Mr Walker's Notes Economics

 The laissez-Faire (FREE/UNPLANNED) market system often fails meaning there is a need for Govt intervention. But;

-          How far should Govts go?

-          What are the best forms of intervention?

The Circular flow of Income model:

Equibrium In CFI:    S + T + M = I + G + X

                                 (LEAKAGES= INJECTIONS)

The Paradox of Thrift:

 In tough economic times (high unemployment), individuals become cautious and try to save rather than spend. This reduces consumption expenditure, so businesses produce and sell less which leads to lower incomes and more unemployment (starting a downward cycle).

·       More Savings (from households/Consumers) mean greater LEAKAGES

·       Less Investment (from Businesses) mean less INJECTIONS

 The CFI gives us an insight into what determines the level of total domestic or national production.

 Aggregate demand (C + I + G + X)

It also helps us understand what would happen if certain variables were changed, and how the Govt can manage total economic activity, to achieve desirable economic objectives.

Economic Objectives:

                             GDP 3-4%  =  (Economic Growth)

Unemployment 3.5% - 5%  = (Full employment)

                             CPI 2%-3% = (Price Stability – controlled inflation)

(Questions 1 to 6, p157)

Nominal GDP: Prices of economic output (Not adjusted for inflation)

        Real GDP: Prices of economic output (Adjusted for inflation)

Govts believe that economic growth allows individuals to increase their consumption and businesses to increase their output, thus creating jobs and thereby raising living standards and national income

 While recurrent positive economic growth is desirable, it must also be sustainable…. And should not impose costs on future generations and the environment.

 There are 3 different methods for measuring GDP

The Production Approach:

-          The total value of final G&S produced in the economy. (Aggregate Demand)

O = C + I + G + X

The Income Approach:

-          All income received by the owners of productive resources (Land, labour, Capital, Enterprise à wages, rent, interest, profit)     (‘Y’ in the CFI)

The Expenditure Approach:

-          The total value of expenditure (excluding Imports – as they are not produced in Aust)  

-          Real GDP shows whether real economic growth has occurred.

The Challenges of economic growth.

 A word of caution to those who simply focus on rising quarterly GDP results as the one true indicator of a nation’s economic success. GDP does not necessarily indicate the general well-being, social cohesion and levels of happiness within a populace.

Eg; if a nation’s GDP rises due to increased production of prisons and coal fired power stations OR via increased spending on education, windfarms and sustainable agriculture.

GDP does not consider:

-          environmental impact, pollution, climate change, and depletion of natural resources.

-          Wealth distribution

-          Jobs becoming redundant and pressure on inflation.

Aggregate demand and supply theory:

 This model helps Govt better understand an economy and develop policies in both the micro- and macroeconomic areas to deal with shocks and to provide stability, economic growth, and related social and economic objectives.

 Keynesian Theory:

 Keynes believed that one of the key roles of govt was to intervene in and manage the macroeconomy. (Control vast peaks and troughs resulting in high inflation or high unemployment)

Aggregate demand:

-          The total (overall) quantity of output demanded at alternative price levels in a given time period.

AD or GDP = C + I + G + (X-M)

 There are similarities to and differences from the law of demand. AD is the relationship between planned AD for the totally domestically produced output (that is, real GDP) and the general price level…… (not the demand and price for one particular product).

(Draw Fig 6.3, p164)

  General rise in prices (inflation) would be transmitted to AD through the effects on wealth (reducing the value of money and bank deposits),

- interest rates (where the rates go up due to increased demand for money) and

-foreign demand (where price rises make exports less attractive and imports more attractive).

(Draw fig 6.4, p164)

An increase in AD can be caused by;

-          Change in disposable income

-          Wealth

-          Price expectations

-          Income distribution

-          Interest rates

-          Demographic changes

-          Profit expectations

-          Innovations

-          Cost of capital goods

-          Govt policy

-          Tariffs or quotas

-          Exchange rates

 General price levels and many of the component factors can be manipulated by govt and provide avenues for demand-side policy management. Govt Exp (G) and interest rates (RBA) and their effects can be transmitted to AD. The effect will be indirect through transmission mechanisms.

-          An increase in the money supply,M:

­Ms à ¯interest rates à ­C, ­I à ­AD

A cut in income tax, T:

¯T à ­ disposable income à ­C à ­AD

These 2 changes (not a change in domestic price level) cause the AD curve to shift.

(Questions 1 to 5, p165)

Components of Aggregate Demand: (Injections into the CFI)

-          Consumption expenditure (largest item – by far)

-          Exports & Business Investment (smaller but more volatile – still influential)

Multiplier Effect:

-          A more than proportional change in the equilibrium level of national income resulting in a change in autonomous expenditure. (The number of times the final increase in national income surpasses the initial increase in the original expenditure eg; Govt exp or Business investment).

