An Overview of Monetary and Fiscal Policy of Australia - Report Example

1. Introduction It has been suggested that the “Rudd Government and the Reserve Bank of Australia have acted appropriately to get the Australian Economy out of the present recession”. The objective of this paper is to produce a report evaluating this statement. Section 2 below provides an overview of fiscal and monetary policy; and section 3 looks at the fiscal and monetary policy approaches adopted by the Rudd Government and the Reserve Bank of Australia in the wake of the current global recession. 2. Overview of Fiscal and Monetary Policy 2.1 Fiscal Policy Fiscal policy is concerned with the effects of government spending and taxation on aggregate demand and aggregate output1. Following the development of organized state budgets, it became evident that different forms and levels of taxes and expenditure have different effects on the economy2. Therefore one can define fiscal policy as a means by which government uses to bring the economy into equilibrium by either altering the level of expenditure on public goods or altering the of the level of taxes3. Fiscal policy can either be contractionary or expansionary. A contractionary or tight fiscal policy is one whereby the government adopts a policy that increases the amount of taxes or reduces the amount of expenditure on public goods and services so as the maintain equilibrium in the economy4. An expansionary or easy fiscal policy on the other hand is one whereby the government adopts a policy that results in an overall decrease in taxes or an overall increase in government expenditure5. Now to look at the effects of fiscal policy on the classical framework, the study will take a look at the ASAD framework. Figure 1: The ASAD framework Figure 1 above shows the aggregate supply aggregate demand (ASAD) framework. AS represents the aggregate supply, which for a closed economy represents the total amount of real goods and services that domestic enterprises in the country are willing to provide at any given ratio of prices and wages6. Aggregate supply can be increased through an increase in productivity resulting from an increase in the amount of productive equipment as well as improvements in technical knowledge or the quality of the work force7. Two conditions are required for aggregate actual output to equal aggregate supply: (1) there must be enough aggregate demand to match the supply failing which output becomes demand-constrained; (2) there must be a sufficient supply of work force to satisfy firm’s labour requirements. for example, if real wages are low, aggregate supply by firms will require more employment than the labour supply forthcoming at these wages, in which case output is constrained by labour shortages8. At equilibrium or full employment of capacity, the aggregate demand is expected to equal aggregate supply. This is represented by the point E1 in figure 1 above where the aggregate demand curve intersects the aggregate supply curve. At this point the quantity demanded and supplied is given by Q1 and the price at which it is sold is given by P1. Let’s assume that there is capacity underutilization in which case the aggregate demand falls below the aggregate supply as shown in figure 2 below. This results in a leftward shift of the aggregate demand curve from AD to AD’ and a decrease in the quantity demanded from Q1 to Q2 as well as a drop in the price from P1 to P2. Figure 2: Effects of expansionary Fiscal and Monetary Policy on the Classical framework. Since the government views the point E1 as the point where there is full utilization of capacity, the government can decided to embark on an expansionary fiscal policy through increase expenditure on public goods and services or reduction in taxes. It can also decide to increase the real wages and salaries of workers. In this case there will be an increase in aggregate demand which might result from increase in investments, consumption and government expenditure on public goods and services. Increasing the real income of citizens will result in an increase in consumption which will automatically lead to an increase in the aggregate demand. This increase in aggregate demand will bid up prices of goods and services and would cause the aggregate demand curve to move from AD’ to AD and the quantity demand demanded to move from Q2 to Q1 as well as the price level to move from P2 to P1. The effect of an expansionary fiscal policy on the classical framework is therefore the fact that helps to move the economy from a slump (when there is underutilization of capacity) to a boom where there is full employment of available capacity. 2.2 Monetary Policy Monetary Policy can be referred to as a government and central bank’s policy to change the cost of money and credit so as to alter the circulation of money in an economy9. This policy is usually implemented to stabilize economic activity. To achieve its effects, monetary policy employs a number of instruments such as the altering of interest rates, printing more money, buying and selling government bonds, changing the requirements for banks to hold cash and reserves, changing the rate at which central banks lend to financial institutions, etc10. Monetary policy is often employed in fighting inflation and other macroeconomic shocks. For example, if there is high rate of inflation, the central bank can decide to increase the cost of borrowing money by raising real interest rates. By so doing there is a reduction in