Fiscal and Monetary Policy

LECTURE 11: Fiscal Policy and Monetary Policy

• Are fiscal stimulus and rate cuts effective policies to combat recession?

OBJECTIVES

• Explain how fiscal stimulus is used to fight a recession.

• Explain the supply-side effects of fiscal policy on employment, potential GDP and the economic growth rate.

• Describe the objectives, the framework and tools of monetary policy.

• Explain the transmission channels through which the Reserve Bank influences real GDP and the inflation rate.

OUTLINE OF LECTURE

• The Australian Government Budget (Budget at a glance)

• Fiscal Stimulus

• Supply side: Potential GDP and growth

• Monetary Policy: Objective

• Monetary Policy Transmission: Fighting Recession

• Credit Creation

• Background to Money market equilibrium

• Interest rate and Asset prices

• Monetary Policy Transmission: Fighting Inflation

• Effectiveness of Monetary Policy

FISCAL POLICY

• The use of the Australian government budget is to achieve the macroeconomic objectives of full employment and high and sustained economic growth

2024 Budget Highlights

• Cost of Living:

  • 7.8 billion budgeted for cost of living relief across multiple measures.

  • 3.5 billion for energy bill relief.

• Health:

  • 3.4 billion over five years for adding new drugs to the PBS or amending existing listings; including COVID, MS, leukaemia, kidney disease and breast cancer drugs.

• Housing:

  • 6.2 billion added to the Homes for Australia plan, bringing it to a total of 32 billion.

  • 1.9 billion in loans for community housing providers to build social and affordable homes under the Housing Australia Future Fund.

  • 1 billion promised for accommodation for women and children fleeing domestic violence.

• Education:

  • 1.1 billion over five years to fund the first stage of the Universities Accord, targeting eight out of ten workers with a tertiary qualification by 2050.

  • 88.8 million budgeted for 20,000 more fee-free TAFE and VET places for construction-related courses.

  • Capped indexation on university student loans to match either the Consumer Price Index or the Wage Price Index (whichever is lower), at a cost of 239.7 million over five years.

2025 Budget Highlights

• Cost of Living:

  • More tax cuts with additional tax cuts in 2026 and 2027.

  • Extending energy bill relief.

• Health:

  • Strengthening Medicare (bulk billing of 7.9 billion).

  • More funding for public hospitals (1.8 billion to fund public hospitals and health services in 2025–26).

  • Boosting the primary care workforce.

  • Better healthcare for women.

• Housing:

  • Investing in infrastructure (17.1 billion over 10 years for road and rail).

  • 3 billion in incentive payments under the New Homes Bonus.

• Education:

  • Investing in every stage of education from early childhood to schools to permanent free TAFE).

  • Cutting student debt (19 billion).

• Supporting small businesses:

  • 56.7 million in grants of up to 25,000 to over 2,400 businesses in the Energy Efficiency Grants for Small and Medium Sized Enterprises program.

SOURCES OF AUSTRALIAN GOVERNMENT BUDGET

• Budget balance = Revenue – Expenses

• Sources of Revenues (receipts):

  • Taxes on individuals

  • Taxes on companies

  • Indirect taxes and other taxes

  • Non-tax revenue

• Categories of expenses (payments):

  • Transfer payments

  • Expenditure on goods and services

  • Debt interest and other payments

• https://tradingeconomics.com/australia/government-budget

THE AUSTRALIAN GOVERNMENT BUDGET - Why Do Deficits and Debts matter?

• Deficits and debts matter for two chief reasons:

  • Lower credit rating and increase interest rate

  • Redistributes C and G across generations

• The Budget Time Bomb

  • The budget time bomb arises from trends in the age distribution of the Australian population.

  • 2023 Intergenerational Report (https://treasury.gov.au/publication/2023-intergenerational-report)

FISCAL STIMULUS

COVID-19 impact on Circular Flow of Economic Activities

• Households, Firms, Banks, Government, Rest of the world are impacted.

• Firms close and unemployment rises.

FISCAL STIMULUS

• John Maynard Keynes: The General Theory of Employment, Interest and Money (1936)

  • AD failure can plunge economy into recession.

  • Business and consumer confidence plays important role to influence AD. As noted in the Great Depression (1929 – 1939)

• The Keynesian View (Arguments for)

  • Fiscal stimulus—an increase in government expenses or a decrease in tax revenue—via multiplier effect to boost real GDP and create or save jobs.

FISCAL STIMULUS

• The Mainstream View (two arguments against)

  • Keynesians overestimate the multiplier effects of fiscal stimulus, and their effects are small, short-lived (unsustainable) and incapable of working fast enough to be useful. Inflation also becomes a problem.