(Ref Fig 6.6, p167)

 A small increase in autonomous expenditure of $500 results in a much larger increase in GDP of $2000 (8000 – 6000). This means the multiplier effect is 4 times.

 The multiplier effect also works in reverse.

Marginal Propensity to Consume (MPC): - the proportion of any small increase in income that is spent on consumption.

·       The higher the MPC, the greater the Multiplier Effect.

Marginal Propensity to Save (MPS): - The proportion of any small increase in income that is saved.

-          The higher the MPS, the smaller the Multiplier Effect

(Questions 1 & 2, p169)

Aggregate Supply (AS)

-          Is the total quantity of output produced (GDP) at alternative price levels in a given time period.

(Draw fig 6.7, p169)

-          It has a positive (direct) relationship between planned production and the general price level. (As Prices go up, so does production)

-          The vertical section is a result of the physical limits of production being reached.

 Factors that cause AS to shift are those that affect the cost per unit of production (wages, fuel). As the AS curve shifts to the right, the vertical section does not move. (fig 6.8a)

 If the increase in AS is due to a change in productivity (improved technology), then the whole curve shifts down and to the right. (fig 6.8b)

(questions 1 to 6, p170)

Equilibrium and the AS and AD theory:

Concepts:

Deflationary Gap: -  the amount by which the equilibrium level of production and income falls short of the full employment level.

Inflationary Gap: - exceeds the full employment level.

When planned AD = AS, the macroeconomy will be in equilibrium

(fig 6.9,p171)

Factors affecting AD & AS:

 These will cause a shift in the AD &/or AS curves.

-          Inflationary demand Shocks à AD shift right à increase in price level & GDP, Decrease in unemployment. Caused by fall in interest rates, decrease in exchange rates, increase in Govt Exp, cuts in income taxes

-          Deflationary demand shocks à AD shift left à decrease in price level and GDP, increase in unemployment. Caused by increase in interest rates, increase in exchange rates, decrease in Govt Exp, rises in income tax.

-          Inflationary Supply shocks à shift AS left à price level and unemployment to rise, GDP decrease. Caused by increased wages, increased cost of production, reduced productivity

-          Deflationary Supply Shocks à shift AS right à decrease in price level and unemployment, GDP increase. Caused by reduced input prices, improved productivity.

FISCAL & MONETARY POLICIES are the main AD management tools.

Fiscal = Govt (tax/expenditure)

Monetary = RBA (interest rates)

(p173 questions 1,2,3)

Global effects on macroeconomic issues

 Economic interactions between nations have a profound impact on an individual country’s economic growth and prosperity. Australia is a small player on the world scene.

 Powerful MNC’s can shift production, resources, capital and personnel around the world with ease based on changing marketing and tax regimes.

Foreign Sector policy:

 Our government has little control over overseas events.

Various ways to influence and benefit our domestic economy include:

-          Tariffs and quotas

-          Trade agreements

-          Membership of international institutions (WTO, APEC, World Bank)

-          Influencing the exchange rate

-          Fiscal and Monetary policy to influence interest rates etc.

(p175, 1 a,b)

Review of Chapter 6 (pp176-183)

Chapter 7 Macroeconomic Objectives:

The role of Govt is to achieve an agreed set of economic objectives to ensure the populations continued improvement in their standard of living.

-          Is our economy making best use of limited resources?

-          How does the level of Aggregate Production compare with potential production?

(Draw figure 7.1)

 The opportunity cost of producing mangoes at point A instead of point B is 1500 mobile phones, conversely, the opportunity cost of producing an extra 1500 mobile phones (point B) is 20000 mangoes.

 All market economies are prone to macroeconomic instability;

-          Unacceptable levels of inflation and unemployment

-          Slow rates of economic growth

 It is therefore necessary for Govts to monitor, manage and intervene in the economy.

Objectives:

Internal Stability:

-          Full employment (3.5% - 5% unemployment)

-          Price Stability – (inflation 2% - 3%)

External Stability:

-          Balance of Payments has not unwanted extreme movements of foreign reserves.

Standard of Living:

-          A measure of lifestyle based on income, possessions, education, health and housing standards.

The following objectives are used as a criteria to assess the performance of the Australian Economy:

-          Sustainable economic growth   (sustainability) 

-          Internal stability   (Inflation 2%-3%, Unemployment 3.5%-5%)

-          External stability   (Exports – Imports)

-          Improved standard of living   (Quality of life getting better)

-          Equitable distribution of income and wealth    (Social Equity)

-          Efficient resource allocation    (Efficiency)

(Questions 2 to 4, p188)

Complete table 7.2. Economic data for Australia.

