Table of Contents

ECODATE

Volume 34, Issue 1, March 2020

ECODATE

Volume 34, Issue 1, March 2020

MONETARY AND FISCAL POLICY: A DOUBLE ACT FOR ECONOMIC PROSPERITY

Dr David Tuffley, Senior Lecturer, Griffith University, Brisbane, Australia

Governments steer national economies on a safe course by striking a balance between monetary policy and fiscal policy. Finding this balance is a moving target, but when the two are properly applied, the economy prospers. When monetary and fiscal policy is not properly applied, economies can become deranged and collapse into recession.

In Australia, monetary policy is set by the Reserve Bank of Australia (RBA) which operates independently of the Government. In contrast, Parliament sets fiscal policy according to the policies of the elected Government.The RBA operates at arm’s length from the Government and maintains a non-partisan attitude to the current political climate.

It is a complicated business knowing how best to coordinate monetary and fiscal policy. There are many variables to consider and no simple answers.Some of these variables are known as macroeconomic indicators.These give insight into how an economy is performing.

Indicators of Economic Performance

Economic indicators are objective measures that can be useful in predicting future economic performance. The RBA publishes a snapshot of the prime economic indicators on their publicly accessible website (see References for link):

  1. The Cash Rate. The foundational interest rate at which funds are lent and borrowed on financial markets, for example, on loans between financial institutions and the public.

  2. Economic growth. The overall measure of how the production of goods and services has grown over a period. Growth creates profit and profit causes stock markets to rise in value.

  3. Inflation. The rise in the price of goods and services over time. In Australia, inflation is measured by the Consumer Price Index (CPI). See Figure 1 showing inflation rates in Australia over the past 100 years.

  4. Unemployment Rate/Employment Growth. Unemployment rate measures what proportion of the workforce is not currently employed. Employment growth is the change in the number of people employed.

  5. Wage growth. Adjusting for inflation, this indicator measures how much real wages have grown over time, thus reflecting purchasing power and living standards.

  6. Average weekly earnings/household saving ratio. Average earnings are the value of the money that people earn. The household savings ratio is what proportion of disposable income is put into savings and superannuation.

  7. Net foreign liabilities. Foreign debt indicates how much is owed to overseas entities minus the value of Australia’s overseas assets.

  8. Exchange rate of the Australian dollar. The current value of Australia’s dollar expressed in terms of another currency, most commonly the US dollar.

  9. China GDP growth/G7 GDP growth. Gross domestic product (GDP) is the total value of all goods and services produced by an economy over a 12-month period.This indicator benchmarks Australia’s performance against China’s GDP and that of the G7 (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States), these being Australia most important trading partners.

Figure 1: End of Year Australian Inflation rates 1920-2020.

Monetary Policy

Monetary policy is a two-fold mechanism by which the Reserve Bank of Australia (RBA) influences (a) how much money is circulating in the economy at a given time, and (b) the structure of interest rates using the ‘cash rate’. Monetary policy is either expansionary or contractionary, depending on the desired effect on the economy.

When the economy becomes overheated, and inflation is rising, the RBA puts the brakes on by withdrawing money from circulation while raising interest rates. Less money at a higher cost usually has the desired effect of slowing down investment and spending.

Later on, when the economy has become sluggish, the RBA counteracts the trend by increasing the amount of money in circulation while lowering interest rates. This dual incentive to borrow can usually be relied on to create economic stimulus.

In March 2020 the RBA reduced the official interest rate to a record low of just 0.5% to counteract the adverse effects of the Coronavirus pandemic on an already sluggish Australian economy. Interest rates had fallen three times in 2019 due to a slowdown in housing construction and the catastrophic bushfires.

Monetary Policy Transmission Mechanism

The transmission mechanism is how the RBA’s monetary strategies flow through to the economy. Having decided to what degree the supply of money should be regulated, and what the interest rate should be, these adjustments made by the RBA flow through to the banks and other financial institutions. Over time these have their effect on the economy. This is how monetary policy is transmitted.

