1. Chapter 7 Fiscal Policy and Monetary Policy
7.1 The Business Cycle
7.2 Macroeconomic policy
7.3 Fiscal Policy
7.4 Monetary Policy
7.5 Macroeconomic policy and the Business Cycle

2. The Business Cycle
The business cycle refers to changes in economic conditions over time. Economic growth is not usually stable over long periods. Economies will experience good times and bad times, going from “boom” to “bust”.

3. The Business Cycle Phases of the business cycle Expansion Contraction
Peak
Trough

4. The Business Cycle

5. Macroeconomic policy
Focuses on ways to influence aggregate demand to change the level of economic activity in an economy.
Macroeconomic policy has two arms, fiscal policy and monetary policy.

6. Government Economic Policy Objectives
The major aim of the government is to achieve the following:
Low inflation
Low unemployment
Sustainable economic growth
A sustainable current account deficit
Question – Are any of these goals conflicting? Why?

7. Fiscal Policy
Economic policy implemented by the Federal Government that seeks to influence the economy through the annual federal budget.
The federal budget is a yearly announcement of all planned government expenditure and any changes to taxation policy for the coming year.

8. Expansionary Fiscal Policy
Aimed at stimulating economic growth through increased government spending or reduced taxation.
By spending on new infrastructure like roads, bridges or hospitals the government will employ workers and buy materials which will boost economic growth.
By cutting taxation consumers will have more disposable income which will lead to higher consumption and economic growth.

9. Expansionary Fiscal Policy
Aggregate demand (AD) equals:
AD = C + I + (G-T) + (X-M)
So any increase in G (government spending) will increase aggregate demand, and therefore increase economic growth.

10. Contractionary Fiscal Policy
Contractionary fiscal policy is when the government reduces net (G – T) by either lowering government spending or increasing taxes.
Question - Why would a government want to slow down economic growth?

11. Contractionary Fiscal Policy
Question – Are there any social reasons why it may be difficult for a government to implement contractionary fiscal policy?

12. Taxation
Taxation is revenue earned by the government by charging a levy to individuals and firms. Lowering taxation gives consumers more disposable income. Raising tax revenue lowers consumption but allows for higher government expenditure.

13. Budget deficits and surpluses
A budget deficit is when the government is spending more than it is earning through taxation revenue (G is greater than T).
A budget surplus is when the government is spending less than it is earning through taxation (T is greater than G).

14. Budget deficits
Budget deficits must be financed by borrowings. Borrowings must be serviced with interest payments. Eventually budget deficits will have to be paid for through higher taxation. Therefore, there is a trade-off between higher economic growth now and higher economic growth in the future.

15. Budget deficits
If the budget is in deficit does this mean the government is implementing expansionary fiscal policy?

16. Budget Surpluses
In good economic times the government may run a budget surplus in order to save for a rainy day.
This money can then be used when economic growth begins to fall, by injecting it back into the economy through increased spending.

17. Automatic and Discretionary Stabilisers
Automatic stabilisers operate in a counter-cyclical way to steady aggregate demand without a deliberate change in policy. i.e. progressive tax system, welfare payments increase the size of the budget deficit in a recession.
Discretionary stabilisers involve treasury deliberately altering tax rates or spending to make the budget more contractionary or expansionary.

18. Limitations of Fiscal Policy
The federal budget is yearly, needs to take into account what may happen during the year (forecasting). The budget has social objectives as well as financial ones (schools, hospitals etc). Large budget deficits cause high interest payments that need to be serviced in the future. Expansionary fiscal policy may result in higher levels of inflation.

19. The Multiplier
The multiplied effect that an increase in spending has on the economy
Size of the multiplier depends on the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).
The MPC is the percentage of income that consumers spend.
The MPS is the percentage of income that consumers save.
The higher the MPC (and the lower the MPS) the higher the multiplier.
The multiplier is the reason why expansionary fiscal policy is worthwhile. Because $1 spent by the government will have a multiplied affect on the total economy.

20. Monetary Policy
Monetary policy is the management of interest rates in order to influence the level of economic growth and inflation in an economy.
An interest rate is the amount of return a lender gets for lending money to a borrower.
Implemented by changing the level of supply of money in the economy in order to manipulate interest rates.
Administered by the RBA.

21. RBA deals with monetary policy
Changes in interest rates impact the economy in a number of ways:
Investment behavior
Spending behaviors of households
Supply of credit
Asset prices
Exchange rates
RBA deals with monetary policy

22. The Cash Rate
The cash rate is the overnight interest rate at which the banks borrow and lend money to each other. This rate is used as the basis for all other interest rates in the economy.

23. Open market operations
To manipulate the cash rate the RBA changes supply of money in the economy by buying or selling government securities (bonds).
If the RBA buys government securities from the public it will increase the supply of money and the cash rate will fall.
If the RBA sells government securities to the public it will reduce the supply of money and the cash rate will rise.

24. Open Market Operations

25. Open Market Operations
The supply of money is a vertical line as the RBA fixes the supply of money on a daily basis. Each day the RBA will alter the supply of money depending on demand to achieve the target cash rate. The cash rate target will remain the same until the RBA decides to change its monetary policy stance at its monthly meeting.

26. Contractionary Monetary Policy
A rise in the cash rate will cause interest rates to rise.
Banks will pass on higher borrowing costs to customers by raising home loan rates.
Consumers have lower disposable incomes as they have to pay higher home loan repayments and have less to spend on day-to-day items.
As a result, spending falls, and so does economic growth.

27. Expansionary Monetary Policy
RBA Lowers the official cash rate.
Banks pass on lower cash rate to consumers in the form of lower home loan rates.
As interest rates fall home loan repayments drop resulting in more disposable income for households.
Therefore, consumption increases resulting in an increase in economic growth.

28. Expansionary Monetary Policy
Question - Do banks have to pass on cuts in the official cash rate to consumers in the form of lower home loan rates? Why/why not?

29. Inflation Targeting
Since 1995 The RBA has officially targeted inflation of 2-3% as its major policy objective. Gives firms and consumers in the economy a reliable gauge as to what inflation will actually be, reducing uncertainty. Successful inflation targeting can stop an economy from overheating in a boom or peak.

30. Limitations of Monetary Policy
There is a trade-off between economic growth and inflation.
The effect of monetary policy is lagged.
Monetary policy can change the value of the exchange rate.

31. Macroeconomic policy and the Business Cycle
Aims to smooth out the fluctuations in the business cycle. Fiscal policy and monetary policy can be used together to achieve longer, steadier periods of economic growth than the market could deliver on its own. The dotted line on the diagram represents the smoothing of the business cycle due to effective macroeconomic policy management.

32. Macroeconomic policy and the Business Cycle