Sustainable Economic Growth: (GDP 3% - 4%)

-          Sustains a nation’s natural resources and the environment.

-          Should not create any significant economic problems for future generations.

Govt attempts to forecast periods of boom, recession and stagnation.

Limitations to usefulness of GDP:

-          Non-market production not included (home grown vegetables, house work, owning your own home and not renting, black market)

-          Changes in quality of goods not measured.

-          Wealth distribution not accounted for.

-          Environmental and social impacts

Alternatives to GDP:

-          Steel consumption

-          Energy consumption

-          Housing approvals

-          Retail sales

-          New motor vehicle registrations

-          Consumer credit

(questions 1,2 p191)

Internal Stability:

Unemployment Types:

Cyclical: - due to downturn in economic cycle

Frictional: - transition between jobs

Structural: - changing economic needs causes jobs to change or disappear (Car industry)

Seasonal: - Tourism/Fruit picking/Snow & Beach seasons/School Graduation

Price Stabilty: (avoiding excessive Inflation : 2% - 3%)

 Consumer Price Index (CPI) interpreted as changes in the cost of living.

High inflation reduces the purchasing power of individuals, puts pressure on interest rates and reduces international competitiveness.

Full Employment: (3.5% - 5% unemployment rate)

 A socially acceptable level of unemployment (there will always exist some unemployment). Full employment does not mean zero unemployment.

Unemployment and under employment means the economy is not producing at it’s full potential, and will experience lower levels of AD (consumption) and business confidence.

Underemployment:

-          Full time workers on reduced hours

-          Part time workers who want to work more

External Stability:

-          Ensuring Australia meets its financial obligations with the rest of the world.

-          Australia’s net external debt position is at a sustainable rate in relation to GDP.

Balance of payments:

-          Summarises the nation’s dealings with the rest of the world

-          (Exports minus Imports)

Current Account: G&S bought and sold internationally

Capital Account: Financial market, investment inflows and outflows.

 The Govt monitors the nation’s debt level and manages external trade policies, thus ensuring external stability.

(Questions 1 to 4, p197)

Improved Standard of Living:

 For many individuals, quality of life is more important than wealth and material things.

Quality-of-life indicators;

-          Standards of health                                                                                                                     (life expectancy, infant mortality, communicable diseases)

-          Food consumption and nutrition levels                                                                             (Aust #5 for Obesity)

-          Education and literacy                                                                                                    (school leaving age, % of GDP spent on Education)

-          Job quality and conditions of work                                                                                 (Hours/wk worked, job security, work conditions)

-          Levels of happiness                                                                                                      (countries that prosper economically have happier, healthier and more productive populations)

Equitable Distribution of Income and Wealth:

 Not all people enjoy the benefits of economic growth.

-          2017 – Aust was ranked 96^th of 118 nations for income equality.

-          Poor families are more likely to experience social isolation, drug dependency, domestic violence, health problems, illiteracy, unemployment, low education and commit (and be victims of) crime.

Income Inequality (rich getting richer) encourages:

-          entrepreneurs to take risks

-          People to attain skills

-          Work longer hours

-          Move to new locations

-          Better allocation of resources

(Question1 p202)

Sustainable Development:

 Efficiency can now be measured by;

-          Capital productivity

-          Labour productivity

-          Environmental harm

Environmental Problems:

-          Global warming and rising sea levels

-          Degradation and loss of farming land and fresh water

-          Overcrowding

-          Depletion of natural resources and habitat loss

-          Pollution

 Conflict of Objectives:

-          Improved quality of the environment v slower economic growth

-          Low inflation v high unemployment

-          Rapid economic growth v balance of trade deficit

-          Reduction of inequality v reduction in incentives

-          Foreign investment v loss of independence

-          Job protection v inefficient use of resources

The Economic/Business Cycle:

(Draw Fig 7.13, p206)

The economy tends to fluctuate in a cyclical manner between periods of recession and boom.

 A range of economic indicators are used to assess and forecast national economic activity and base appropriate policy response.

 Fluctuations in unemployment and inflation usually lag behind fluctuations in real GDP.

(Questions 1 to 4, p207).

Economic Indicators:

 Leading Indicators: (in advance of fluctuations)

-          Factory overtime

-          Dwelling approvals

-          Money supply

Coincident indicators: (at the same time as peaks and troughs)

-          Retail sales

-          New car registrations

-          Factory production

-          Job vacancies

Lagging indicators: (after the trade cycle)

-          CPI

-          Unemployment

-          Investment expenditure

Inflation and Unemployment:

 The 2 most useful indicators of the current state of the Australian economy.