Limitations of Monetary Policy

As the old saying goes, you can lead a horse to water, but you can’t make him drink. The RBA can lower interest rates which flows through to the banks, but people might still decide not to borrow. They have free will, after all. They might not want further debt, even at lower interest rates. In this situation, the stimulus will be slow to arrive. An incentive increases the likelihood of an outcome, but it is no guarantee.

Ultra-Low Interest Rates

It might be expected that ultra-low interest rates such as those in Australia in 2020 would stimulate the economy, but this is not always the case. Sometimes interest rates approaching zero will set up a boom/bust cycle that destabilises the economy and leads to recession. In recent years there had been a boom in Australian housing construction which turned to bust in 2019. Coronavirus has brought interest rates down to an ultra-low 0.5% in March 2020.

Overseas examples of this phenomenon include the dot.com bubble from 1994 to 2000 and the US housing boom and mortgage financing bust that triggered the global financial crisis of 2008. Other boom/bust events occurred in Iceland, Spain, and Ireland.

In every case, the underlying cause is the easy access to low-interest rate loans.

Quantitative Easing (QE)

Applied in ultra-low interest rate environments, Quantitative Easing (QE) is an expansionary monetary policy that has immediate effect. The Reserve Bank buys quantities of government bonds or securities as a way of directly injecting liquidity into the economy, lowering interest rates and easing unemployment.

But quantitative easing is controversial because it can cause inflation, but without economic growth, a situation known as stagflation. This is characterised by slow economic growth, declining GDP, high unemployment and rising prices.

The opposite of Quantitative Easing is Quantitative Tightening (QT). It is a contractionary monetary policy.

Fiscal Policy

Working hand in hand with Monetary Policy is the instrument known as Fiscal Policy.Essentially, Fiscal Policy can be neutral, expansionary or contractionary depending on whether the economy needs to be stimulated, slowed down or kept the way it is.The Government implements Fiscal Policy by adjusting tax rates up and down and spending more or less on services.

The principles of Fiscal Policy are well-established in economics, being based on the work of British economist John Maynard Keynes (1883-1946).Keynes advocated for tax levels and public spending to be adjusted up or down as required to keep inflation around the ‘sweet spot’ of 2-3% At this level employment is stimulated and the value of money is maintained.

Australian Fiscal Policy

The Australian Government’s fiscal policy in 2020 is is aimed at achieving budget surpluses over the coming economic cycle with the aim of some overall economic stimulus.

The Government’s fiscal policy is to strategically spend on boosting productivity and workforce participation. But overall spending will be regulated in order to free up resources for private investment and job creation. Tax rates will be kept to sustainable levels with a tax to GDP ratio of 23.9% of GDP or less, and a budget surplus of at least 1% of GDP. The Government will seek to strengthen its balance sheet by borrowing less and paying down debt.

Fiscal and Monetary Policies Working Together

The combined effect of fiscal and monetary policy will determine what is known as Aggregate Demand (AD). This is the overall demand for goods and services in an economy, as indicated by how much people spend on those goods and services, how much they invest in business ventures and by how much the Government is spending.

Fiscal policy has an impact on aggregate demand by influencing levels of employment and household income. This in turn influences consumer spending and investment.

Monetary policy and the availability of money has an impact on levels of business activity which in turn feeds into aggregate demand.

The underlying principle at work here is that for economic stability it is necessary to spend more and tax less when economies are depressed and then do the electorally unpopular thing of raising taxes and/or cutting spending during the good times.

Surplus

A budget surplus is the opposite of budget deficit. A surplus happens when the amount of tax revenue collected by the Government exceeds the amount spent on areas such as social security, defence, infrastructure, and so on.

