14.

1 The meaning of fiscal policy

Fiscal policy is a macroeconomic policy that can influence resource allocation, redistribute
income and indirectly influence economic growth. Its instruments include government
spending and taxation and the budget outcome aim to reduce the fluctuations of the business
cycle
The budget is the tool of the government for the exercise of fiscal policy. It shows the
governments planned expenditure and revenue for the next financial year
Major items of the budget include social welfare, health, education, general public services and
defence
Government make major policy changes in response to changing economic or political
conditions
Mid-Year Economic and Fiscal Outlook Statement (MYEFO): revision of the forecast in the
budget, includes the small fiscal changes
14.2 Budget Outcome
The budget outcome gives an indication of the overall impact of fiscal policy on the economy.
There are 3 different budget outcomes:
o Budget surplus: T>G
o Budget deficit: T<G
o Budget balance: T=G
There are 3 different measures of the budget outcome which are the result of different
accounting methods:
o Fiscal outcome (long-term): fiscal surplus or fiscal deficit is calculated as total revenue
less total expenses less net capital investment (assets) e.g. privatisation of Telstra
! Fiscal outcome is calculated using the accrual accounting method, which
measures expenditures and revenues when they are incurred or earned,
rather than when a cash transaction actually occurs
o Underlying cash outcome (short-term): cash surplus or cash deficit is calculated in a
similar way as the fiscal outcome,
! Except that it is calculated using the cash accounting method (which records
revenues and expenditures when the money is collected or spent)
o Headline cash outcome (includes one-off)
! Selling government assets simply transfers ownership of productive resources
from the public sector to the private sector, and this mere transfer of assets
! One-off transactions need to be removed to be able to identify the real state
of the budget outcome
The governments main fiscal policy aim is to achieve fiscal surplus
14.3 Changes in the Budget Outcome

Changes in the budget outcome impact two factors:

o Changing economic conditions (cyclical or non-discretionary changes)
! Final budget outcome also influenced by discretionary changes
! E.g. during recession, budget deficit will decrease
! Non-discretionary changes influence cyclical component of budget outcome
o Changes in government policies (structural or discretionary changes)
! Deliberate changes to fiscal policy e.g. changing spending and taxation
! Discretionary changes influence structural component of budget outcome
Budgetary changes that are influenced by the level of economic growth are also known as
automatic stabilisers
o Automatic stabilisers: changes in the level of government revenue and expenditure
that occur as a result of changes in the level of economic activity
There are two main automatic stabilisers:

Unemployment benefits
! E.g. higher u/e during recession leads to more u/e benefits which encourage
spending hence counteracting the fall in economic growth
o Progressive income tax system
! E.g. employment opportunities are increasing and incomes are rising. Rising
incomes move workers into higher income tax brackets, hence reducing
consumption and economic growth
Automatic stabilisers are built into the Budget with counter-cyclical role
o Counter cyclical policies: economic policies designed to smooth the fluctuations in the
business cycle. Macroeconomic policies such as fiscal and monetary policies, are
usually used as counter-cyclical policies
! E.g. high economic growth, demand is automatically slowed by higher
taxation and reduced government expenditure
Automatic stabilisers are usually not strong enough to counter effects of the economic cycle.
Governments still rely upon discretionary policy measures to smooth the economic cycle
o E.g. GFC stimulus package

Impacts on economic activity

Fiscal has a strong impact on short-term economic activity

There are three different budget stances, which refers to the impact of fiscal policy on
economic growth:
o Expansionary: leads to a multiplied increase in consumption and investment and
stimulates AD, which will increase the level of economic activity
o Contractionary: leads to a multiplied decrease in consumption and investment and
dampens AD, which will decrease the level of economic activity
o Neutral: no effect on the overall level of economic activity

Impacts on resource allocation

Fiscal can influence the allocation of resources in the economy:

o Directly
! Through government spending in particular areas of the economy e.g. road
extensions to speed movement of traffic across the city
! Governments are more likely to use direct measures to provide goods or
services if they expect that markets will not provide the resources quickly
enough without government intervention e.g. public goods
o Indirectly
! Through tax and spending decisions that make it more or less attractive for
resources to be used in a particular way e.g. removing taxes to redirect
resources
! Governments use specific taxing and spending policies that lead to changes in
resource use that meet government objectives e.g. applying a higher tax on
tobacco products to discourage consumption, which in the longer-term may
reduce costs to the health-care system