Controlling inflation is important because it;

-          Maintains the value of money

-          Protects the value of savings

-          Boosts consumer and business confidence

-          Promotes productive investment, long-term growth and job creation

-          Protects international competitiveness

-          Reduces exchange rate volatility

-          Protects equitable distribution of income and wealth.

 The prices of ALL goods do not always change at the same rate. CPI is the most widely used price index. It does have shortcomings, however.

-          Only shows changes at the retail level

-          Does not account for changes in the mode or style of living

-          Does not account for change in quality of goods

-          Excludes seasonal factors, petrol prices, and govt and financial charges

RBA usually sets an inflation target of 2-3% annually.

GDP deflator: - provides a broader coverage of price changes than the CPI (which only includes retail prices changes).

-          It includes all components of output and price movements of all sectors of the economy.

Forms of Inflation:

1)      Demand-Pull inflation:

-          Results from excessive demand (Sydney house prices, New cars from Covid)

-          “Too much money chasing too few goods”

2)      Cost-Push inflation:

-          Results from rising production costs. (Wages, rent, raw materials)

-          Rising costs are passed on to the consumer.

3)      Imported inflation:

-          Changes in the cost of imported goods

-          Fluctuations in the exchange rate

Effects of Inflation:

 If inflation is high

-          Borrowers benefit at the expense of lenders and savers

-          People on fixed incomes suffer (pensions and retirees)

-          As incomes rise, wage earners move into higher tax brackets (Bracket creep), so a greater percentage of their income goes to tax.

-          Exporters suffer (as their costs and prices are higher)

-          Encourages people to invest in unproductive assets (property and precious gems)

-          Creates a climate of instability

-          Business confidence tends to decline

(Questions 1a,1c, 3, 5 p220)

Measuring Unemployment:

Employed person: a person who works at least 1 hour per week.

● You must be without work in the reference week

● You must have been actively looking for work in the previous four weeks

● You must be available to start work in the reference week

Labour Force: (working population)

 The total number of people over the age of 15, currently employed plus those currently unemployed but actively seeking a job.

Types of Unemployment:

1)      Frictional unemployment (when people change jobs)

2)      Structural unemployment (new industries, methods of production, new locations)

3)      Cyclical Unemployment (Boom and bust of the economic cycle)

4)      Seasonal Unemployment (Fruit picking, shearing, ski season)

5)      Hidden Unemployment (Discouraged workers, underemployment)

Natural unemployment rate:

 Some frictional, structural, cyclical, seasonal and hidden unemployment will always exist in an economy (3.5% - 5%).

The effect of unemployment:

GDP gap: the difference between actual and POTENTIAL GDP

Long-term unemployed: - 52 weeks or more (become more difficult to re-employ)

Incidence of Unemployment:

 The extent to which different groups (young, indigenous, rural) of people experience unemployment.

Stagflation:

-          Occurs when inflation occurs simultaneously with low levels of economic activity (GDP), and high unemployment.

The Phillips Curve:  Shows a trade-off between inflation and unemployment.

(A reduction in one would lead to an increase in the other).

(See figure 7.25, p226)

(Draw figure 7.28, p228)

Increasing AD are represented by a movement along the Phillips curve (a to  b)

Stagflation is a shifting of the curve from P0 to P1

(Caused by rising oil prices, demands for higher wages, higher input costs)

(Questions 1 to 6, p229)

The Role of Government in managing the economy:

3 Main roles:

1)      Allocative

2)      Distribution

3)      Stabilisation

Allocative:

-          Legislation (make laws)

– prevent monopolies, maintain competition

Regulate foreign investment and ownership

License and regulate trade and professions

-          Taxation and Expenditure (tax incentives and disincentives)

Expenditure on transport, mining and farming

Subsidies for R&D, training and education

Public Goods (Defence) and Merit Goods (CSIRO, symphony orchestras)

Public enterprises (Railways, Utilities)

Distribution:

-          Pensions and social security

-          Minimum wages

-          Price controls

-          Anti-discrimination laws

Stabilisation:

-          Fiscal policy (Govt taxation and spending)

-          Monetary Policy (Interest rates and money supply)

-          External policy (tariffs and exchange rates)

-          Microeconomic reform – increase aggregate supply (AS).

