Introduction to Economics – 11175

Week 12

Government and Reserve Bank Policies

 Week 12 Lecture

1. Understand fiscal policy and monetary policy

2. Distinguish between automatic stabilisers and

discretionary fiscal policy.

3. Explain the role of cash rate in setting monetary

policy.

4. Analyse the effect of fiscal and monetary policy

using the AD-AS model.
Macroeconomic Policy Objectives
• Economic growth
• Full employment
• Stable price level
• Balance in the BOP (Balance of Payment)
in medium term

3
Policy Instruments
• Fiscal policy
• Monetary policy

4
 Fiscal Policy
What is fiscal policy?

• Fiscal Policy: Changes in federal taxes (& transfer payments)

and purchases that are intended to achieve macroeconomic
policy objectives, such as high employment, price stability
and healthy rates of economic growth.

• Fiscal policy refers to the actions of the federal government,

and not state, territory or local governments.

5
Australian Government spending to GDP

6
Government expenditure by
function, 2018/19
Government revenue by source,
2018/19
 RecessionaryProblem
Unemployment Gap
P AD0 LRAS SRAS
AD1

AD= C+I+G+NX

.A
P1 .B Recessionary Gap
Unemployment
problem

Y1 Y2 Y 9
Disp. Income= Gross Income - Taxes + Transfer
 Using Fiscal Policy to Influence
Aggregate Demand
Expansionary fiscal policy
• Expansionary fiscal policy: Increases in government purchases
and/or decreases in taxes in order to increase aggregate
demand.

• An increase in government purchases will increase aggregate

demand directly.

• A reduction in taxes has an indirect effect on aggregate demand

through the affect on disposable income.

10
 Using fiscal policy to influence
aggregate demand
Expansionary fiscal policy, cont.
• The goal of expansionary fiscal policy is to increase aggregate
demand by more than it would have increased without policy.
• Appropriate when the economy is in equilibrium below full-
employment, e.g. during an economic contraction or recession..

11
 Recessionary
Expansionary fiscalGap
policy
P AD0 LRAS SRAS
AD1

.A
P1 .B

Y1 Y2 Y 12
 Recessionary Gap
Inflation Problem
P LRAS SRAS
AD1
AD0 AD= C+I+G+NX

Inflationary Gap –
P1 .B Inflation problem
P0 .A

Y1 Y2 Y 13
Disp. Income= Gross Income - Taxes + Transfer
 Using fiscal policy to influence
aggregate demand
Contractionary fiscal policy
• Contractionary fiscal policy: Decreases in government
purchases and/or increases in taxes in order to reduce
aggregate demand.
• Appropriate when the economy is above full employment
equilibrium and the inflation rate is high.

14
 Recessionary Gap
Inflation Problem
P LRAS SRAS
AD1

AD2

P1 .B
.A

Y1 Y2 Y 15
 Fiscal Policy
Actions by the
Problem Type of Policy Result
Government
Economic Expansionary Increase Real GDP and the
contraction or government price level rise by
recession spending or cut more than they would
taxes have without policy

Rising inflation Contractionary Decrease Real GDP and the

rate government price level do not rise
spending or raise by as much as they
taxes would have without
policy

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 Fiscal policy
Automatic stabilisers versus discretionary fiscal policy

• Discretionary fiscal policy: When the government is taking actions to

change spending or taxes to achieve its economic objectives (fiscal
policy).

• Automatic stabilisers: Transfer payments and taxes that automatically

increase or decrease along with the business cycle.

➢ They work to stabilise the economy without the need to change

policy.

17
 Automatic Fiscal Stabilisers
• Consider progressive personal income tax rates and transfer
payments
➢ When GDP rises, taxes increase
and transfer payments fall

➢ When GDP falls, taxes received fall,

and transfer payments rise

18
 The Limits of Using Fiscal Policy
to Stabilise the Economy
• There are two main problems associated with fiscal
policy effectiveness:

➢ Timing lags
➢ Crowding out

19
 The limits of using fiscal policy
to stabilise the economy
Timing lags

➢ It takes time for policy makers to collect data and ascertain

there is a problem to be addressed.

➢It takes time to have policy approved by both Houses of

federal parliament.

➢It then takes time to implement the policy, and for the policy
to take effect.
20
 The limits of using fiscal policy
to stabilise the economy
Does government spending reduce private spending?
• Crowding out: A decline in private expenditures as a result of an
increase in government purchases.
• An increase in government purchases can divert money and
resources away from the private sector.
• Most economists agree that there is partial crowding out in the short
run, and complete crowding out in the long run.

AD= C+I+G+NX

21
 What is Monetary Policy?
• Monetary policy: The actions taken by the Reserve
Bank of Australia to manage interest rates in the
pursuit of macroeconomic objectives.

• The goals of monetary policy:

➢ Full employment of the labour force

➢ Stability of the Australian currency.

