplus or deficit) = less
If moving away from balanced (e.g. increase in surplus or deficit) = more
Outcome and stances
Increased surplus
= more contractionary
Decreased surplus
= less contractionary
Increased deficit
More expansionary
Decreased deficit
= less expansionary
From deficit to surplus = contractionary
From surplus to deficit = expansionary
Countercyclical
Stances = structural component of the budget
Technically speaking the stance of the budget is only reflected in the structural component of the budget
E.g. not including any automatic (cyclical changes in the budget)
The structural component of the budget tells us more about the governments intentions
KK19 - The effect of the budgetary policy stance and budgetary initiatives over the past two years and their likely effect on the achievement of the domestic macroeconomic goals and living standards
Budget stances over the past two years
25/26
The budget had a $-28.3B budget outcome
26/27
The budget had a predicted $-31.5B budget outcome
Consumption |
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Government (G1) Current spending Like cash flow from operating |
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Government (G2) Capital spending Like cash flow from investing
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Business investment |
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KK19 - The effect of the budgetary policy stance and budgetary initiatives over the past two years and their likely effect on the achievement of the domestic macroeconomic goals and living standards
A+ sample question
c. Describe how two discretionary budgetary policy initiatives announced in either 2019 or 2020 might influence aggregate demand and the achievement of the domestic macroeconomic goal of strong and sustainable economic growth.
Strong and sustainable economic growth involves achieving the strongest growth rate possible, consistent with employment growth, but without adding to unacceptable inflationary, external, or environmental pressures often around 3 to 3.5% per annum. A discretionary initiative designed to influence AD and the achievement of the goal is JobKeeper. This is a $130 billion wage subsidy of $1500 per fortnight which are designed to allow businesses to retain employees in light of lockdowns and the covid pandemic's economic shock. Hence, it ensures that employees are able to continue to contribute to levels of consumption during this time, increasing levels of AD. Additionally, it reduces the need for any re-employment processes after the pandemic, reducing the potential for immediate labour bottlenecks and skill shortages, as well as allowing AD to rebound more easily and sustainably.
Another policy is the instant asset tax write off scheme, allowing firms to claim back the full costs of depreciable assets, such as machinery and equipment. This encourages greater business investment and stimulates AD and real GDP. In addition, by incentivizing businesses to invest, it is likely that new capital will drive down average production costs, encouraging growth in productive capacity or aggregate supply. This helps to reduce prices and encourage further growth in AD, which leads to stronger and more sustainable growth once the pandemic ends.
KK20 - The strengths and weaknesses of using budgetary policy to affect aggregate demand and influence the achievement of the domestic macroeconomic goals and living standards
Strengths of budgetary policy as a tool to impact AD
Can target areas of weakness
The budget can, by changing the composition/structure of expenses or revenues target areas of weakness in the economy / specific industries
For example
Spending can be target to specific households, businesses or geographic areas etc.
For example, the government's $2 billion local infrastructure fund targets Australia's housing shortage by funding the essential infrastructure required to support up to 65,000 new homes
For example, the government is also investing $1.8 billion, plus ongoing annual funding, in 137 Medicare urgent care clinics. This targets limited access to affordable urgent healthcare and capacity pressures within the hospital system.
Has a short impact lag
The budget impacts the level or AD relatively quickly (e.g. without a long lag)
For example
Tax or spending changes, once implemented, will quickly impact the level of AD in the economy
For example, cash transfers or electricity bill relief can quickly impact household finances to support a change in AD and activity.
Affects both AD and AS impacts
Budgetary policy can increase both AD (in the short term) and AS (in the long term)
This occurs through
Education
Infrastructure
Research and development
Tax reforms
Think the government building a new port (AD through (G) component) and long term AS increase as productive capacity increases
Weaknesses of budgetary policy as a tool to impact AD
Is subject to political bias / constraints.
The budget is highly politicised. Often its used for political purposes rather than financial.
For example
A tax cut may be politically popular, but not economically suitable given the macro conditions.
Subject to financial constraints
The budget is subject to financial constraints due to governments need/want to bring the budget back to surplus and reduce public debt
There is a trade-off between spending and stimulating economy growth and budget surpluses and reducing debt. In contractions / recessions this is a limitation due to decreased revenue.
Has a long implementation lag
Often budgetary policy initiatives take a long time to be implemented
Must be voted on by both houses (lower and upper) of parliament
Usually most policies are implemented in may (the budget) or in December during the MYEFO (update on the budget)