(question 3, p231)

(Chapter 7 Review, pp232-238)                                                                                                                                       

Chapter 8: Fiscal Policy:

 Fiscal Policy  (Govt spending and taxation)

The Budget is the Govt’s planned revenues (Tax) and expenditure for the next financial year. The estimates can change throughout the year as economic conditions (eg; Covid) and government policy priorities change (eg; was reduced Govt spending à changed to protecting jobs and massive spending during Covid).

 In December of each year, a Mid-Year Economic and Fiscal Outlook (MYEFO)  is released updating forecasts.

 By Varying the level of taxation (leakages) and expenditure (injections) the govt can influence the;

-          Level of growth (GDP)

-          Level of employment

-          Inflation (Price stability)

-          Distribution of income (equality)

Types of Govt Income:

-          Direct taxes (income, medicare levy, company)

-          Indirect taxes (GST, customs and excise duty)

-          Other revenues (Govt businesses, sale of govt assets)

(ref fig 8.1, p241)

2016-17 Govt revenue and spending

(Question 1,2 p242)

4 Principles of taxation:

1.      Equity – Rich should pay more (is it fair?)

2.      Collection (-ease of)

3.      Certainty – how much and when it applies.

4.      Convenience (-least in time and manner to the taxpayer)

Modern Criteria is EQUITY, EFFICIENCY, SIMPLICITY

(Questions 1,2 p243)

Types of Taxation:

-          Income

-          Company

-          Superannuation funds tax

-          GST

-          Petroleum resource tax (profits of offshore oil and gas)

-          Customs duty (Imported Goods)

-          Excise Duty (Alcohol, tobacco, petrol)

-          Fringe Benefits Tax (private use of company car)

-          Other taxes (license fees, gambling etc)

(Draw Fig8.3, p244)

Proportional Tax: (Flat rate)

 The amount people pay is proportional to their Income (eg 20% flat rate). A problem with this is that the rich get richer and the poor get poorer.

Progressive Tax:

 As income levels rise, so does the rate of taxation. (Rich pay more).

The Aust Income tax system is based on this. (2024-25)

In Class Research Task: Define and explain the term ‘Bracket Creep’

Regressive tax:

-          Takes a decreasing proportion of the taxpayer’s wage as their income rises.

Consider 2 taxpayers, one earning $500/wk and the other $1000/wk. They both buy an item which has $20 GST. For the first person that represents 4% of their wage, but for the richer person it is only 2% of their wage. (The poor person is more greatly affected).

The Incidence of taxation:

 It is very important to know if the person on whom the tax is levied is the person who ultimately bears the burden of the tax, or whether this burden is shifted onto someone else.

Indirect taxation:

 GST, excise tax, and Customs duty.

The wholesaler, retailer, importer or manufacturer eventually pass on part, or all, of the tax to the consumer in the form of higher prices.

Indirect taxes are popular with the Govt for a range of reasons:

-          They are convenient and inexpensive to administer

-          They are, to some extent, concealed from those on whom they fall. (The average consumer has only a vague idea of what fraction of the price paid is tax).

INDIRECT TAXES HAVE A MUCH GREATER IMPACT ON THE POOR THAN THE RICH

Effects of Taxation:

Bracket Creep:

As inflation causes increases in wages, people continually move into higher and higher income tax brackets, and therefore pay higher rates of taxation.

 Higher rates of taxation leave consumers and producers with less money to spend.

Sin Taxes:

-          To discourage consumption (Alcohol and tobacco)

Import taxes (tariffs) are designed to encourage people to buy domestic goods.

(Question 1 to 9, p249) Do 1^st bullet point of Q9.

Fiscal Policy:

 Main objectives of

-          full employment (3.5% - 5% unemployment) and

-          price stability (Inflation 2% - 3%)

-          sustainable economic growth (GDP 3% - 4%)

Budget Outcomes:

-          Deficit (Expenditure > Taxation) – Expansionary Stance

-          Surplus (Expenditure < Taxation) – Contractionary Stance

-          Balanced budget (Expenditure = Taxation) – Neutral Stance

(Draw Fig 8.6, p251)

Discretionary Fiscal Policy:

Structural Change: - a deliberate action of the govt to change tax rates and/or expenditures in the budget.

Non Discretionary Fiscal Policy:

Cyclical Change: - the state of the economy.

Automatic stabilisers are triggered (Unemployment benefits, income tax) to counteract problems.

Deficit finance and public debt:

 When there is a budget deficit, the govt is spending more than it’s receiving in taxation. It must therefore obtain additional funds.