  • Government stimulus “crowds out” investment. (i.e. Crowding-out effect)

Crowding out effect (pp.623)

• Total Savings = Public + Private Savings.

• But because Gov is in deficit, that means there is no Public Savings. So, total savings is only made up of Private savings. (PS)

• Budget deficit: To finance this deficit, the Gov has to borrow which reduces the amount of loanable funds (LF). Private Investment crowded out.

FISCAL STIMULUS AND AGGREGATE DEMAND

• Suppose potential GDP is 2.0 billion, real GDP is 1.9 billion.

  • There is a 0.1 billion recessionary gap.

  • An increase in government expenditure or/and a tax cut increases expenditure by ∆E.

  • The multiplier increases induced expenditure.

  • The AD curve shifts rightward to AD1.

  • The price level rises to 105, real GDP increases to 2.0 billion and the recessionary gap is eliminated.

FISCAL STIMULUS - Limitations of Discretionary Fiscal Policy

• Legislation lag

  • Process for Parliament to pass the law takes time.

• Potential GDP is imperfectly estimated

• Inflation can become a problem (i.e. AS curve).

• Economic forecasting is not an exact science (Impact lag)

• Behavioural Economics – consumer behaviour can be irrational.

SUPPLY SIDE: POTENTIAL GDP AND GROWTH

• Supply-side effects are the effects of fiscal policy on potential GDP. Reflects government policies that increase aggregate supply to achieve long- run growth in real output, full employment and a lower inflation level.

• Potential GDP depends on:

  • Full-employment quantity of labour,

  • Quantity of capital, and

  • State of technology.

• But also depends on fiscal policies such as:

  • Changes in taxes

  • Government expenditure

  • Government reforms

SUPPLY SIDE: POTENTIAL GDP AND GROWTH

Tax cuts:

• Reaganomics (supply-side economics) states that tax cuts give companies more cash to hire new workers, expand their businesses and create a supply of goods and services. Cuts give workers more incentive to work, increasing the supply of labour.

• However, Reagan 1980 tax cuts caused the US deficit to explode (Niskanen and Moore, 1996).

• “Tax cuts without spending cuts will swell the budget deficit and bring a crowding-out effect” (Martin Feldstein, Harvard professor; Reagan’s chief economic adviser)

SUPPLY SIDE: POTENTIAL GDP AND GROWTH

Government expenditure:

• Government spending on infrastructure, health and education can increase output; potential GDP; and long term economic growth.

• Is this focusing on demand side or supply side?

• Can the government spend the money more effectively than the private sector?

• The NBN: why it's slow, expensive and obsolete Rod Tucker, Sydney Morning Herald, September 2015
  Australia’s NBN rollout is nearly done, so has it been a success? Experts give their verdicts

SUPPLY SIDE: POTENTIAL GDP AND GROWTH

Government Reforms:

• Deregulation (examples) to increase competition:

  • Australian telecommunications (from late 1980s) and Australian financial system (early 1980s)

MONETARY POLICY - RESERVE BANK OF AUSTRALIA

RBA CUTS RATES IN 2020

• Reserve Bank cuts interest rates to record low of 0.1 per cent during COVID-19 recession (November 2020)

• Rates cut to 0.5 pc - the fourth in less than 12 months - follows turmoil in financial markets over the past week driven by fears about the impact of the global coronavirus outbreak.

INFLATION RATE AND CASH RATE, AUSTRALIA

Inflation Rate vs Interest Rate from 2016-2025

FINANCIAL REVIEW

Reserve Bank on high alert for rate rise

• The Reserve Bank is set for a string of interest rate rises over the next year potentially taking the cash rate to 2.5 per cent, as it indicated Australia's inflation outbreak will not be brought under control until mid-2024.
  The Reserve Bank of Australia is "very alert" to the cost of stubbornly high inflation lingering in the economy, signalling interest rates will need to stay higher for longer and might have to go up to curb price rises.

OBJECTIVE (only pp. 404-405) Monetary Policy Objectives

• The stability of the currency of Australia

• The maintenance of full employment in Australia

• The economic prosperity and welfare of the people of Australia.

• Statement on the Conduct of Monetary Policy

• The Reserve Bank and the Australian Government agree on the goal of keeping consumer price inflation between 2 and 3 per cent, on average, over the business cycle. (i.e. Inflation targeting)

  • Why 2 – 3%? Why not 0%?

MONETARY POLICY TRANSMISSION – FIGHTING RECESSION

• RBA decreases Reserve supply which increases Cash Rate, increasing Other interest rates, increasing C and I, increasing AD

  1. To lower the case rate, the RBA buys Commonwealth Government Securities (CGS) from banks to stimulate the economy. (via as open- market operations).