➢ Economic prosperity and welfare for the people of Australia.

22
 What is monetary policy?
The goals of monetary policy, cont.
• Since 1993 the Reserve Bank of Australia (RBA) has focused
monetary policy mainly on achieving price stability.
• Inflation targeting: Conducting monetary policy so as to
commit the central bank to achieving a publicly announced
level of inflation.
➢The RBA’s target inflation rate is between 2% and 3% per
annum, on average over the medium term.

23
 Consumer price Inflation

Source: Reserve Bank of Australia (2014), Measures of consumer price inflation, Table G01, at <www.rba.gov.au>, viewed 18 March 2015.
24 Copyright ©2016 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781486022847/Hubbard Essentials of Economics/3e
 ABS latest release CPI
Inflation rate between June 2022 and June 2023=
𝟏𝟑𝟑.𝟕 −𝟏𝟐𝟔.𝟏
Mar-2022 123.9 x 100 = 6%
𝟏𝟐𝟔.𝟏

Jun-2022 126.1 Food and non-alcoholic beverages 7.5

Alcohol and tobacco 4.7

Sep-2022 128.4
Clothing and footwear 0.3
Housing 8.1
Dec-2022 130.8
Furnishings, household equipment
6.3
and services
Mar-2023 132.6
Health 4.9
Recreation & culture 6.8
Jun-2023 133.7 Insurance & financial services 8.5
Education 5.2
25
 Money Vs Bonds
• Money: Currency in circulation and deposits in the
banking system.
• Bonds: are a method of raising finance available to
businesses and governments.
➢Bonds are a legal promise to repay a loan, usually including
a principal amount and regular interest payments. On issue,
the agreed interest rate is called the coupon rate and the
interest payments are called the coupon payments.

10-26
 The Demand for and Supply of
Money
The demand for money
• The money demand curve is downward sloping to show the
inverse relationship between the interest rate on financial
assets and the quantity of money demanded.
• The interest rate on financial assets is the opportunity cost of
holding money.
➢ Low interest rates reduce the opportunity cost of holding
money.
➢ High interest rates increase the opportunity cost of holding
money.

27
 The Demand for money
Interest
rate i
1. A
decrease in
the interest
rate…
2. …causes an
7% increase in the
quantity of
6%
money
demanded.

Money demand, MD

0 $250 300 Quantity of money, M

(billions of dollars)
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 Supply of Money & Equilibrium
• The money supply is influenced by the RBA and consists of
notes and coins in circulation plus deposits in the banking
system.
• Does not depend on interest rates, so money supply curve
is vertical with respect to interest rates.
• Equilibrium interest rate occurs where money demand
and supply curves intersect.

10-29
 Money Market Equilibrium

10-30
Monetary Policy by targeting money supply
(prior to 90s)
The Effects of an
Increase in the Money
Supply on the Interest
Rate
An increase in the
supply of money leads
to a decrease in the
interest rate.

Equivalently, if the
central bank wants to
raise the interest rate, it
must decrease the
supply of money.
 Open-Market Operations
• Open-market operations (OMOs), which take place
in the “open market” for bonds, were the standard
method central banks used to change the money
stock.
➢Open market operations (OMOs): The RBA purchasing
or selling financial assets (such as Commonwealth
Government Securities and private bonds), either by
outright purchase or sale.
Monetary Policy & Cash rate
• RBA no longer targets the money supply to conduct
monetary policy. It now targets the interest rate. The
interest rate RBA targets is the cash rate.

➢ Cash rate: The interest rate that financial institutions charge on

loans or pay to borrow funds in the overnight money market.

➢ The cash rate is determined by the interaction of demand for and

supply of funds in the overnight money market.
The Demand for and Supply of
money
• Overnight money market: short term money market where
financial institutions lend or borrow funds in their
exchange settlement accounts.
➢ Exchange settlement accounts (ESAs): Accounts held with the RBA
by banks and other financial institutions to enable the overnight
transfer of funds (cash) between financial institutions, and
between the RBA and financial institutions.
➢ Balances held in ESAs are called exchange settlement funds.
 RBA Targets the Cash Rate
• At its monthly meeting the RBA board of governors
decides what changes, if any, shall be made to the cash
rate.
• Having set the cash rate, the RBA conducts open
market operations to achieve it.

Philip William Lowe,

Governor of the RBA
 Recessionary Gap
Recessionary gap
P AD0 LRAS SRAS
AD1
AD= C+I+G+NX

.A
P1 .B
Recessionary Gap –
Unemployment problem

Y1 Y2 Y 36
Monetary policy and economic
activity
• Suppose there is a recessionary gap in the economy. To close this
gap, RBA would announce its intention to decrease the cash rate.

• Expansionary monetary policy: The use of monetary policy by the

RBA to decrease interest rates to increase real GDP.