-          Borrow from the RBA (Doesn’t do this anymore - basically printing more money)

-          Sell Govt Bonds to the general public (Can result in ‘Crowding Out’)

-          Borrow from overseas (creates sovereign debt and interest payments to overseas)

Crowding Out refers to the private sector raising interest rates to compete with Govt Bonds. The competition can force up interest rates and reduce the effectiveness of expansionary fiscal policy.

(Questions 1 to 6, p255).

Time Lag Indicators:

 The time it takes to decide upon a policy, implement it, and for the effects to flow thru to the economy.

Inside Lags:

-          Recognition Lag

-          Decision-making Lag

-          Implementation Lag

Outside Lags:

-          Autonomous Expenditure Lag

-          Induced Expenditure Lag

 Some economists believe that lags mean Govt intervention can create economic instability.

Keynes proposed that Govts should;

-           spend (Budget Deficits) during downturns, recessions and depressions

-          Tax (Budget Surplus) during Boom (inflationary) periods.

The Phillips Curve:

 The relationship between the trade off between Inflation and the Unemployment rate.

(Draw Fig 8.18, p269)

Fig 8.17, p 268 - For every small increase in GDP (Increase in AD) and decrease in unemployment, there is an increasing rise in the general price level.

·       Govts can lower unemployment by stimulating AD but must accept a higher rate of inflation as a trade off.

 Policy makers can choose a desired inflation – unemployment combination using the Phillips curve.

Stagflation: - where inflation and unemployment rise at the same time. (P0 – P1, fig 8.18).

This occurred in Aust in the 1970’s.

Inflationary expectations: - Wage earners need to ensure that their wages increase in line with expected inflation, otherwise they will suffer a decline in spending power (real wages).

Investors must also account for inflation to determine expected (real) returns.

Incompatible economic objectives:

-          Economic growth and price stability (GDP and Inflation)

-          Economic growth and environmental quality (sustainability)

-          Improved equity – reduced incentive to work or invest

-          Improved technology – structural unemployment

-          Promotion of Superannuation – reduced C, T and standard of living

Global Influences:

-          Covid

-          Wars

-          Depression/Recession

-          Oil prices

-          Influence of Multi Nationals

Political Restraints:

-          Political survival of Govts influence policy

-          Increase Taxes, Decrease spending (unpopular)

-          Decrease Taxes, Increase spending (popular)

(Questions 1,2,5,6b,6c, p271-2)…. Review of Ch 8 pp273-276

Chapter 9 -Monetary Policy:

-          Involves the Reserve Bank of Aust (RBA) changing the level of interest rates to influence the cost and availability of credit.

-          To expand economic activity, it lowers interest (cash rate) to boost consumer spending, and reduce the incentive to save. Businesses are more likely to purchase new capital equipment. There will be an increase in Aggregate Demand (AD) stimulating economic activity (to increase employment).

-          To ease economic activity, it increases interest rates, to reduce consumer spending and business investment. This reduces AD and economic activity (to reduce inflation).

Cash Rate and Interest Rate:

 Cash rate is the rate that banks pay to borrow funds from other banks. It is not the same as interest rates charged to consumers but influences wholesale and retail interest rates greatly. They all move in the same direction.

 The RBA’s key operational objective is to contain inflation in Aust between 2% and 3%.

*The RBA operates independently of the Govt. – this allows it to make decisions that maybe unpopular with public opinion and the govt of the day.

(Questions 1 to 4, p280)

Headline rate of inflation: - CPI

Underlying Rate of inflation: - CPI excluding one-off or seasonal factors (prices of bananas after a cyclone).

Basis point: = 1/100 of 1% (0.01%)

-          1% = 100 basis points

-          If an interest rate was to increase from 2% to 3% it is said to have risen by 100 basis points.

*Interest rate comparisons with overseas:

- If Aust has lower rates than overseas, it could lead to a serious capital outflow and a depreciation of the Aus$. The reverse could happen if overseas rates were lower.

Inflation target: (2 -3%)

 The purpose of inflation targeting is to maintain;

-          The stability of the currency of Australia

-          Full employment

-          Economic prosperity and the welfare of the Australian people

(Questions 1-4 p283)

Selecting the Monetary Policy Stance:

The 2 main instruments are:

1)      altering the cash (interest) rate and

2)      changing the money supply.

-          Is inflation within the target range (2-3%)

-          Wage growth below 3% is likely to stabilise inflation rate. Wage growth above 4.5% is usually associated with an inflation rate above 3%.

-          GDP above 4% indicates AD is greater than AS which will likely push the inflation rate beyond the target range.

-          Compared to overseas interest rates, if Australia’s is lower, a serious capital outflow may occur leading to a depreciation of the $AUS. (the reverse will also occur).