Surpluses allow governments to create cash reserves for use in recessionary times. While a budget surplus sounds like a good thing, it can nonetheless cause problems if too much money is held in reserve.The more that is sequestered in government reserves, the less there is for investment and other economic activity. When the Government retains too much money, it can trigger a recession.

Causes of Recession

There are many causes of the recession. As discussed, recessions can be triggered when governments starve the economy of funds by retaining too much cash in reserve. People might invest if they could access the funds. Or a recession can happen when people lose confidence in the investment market and cease activity.

In extreme cases, this leads to a stock market crash. Recession can also be the result of the RBA setting interest rates too high, or when consumer confidence falls, and people stop buying things. It can happen when there is a significant decrease in real wage levels, leaving people with less to spend.

During recessionary times, there is always a downturn in the stock market, while unemployment levels rise along with national debt.

Conclusion

Healthy economies depend on the careful coordination of monetary and fiscal policy over time. It is a tricky balancing act because small changes in policy can result in larger or smaller flow-on effects than expected. Sometimes the effects don’t come at all, and sometimes they arrived later than expected. It calls for fine judgment and steady nerves on the part of the Treasury and Reserve Bank of Australia.

What happens if a coordinated policy is found wanting? Recession surely follows. Argentina, for example, has had multiple severe recessions in recent history; 1974-1990, 1998–2002 and most recently in 2018 that saw their currency devalued to ‘junk’ status and the collapse of the Argentine banking system. Deep recession is underway in Argentina, inflation is running high, and millions are being plunged into poverty.

Student activities

1. In Australia, which entity determines Fiscal Policy?

2. What does the economic indicator ‘Inflation’ measure, and what is the name of the index by which it is measured?

3. Explain how the Reserve Bank’s Monetary Policy flows through to the economy.

4. How does Quantitative Easing (QE) stimulate an economy?

5. What are the characteristics of ‘stagflation’ and under what circumstances is it likely to occur?

6. Broadly speaking, what are the causes of a recession?

7. Under what circumstances do budget surpluses occur, and why is a surplus not necessarily a good thing?

8. Define Aggregate Demand.

9. What happens when Monetary Policy and Fiscal Policy are not properly coordinated?

10. Outline the goals of the Reserve Bank and explain how the composition of its Board can help to achieve them and a balance with fiscal policy.

11. Why did the Australian government budget for a surplus in 2019-20 when the Reserve Bank continued to lower interest rates and talk of quantitative easing? Explain the circumstances that have led to the Government to dropping the goal of a surplus in 2019-20 and aligning the stance of fiscal policy more to the stance of monetary policy. In your answer, refer to the limitations of both monetary and fiscal policy.

References

Reserve Bank of Australia (RBA) 2020, Key Economic Indicators Snapshot, available at https://www.rba.gov.au/snapshots/economy-indicators-snapshot/, accessed February 2020.

Reserve Bank of Australia (RBA) 2020, Inflation and its Measurement, available at https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html accessed February 2020.

Investopedia (2020) Fiscal Policy vs. Monetary Policy: Pros & Cons , available at https://www.investopedia.com/articles/investing/050615/fiscal-vs-monetary-policy-pros-cons.asp Accessed February 2020.

Investopedia (2020) Monetary Policy vs Fiscal Policy: What’s the Difference?, available at https://www.investopedia.com/ask/answers/100314/whats-difference-between-monetary-policy-and-fiscal-policy.asp Accessed February 2020.

Australian Government, Department of Treasury, 2020, Mid-Year Economic and Fiscal Outlook, available at https://budget.gov.au/2019-20/content/myefo/index.htm accessed February 2020.

Investopedia, How Do Fiscal and Monetary Policies Affect Aggregate Demand? available at https://www.investopedia.com/ accessed February 2020.

Australian Government, Department of Treasury, 2020, Australia’s response to the global financial crisis, available at https://treasury.gov.au/speech/australias-response-to-the-global-financial-crisis accessed February 2020.