the circulation of money in the economy which results in a slowdown in the inflation rate. Like fiscal policy, monetary policy can either be contractionary or expansionary. A contractionary monetary policy is one that is aimed at reducing the circulation of money often employed in times of inflation. An expansionary monetary policy on the other hand is one that is aimed at increasing the amount of money in circulation11. Taking a look at figures 1 and 2 again, we describe figure 1 as the ideal situation where there is full utilization of capacity. Let’s assume again that the amount of money in circulation reduces. This will result to a decrease in aggregate demand which will lead to a leftward shift in the aggregate demand curve from AD to AD’. Since the amount of money in the hands of consumers is too small, their purchasing power will be very low and they will be force to bid down prices of goods and services in supply. By so doing the price level will move from P1 to P2 and the quantity demanded from Q1 to Q2. It should be noted that because price levels are relatively low, the long-run effects of such a situation may be a fall in wages resulting in a decrease in productivity which will result in a fall in aggregate supply as well. In order to avoid such a situation and move the economy bank to its ideal point E1, the government and the central bank can decide to embark on an expansionary monetary policy such as the printing of more money or a reduction in interests rates. By so doing, there will be an overall increase in the supply of money in the economy which will result to an increase in consumption. Prices will move back from P2 to P1, the quantity demanded from Q2 to Q1 and a shift in the aggregate demand curve from AD’ to AD. The economy will therefore move back to its ideal equilibrium point E1. This is demonstrated as shown in figure 2 above. An expansionary monetary policy has the same effects of an expansionary fiscal policy in that they both help in moving an economy from a slump to a boom. 3. Fiscal and Monetary Policy in Australia and the current Economic Recession Following the outbreak of the global recession, a number of governments around the world including Australia under Prime Minister Kevin Rudd initiated a number of fiscal and monetary policy actions to help combat the recession. As concerns fiscal policy, many governments were forced to reduce taxes and increase spending. As concerns monetary policy, governments were forced to cut interest rates so as to increase the supply of money. These fiscal and monetary policy measures were deemed necessary as it was expected that they were stimulate consumption, which will eventually return the economy to full employment. Following the downturn, the Rudd Government responded by providing a stimulus package of $42billion12. It was expected that this money will help stimulate aggregate demand and bring the Australian economy back to full employment. However, some commentators feel that the money is not directed towards the right projects. Some people believe that the benefits expected to be derived from the said package do not outweigh the costs that are currently being incurred13. On their part, the Board of Governors of the Reserve Bank of Australia responded to the recession by easing monetary policy14. Short term interest rates were brought to their lowest levels since the early 1960s. Most of the easing took place in expectation of the current recession and before the emergence that inflation was declining15. The combined effects of the fiscal stimulus and low interest rates are expected to provide significant support to domestic demand16. Given that interest rates are at their lowest levels, the Reserve Bank of Australia believes that it is appropriate to make smaller less frequent adjustments to the cash rate than was the case up until February, 2009 when conditions where deteriorating rapidly17. BIBLIOGRAPHY Black J. (2002). Aggregate Demand. A Dictionary of Economics. Oxford University Press. Oxford Reference Online. http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t19.e56 Calhoun C. (2002). budgetary or fiscal policy"   Dictionary of the Social Sciences. Oxford University Press 2002. Oxford Reference Online. Calhoun C. (2002). Monetary Policy.   Dictionary of the Social Sciences. Oxford University Press Oxford Reference Online.   http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t104.e1102 Kver B. L., Maggs G. E. (1995). Monetary Policy Rules, Supply Shocks, and Price-Level Elasticity of Aggregate Demand: A Graphical Examination. Journal of Economic Education, vol. 26, No. 4. p. 364 Moles P., Terry N. (1997). Closed Economy.  The Handbook of International Financial Terms.. Oxford University Press Oxford Reference Online.   http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t181.e1359 Novak, J., & Davidson, S. (2009), “5 ½ big things Kevin Rudd doesn’t understand about the Australian economy”, available online at: http://ipa.org.au/library/publication/1248933179_document_davidson_novak_5-5_things_rudd_doesnt_understand.pdf Paul de G. (2000). Economics of Monetary Union [Oxford, England ; New York] Oxford University Press (UK) Reserve Bank of Australia (2009), “STATEMENT ON MONETARY POLICY”, available online at: http://www.rba.gov.au/PublicationsAndResearch/StatementsOnMonetaryPolicy/statement_on_monetary_0509.html Roberto Z., Gobing N. T. (2005) Economic Growth in the 1990s: Learning From a Decade of Reform Washington, D.C World Bank Read More