Impacts on income distribution

Australia has progressive income tax system designed to create a more equal distribution of
income:
o Higher incomes pay higher rates of income tax which the government uses to assist
lower income earners through transfer payments
Changes to taxation affects income distribution:

Less progressive tax system may create less equal distribution of income e.g. GST
(regressive tax)
Changes to government spending can also affect income distribution:
o Increasing spending on community services e.g. health care or increases in welfare
payments will lower income inequality

Impacts on savings and the current account deficit

There is a long-term relationship between budget outcome, CAD, savings and foreign debt:
o Crowding effect: A budget deficit decreases national savings because Government
must finance its budget deficits by borrowing from the private sector. The greater
competition for a limited amount of savings to finance domestic consumption and
investment will make it more difficult to access funds and place upward pressure on
interest rates, making private sector investment more expensive
o Private sector borrowers may simply turn to overseas sources of funds to finance
domestic investment and consumption, however this will show up as an inflow on the
KFA and will increase the size of Australias foreign debt.
o Similarly, the government can borrow from overseas to finance the shortfall when
G>T. This inflow of funds will increase Australias foreign liabilities, raise NPY as
higher level of foreign liabilities is serviced with higher interest repayments, hence
increasing the CAD
Australias CAD is mainly related to the imbalances of private savings and private investment,
rather than public sector borrowing. But, the government still aims for a surplus budget
outcome so that fiscal policy is not contributing to a higher CAD in the longer term

14.4 Methods of financing a deficit

There are a few methods of financing a deficit:

o Borrowing from the private sector
! Main form of deficit financing by selling Treasury Bonds domestically under a
tender system where the government sets the value of bonds to be sold
(determined by size of deficit to be financed) and the prospective purchasers
tender (offer) to buy a certain quantity at a particular rate of interest.
Government accepts tenders, starting with those offering the lowest interest
rates
There are two advantages to this system:
o Government can be certain that it will fully finance its
deficit
o Market will set interest rate on these newly issued bonds
cheapest rate
! However, domestic borrowing from the private sector has an effect on
private sector spending and investment
Crowding out effect: private sector is crowded out of the
domestic market by government borrowing, since lenders will
prefer to lend money to the government. The upward pressure on
interest rates will reduce spending and investment.
! The strength of the crowding effect depends on economic conditions:
Recession: increases in fiscal deficit will less likely crowd out
private sector, since investment spending will be low at this time
Boom: higher private sector activity thus significant crowding effect
However the globalised structure of financial markets has reduced
the overall strength of crowding out effects, as there is the option of
borrowing from overseas

o
o

E.g. 70% of Australian government bonds were owned by

offshore investors reflecting AAA credit rating

Borrowing from overseas

! Government may borrow from overseas financial markets in order to
minimize the crowding out effect, whilst still stimulating growth. Although
this can be a less expensive option, it directly adds to Australias foreign
debt, with interest repayments recorded as debits on the NPY
Borrowing from the RBA (printing money)
! Government may finance its deficit by monetising the deficit (literally
printing money)
! However the Australian government has avoided monetary financing to
ensure that it does not increase the money supply and add inflation
! This also means that there is no longer any direct connection between the
implementation of monetary policy and fiscal policy (i.e. they operate
independently)
! Quantitative easing: process by which low liquidity instruments (bonds) are
replaced with high liquidity cash reserves. Money that is not liquid (the blue
area) cannot easily be lent, and it cannot easily be spent, which are the two
critical pillars to driving economic growth. Hence quantitative easing
increases liquidity and loanable funds, which drive consumption, investment
Sell government assets
! By selling assets, such as Commonwealth land or business, the government
can fund its deficit
! This will create a headline budget surplus, however the demand for funds
from our domestic savings pool remains essentially the same. Instead of
government borrowing fund for deficit financing, the business purchasing the
asset needs to borrow, or use their own savings, to finance the asset purchase