Expansionary Monetary Policy = lowering the cash/interest rate & RBA buying Govt Bonds

Contractionary Monetary Policy = raising the cash/interest rate & RBA selling Govt Bonds.

Open Market operations : = buying/selling of Govt securities.(By the RBA)

Impacts of changes in the cash/interest rate:

Lower interest rates will; (Covid situation) – Expansionary Stance                                                                                                                                       

-          Discourage saving and encourage investing (borrowing and consumption)

-          Reduce the cost of servicing debt, giving more cash flow and disposable income to households and businesses.

-          Encourage the purchase of assets such as houses, property, shares and bonds.

-          Encourage capital outflow which leads to a depreciation of $AUS.

Higher interest rates will; (Current situation) – Contractionary Policy Stance- Monetary

-          Encourage savings and discourage investing (borrowing)

-          Increase the cost of servicing debt, leaving less cash flow and disposable income to households & businesses

-          Discourages the purchase of assets (such as houses/cars)

-          Encourages capital inflow which leads to an appreciation of $AUS.

The Transmission Mechanism:

2 stages:

1)      Changes to the cash rate affect the other interest rates in the economy

-          cash rate à Interest rates

-          cash rate à interest rates

2)      Changes to these interest rates affect economic activity and inflation.

cash rate à Interest rates à Spending & Investment à AD à Inflation

  cash rate à interest rates à Spending & Investment à AD à Inflation

       interest rates à Exchange rate à Exports, Imports à AD à Inflation

Inside Lag: - the time it takes to recognize the state of the economy and decide on appropriate policy. (Reaction lag)

Outside Lag: - the time it takes for the policy decision to have its effect on the economy. (Result lag)

The effectiveness of monetary Policy is enhanced by short inside time lags, but significantly reduced by the long and variable outside time lags before policy changes are fully transmitted and changes in economic activity occur.

*The RBA’s relative independence from political influence is perhaps monetary     policy’s greatest advantage over fiscal policy.

Limitations of Monetary Policy:

·       Monetary policy is relatively quick to implement, but changes in the cash rate take up to 6 months to begin to significantly affect real economic outcomes, and between 1 -2 yrs to have their maximum effect on economic activity and inflation; and it may be 3 yrs before their full effects are felt in the labour market.

Indirect Transmission Mechanism:

 Reducing interest rates will only induce an increase in consumption spending and business investment when households and firms feel confident that business conditions will improve. Lower interest rates will not induce consumers to borrow if they fear that their employment or hours of work are under threat. They may instead choose to boost their repayment of outstanding debts, such as mortgages, rather than increase their consumption spending.

 Banks and other financial institutions determine the pace and degree to which they respond to changes in the cash rate, based on their own commercial considerations.

 While an increase in the cash rate is usually passed on very quickly, a cut to the cash rate may not result in any immediate change in market rates.

 The effectiveness of monetary policy is compromised by long and variable time lags linked to the indirect way that changes in the cash rate are transmitted through different channels.

Investment spending and housing markets are more sensitive to changes in interest rates, so changes to monetary policy settings work more quickly through these channels.

Competing Objectives:

 There can often be a degree of incompatibility between key economic objectives (such as economic growth and inflation). A degree of trade-off remains between monetary policy settings that restrain inflation and ones that promote economic growth and employment.

 There is strong concerns that returning interest rates to more historically normal levels would risk financial hardship and mortgage defaults by highly indebted investors and home owners, sparking a crash in housing prices and an economic downturn via the asset prices and wealth channel.

Strengths of monetary policy is the short inside time lag and freedom from political restraints.

(Questions 1-5, p303)

(Chapter review pp304 – 310)

Chapter 10 Economic Management:

Microeconomic Policies:

Microeconomics: - the study of economic behavior at the level of the individual units of an economy.

 It focuses on factors affecting the decisions made by individuals, firms and governments about the allocation of resources and the prices of G&S.

Supply-side policies: are govt initiatives that promote economic change at the microeconmic level. They aim to increase efficiency of resources allocation and raise productivity.

 This makes Australian industries internationally competitive.

 Key elements of Australian microeconomic reforms include increased public and private investment in infrastructure, education and training, and welfare and taxation reform.

Structural change: industry-wide changes in the pattern of production that result in certain products, production processes and even industries disappearing while new ones emerge.

 Structural change can be very disruptive to an economy, workers, firms and Govts. Whole occupations can disappear (Cane cutters), and even workers who retain their jobs need to acquire new skills and ways of working.

 An economy will decline unless it responds to structural change (Broadband internet).

Main areas of supply-side reform:

 Infrastructure: Telecommunications, transport, power, schools, hospitals and public housing.