Example:
current cash rate = 4.1%
target cash rate = 3.5%
 RBA and Interest Rates
RBA conducts Open Banks eager to
Market purchase of lend in the
bonds/ financial assets overnight cash
from banks market

Balances in ESAs go Affects the overnight

up cash market (more
funds leads to fall in
the cash rate)

Expansionary Monetary Policy

 Recessionary Gap
Inflation Problem
P LRAS SRAS
AD1
AD0 AD= C+I+G+NX

P1 .B IInflation problem
P0 .A

Y1 Y2 Y 39
 Monetary policy and economic
activity
• Suppose there is an inflationary gap. To address this inflationary
problem, RBA announces its intention to increase the cash rate.

• Contractionary monetary policy: The use of monetary policy by the

RBA to increase interest rates to reduce inflation.

Example:
current cash rate = 4.1%
target cash rate = 4.5%

40
 RBA and Interest Rates
RBA conducts Open Banks eager to
Market sell of borrow in the
Bonds/financial assets overnight cash
to banks market

Balances in ESAs go Affects the overnight

down cash market (less
funds leads to
increase in the cash
rate)
Contractionary Monetary Policy
 Flow-on Effects of Cash Rate
• Monetary policy seeks to affect all interest rates in the
economy, not just the overnight cash rate.
• Longer term interest rates do tend to track the cash rate
quite closely.
Aggregate demand and the Interest
Rate
• The level of interest rates in the economy affects
Aggregate demand.
• A rise in interest rates reduces household
consumption expenditure through:
➢Encouraging households to save more as the reward for saving
increases.
➢Discouraging household spending that would be financed by
credit e.g. consumer durables.
 Aggregate demand and the
Interest Rate
• A rise in interest rates reduces investment expenditure
through:
➢ Increasing the cost of borrowing reduces the profitability of business
investment in capital equipment.
➢ Increasing the cost of mortgages for residential housing.
• Thus, at any given level of output, both investment and
consumption spending decline when interest rates increase.
• The converse is true when interest rates decrease. Therefore,
the RBA can use changes in the interest rate to eliminate
recessionary/inflationary gaps and stabilise the economy.
 Question 1
1. Fiscal policy refers to the
A. government's ability to regulate the functioning of
financial markets.
B. policy applied by the Reserve Bank of Australia
to affect the cash rate.
C. techniques used by firms to reduce their tax
liabilities.
D. spending and taxing policies used by the
government to influence the level of economy
activity. 45
 Question 2
2. Which of the following is an automatic
stabiliser?
A. Interest rate changes.
B. Increases in government spending on
schools
C. Reductions in nominal wages as inflation
rates rise
D. Unemployment benefit payments to the
unemployed 46
 Question 3
3. Discretionary fiscal policy is when
A. existing taxation policy automatically smooths out
business cycle fluctuations in the economy.
B. the government changes the level of expenditure or
taxation to achieve a macroeconomic aim.
C. policy is left to the discretion of the Reserve Bank of
Australia.
D. politicians are discrete about policy changes, and do not
advise consumers or producers of new policies.

47
 Question 4
4. When the economy is in a recession the government can:
A. Reduce expenditures and leave taxes constant in order
to stimulate aggregate demand.
B. Increase government purchases or decrease taxes in
order to increase aggregate demand.
C. Decrease government purchases or increase taxes in
order to decrease aggregate supply.
D. Change spending and taxation but not aggregate
demand or aggregate supply.
48
 Question 5
5. Which of the following is the main goal of
monetary policy in Australia?
A. Lowering the rate of unemployment
B. Increasing the value of the Australian dollar
relative to other currencies
C. Economic growth
D. Price stability

49
 Question 6
6. The policy aimed at managing interest rates to
pursue macroeconomic objectives is called
A. fiscal policy.
B. interest rate policy.
C. monetary policy.
D. exchange rate policy.

50
 Question 7
7. The Reserve Bank of Australia's main monetary
policy target is
A. the money supply.
B. the inflation rate.
C. real GDP.
D. the unemployment rate.

51
 Question 8
9. The cash rate is the interest rate
A. the Reserve Bank of Australia charges
commercial banks.
B. banks charge their largest customers.
C. banks charge each other for overnight loans.
D. on a government bond or security.

52
 Question 9
9. If the Reserve Bank of Australia lowers its
target for the cash rate, this indicates that it is
A. pursuing an expansionary monetary policy.
B. pursuing a contractionary monetary policy.
C. attempting to combat inflation.
D. concerned that the growth in aggregate
demand will exceed potential GDP.

53
 Question 10
10. Which of the following describes what the Reserve
Bank of Australia would do to pursue an expansionary
monetary policy?
A. Use open market operations to buy bonds and
securities.
B. Use open market operations to sell bonds and
securities.
C. Use open market operations to increase the overnight
cash rate.
D. Increase interest rates on mortgages and corporate
loans. 54