  2. This increases the banks' reserve supply, which lowers the cash rate.

  3. The increase in banks reserve supply increases the money supply (MS0 to MS1).

  4. Consequently, all other interest rates fall.

  5. The lowering of interest rate encourages borrowing for C and I.

  6. ↑C and ↑I (and multiplier effect) shifts AD to the right.

CREDIT CREATION (after OMO)

• Suppose initial Cash Deposit = 100 and Min. Reserve Ratio (R) = 20%

MONEY MULTIPLIER

• The Money Multiplier (K) is defined as:

  • K = \frac{Total \ Deposits \ created}{Initial \ Deposit}

• Which is also expressed as: K = \frac{1}{R}

• Where R is the reserve ratio.

• So, if R = 20%, then K = \frac{1}{0.20} = 5

• Amount of money created = R x initial deposit = 5 x 100 = 500

BACKGROUND TO MONEY MARKET EQUILIBRIUM (pp. 278-279)

• MS is vertical because the quantity of money is fixed by the RBA regardless of the nominal interest rate.

• Why is MD downward sloping?

• Let’s say r = 6%, will people want to hold more or less money?

INTEREST RATE AND ASSET PRICES (p. 234)

• People want to hold onto interest bearing assets D for bond --> r¯ --> P of bonds ↑

• There is an inverse relationship between asset price (eg. bond price) and r.

INTEREST RATE AND ASSET PRICES (p. 234)

• Suppose an asset (e.g. bond) sold for 200 yields 6 interest each year (assume that the payment of 6 is a fixed sum each year)

• Suppose the bond price rises to 300

• The annual return of 6 is equivalent to only 2% interest return.

• So, when bond price rises, interest rate drops.

  • \frac{6}{200} × 100 = 3\%

  • \frac{6}{300} × 100 = 2\%

MONETARY POLICY TRANSMISSION – FIGHTING INFLATION

• RBA increases Reserve supply which decreases Cash Rate, decreasing Other interest rates, decreasing C and I, decreasing AD

  1. To raise the cash rate to 4%, the RBA sells Commonwealth Government Securities (CGS) in the financial markets to banks. (via as open-market operations).

  2. This decreases the banks' reserve supply and cash rate rises.

  3. The decrease in banks reserve supply decreases the money supply.

  4. Consequently, supply of loanable funds decreases (next slide).

  5. … and higher interest rate discourages borrowing for C and I.

  6. ↓C and ↓ I (and multiplier effect) shifts AD to the left.

EFFECTIVENESS OF MONETARY POLICY - VARIABLES TO CONSIDER

• AD --> Y --> P

• SAS

• r ¯ --> LF­ --> AD­ --> Y­

• h LF r

• LF­ --> -->Y­

• DLF

• K

• h = interest elasticity of loanable funds

• K = multiplier effect

• P = price effect (i.e. slope of AS)

• LF=Loanable funds

• P reserves

• RD
  *Cash rate r ¯

EFFECTIVENESS OF MONETARY POLICY INTEREST RATE

It’s a liquidity trap! Liquidity trap is a situation in which the central bank’s efforts to stimulate spending fail because people hoard cash instead.

EFFECTIVENESS OF MONETARY POLICY

The effectiveness of monetary policy depends on a few key behavioural parameters:
1. Interest elasticity of investment How much does demand for investment go up, when the interest rates go down? (Loanable funds market)
2. Price effect (inflation) (AD-AS model; slope of AS curve)
3. Expectations/human behaviour: The RBA does not control the amount of money that households choose to hold as deposits in banks. The RBA does not control the amount of money that banks choose to lend.

RECALL: WHY IS INFLATION CURRENTLY SO HIGH?

• A combination of factors:

  • Supply problems (e.g. labour shortages, war (surge in gas and oil prices), lack of vacant properties) kept inflation high (Beckers, Hambur, and Williams, 2023).

  • The significant amount of fiscal and monetary support provided by the government underpinned a strong recovery in demand and put further pressure on prices.

  • “In 2023, the Reserve Bank of Australia (RBA) had raised the official cash rate by 1.25% to 4.35%. However, the high inflation rate persisted beyond the 2–3% range since the start of 2024”.

  • Which factors identified above are not affected by interest rate hikes? Note that monetary policy is only effective in curbing demand-side factors.

REVIEW OF LECTURE

• The Australian Government Budget

• Fiscal Stimulus

• Supply side: Potential GDP and growth

• Monetary Policy: Objective, framework and tools

• Monetary Policy Transmission: Fighting Recession

• Credit Creation

• Background to Money market equilibrium

• Interest rate and Asset prices

• Monetary Policy Transmission: Fighting Inflation

• Effectiveness of Monetary Policy