Education and training

Deregulation and competition policy

The productivity commission

Labour market reform

Taxation reform.

The floating of the exchange rate

Trade and industry policies.

(questions 1,4,6,10 p315 - 316)

How Microeconomic reforms increase output:

-          reduce business costs by improving efficiency and increasing productivity, so that G&S can be produced at lower prices.

-          Effect is to shift the long-run AS curve to the right (Fig 10.1)

-          Results in more goods sold at a lower price.

-          More goods at a lower price encourages firms to invest which increase AD.

-          Encourage the efficient operation of markets

Productive Efficiency: - the ability of an economy to achieve the maximum quantity of output from a given quantity of resources. à G&S being produced at the lowest cost.

Dynamic Efficiency: - the ability of an economy to respond to changing consumer demands by reallocating resources to new industries or production processes. à adopting new technology

Allocative efficiency: - a country’s resources are used in combinations that generate the maximum benefits.

(questions 1,2,3,4 p320)

The relationship between microeconomic reform and domestic macroeconomic objectives:

The ultimate aim of economic management is to maintain economic prosperity and increase the population’s standard of living and quality of life as well as equity in wealth distribution and Intergenerational equity.

 The existence of poverty in Australia and the high percentage of national income that flows to the top quintile of income earners provide clear evidence that there is an uneven distribution of income and wealth. It is a widely held belief that a significant number of citizens do not enjoy or receive a ‘fair share’ of the benefits of economic growth.

 There are also concerns about intergenerational equity (sharing of economic benefits and costs between the present and future generations).

Optimum Population: - the ideal population for an economy considering size, demographics (age, gender, ethnic/cultural mix) geographic and resource limitations.

Aggregate supply (AS) policies determine the capacity of an economy to expand its output of G&S, and improve the efficiency with which it uses its productive resources. The key determinant is to increase the success of domestic producers and raise the living standards of households.

Infrastructure, education and training, innovation and R&D are the most important areas of expenditure.

Progressive taxation and social welfare programs have helped build social cohesion and compensated for the failure of the market economy to provide equitable outcomes.

Publicly owned business enterprises:

 Citing ‘public interest’, govts in Aust have established govt business enterprises (GBE’s) to provide competition for private sector firms, especially in markets considered to be natural monopolies, to reduce prices or improve the quality of G&S.

-          Commonwealth Bank (1911)

-          Commonwealth Shipping Line (1917)

-          Qantas

-          Medibank Private (1975)

-          NBN (2009)

Privatisation of GBE’s has been a major feature of reform to the supply-side of the economy since the 1990’s. Sometimes partial or outright sale.

 The main justification is the assumption that privately owned enterprises are likely to be more efficient because, unlike GBE’s, they face competition.

GBE’s which have been sold include;

-          Commonwealth Bank

-          Qantas

-          Medibank Private

-          Telstra

-          Airports in Sydney, Melbourne, Brisbane and Perth

-          Aust National Railway

 Financial industry deregulation:

-          ASIC

-          APRA

-          ACCC

-          OFT

Revenue Collection – Aust Taxation Office (ATO)

Regulator Failure: - Excessive Govt regulation results in inefficiency.

-          Floating of the $AUS (1983)

-          Deregulation of Airlines (1990’s)

-          Optus allowed to compete with Telstra (1992)

(Questions 1, 8 p331)

Investment in Infrastructure:

-          Sydney Harbour Bridge (1932)

-          Snowy mountains hydro (1974)

-          Trans-Australian railway (1974)

These projects provide employment during both the construction and production phases, deliver new goods or services, and help use Aust’s resources in new and productive ways.

 Infrastructure underpins economic growth and competitiveness of Aust producers. It accounted for 13% of GDP in 2011.

Education and Training:

-          Free University education (1974)

-          HECS (1989)

External Policies: - Floating of the $AUS (1983)

Research, development (R&D) and innovation: (CSIRO)

R&D is critical to the innovation process but costly, and there is no guarantee that investment will lead to the successful development of a new product or production process.

 Labour market reform:

 Policies that influence pay and conditions of work seeks to control inflation, reduce unemployment and achieve an equitable distribution of income. They set award wages and conditions with the objectives of;

-          Controlling the expectations and demands of workers to achieve wage restraint and reduce upward pressure on prices.

-          Protecting workers income and working conditions

-          Provide a framework for the settlement of industrial disputes

Taxation reform: GST

Optimum Population:

 Aust’s rapidly growing population is concentrated in the major cities on the eastern seaboard. This growth is occurring without the support of carefully planned infrastructure, which puts pressure on the natural environment.