Using budget surpluses

The government can use the surplus in three ways:

o Depositing it with the RBA
o Using it to pay off public sector debt
o Placing the money in a specially established, government-owned investment fund
For several years during the late 1990s and early 2000s, the government used surplus funds to
pay off public sector debt, which frees up funds on financial markets for other purposes.
o E.g. increase in funds available for private sector investment may lead to economic
activity that offsets the contractionary effect of the fiscal surplus
Establishment of dedicated investment funds in recent years represents a shift away from the
traditional approach of simply putting surplus funds in the RBA, earning lower rates of interest
o E.g. A Future Fund (sovereignty wealth fund) was established in 2006 to address the
Commonwealth Governments superannuation liabilities to public servants
! Sovereignty wealth fund: pools of money derived from a countrys reserves,
which are set aside for investment purposes that will benefit an economy
! In 2013, its assets were valued at $85bn, more than half of future
Commonwealth superannuation obligations
o E.g. The Building Australia Fund established in 2008-09 budget, to expand
Australias productivity capacity through long-term investment in transport and
communications infrastructure
! In 2013, its assets were valued at $5bn

Public sector borrowing and debt

The overall impact of the public sector on the economy is reflected in the public sector
underlying cash outcome
o Public sector cash deficit or surplus shows the borrowing needs or surplus funds from
all levels of government, as well as government authorities and public trading
enterprises (government business enterprises e.g. Australia Post, CityRail
! A negative outcome means theres an overall public sector deficit
The public sector cash outcome was in surplus from the late 1990s till 2008. The
contractionary fiscal policy after the GFC was the main cause of the public sector cash outcome
moving into a deficit
Public sector debt: accumulated debt of the government sector, which is owed both
domestically and overseas
o Rising public sector debt during 1990s recession, then steady decline during the long
growth cycle of the mining boom. This reflects lower budget deficits and the
privatisation of government businesses by Commonwealth and State governments
! E.g. Privatisation of Telstra and Qantas
o With larger fiscal deficits from GFC, net public sector debt has risen sharply, although
as the Budget returns to surplus net debt is expected to stabilise and then decline
Public sector debt is different to foreign debt, which is the amount owed by both the public
and private sectors to overseas lenders, consisting primarily of private sector borrowings
o Government generally source their borrowings from within Australia, hence avoid
being exposed to exchange rate movements that may increase their debt and interest
servicing cost
! In 2000s, public debt was 5% of net foreign debt
! Recently, public debt is 20% of net foreign debt

14.5 The current stance of fiscal policy

In 2008, Australias large expansionary policy successfully moderated the impact of the global
recession. Combination of discretionary stimulus spending and a cyclical fall in taxation
revenue saw the fiscal balance shift $75bn (6% of GDP) from surplus to deficit. This
contributed to a steady rise in net public debt
Since the GFC, the government gave priority to fiscal consolidation, bringing the Budget
back to surplus, in order to pay off the debt from the GFC stimulus package
o Fiscal consolidation: minimise deficits and shrinking the accumulation of debt
After the 1990s recession till late 2008, fiscal policy played a less active role in the economy
policy mix. A long period of sustained economic growth contributed to sustained budget
surpluses and reductions in public debt
o At the time, the Budgets main role had been to minimise the extent of public
borrowing and to implement specific policy changes in targeted areas of the economy

15.1 Introduction

Monetary policy: action by the RBA, on behalf of the government, to influence the cost and
availability of money and credit in the economy
o Used to smooth the effects of fluctuations in the business cycle and influence the level
of economic activity, employment and prices
The main instrument of monetary policy is domestic market operations (DMO), which
indirectly influence the level of interest rates, achieving objectives relating to economic
growth, inflation and unemployment
o DMO: actions by RBA in the short-term money market (STMM) to buy and sell
second-hand Commonwealth Government Securities in order to influence the cash
rate and the general level of interest rates
o E.g. In short term, tightening monetary policy through upward pressure on interest
rates will slow down economic activity through reducing consumption, as consumers
face higher mortgage costs. Businesses also usually need to borrow money in order to
purchase new capital equipment. Higher interest rates, more expensive to borrow,
business investment will decline. This results in lower AD and economic activity
o E.g. In short term, loosening monetary policy by reducing interest rates, increase
consumer spending and business investment

15.2 Objectives of monetary policy

Monetary policy is the primary macroeconomic policy used to manage the level of economic
growth:
o Expansionary (loosening): reducing interest rates if growth rises too fast,
inflationary pressures will also increase, inconsistent with one of the governments
long-term aims
o Contractionary (tightening): increasing interest rates reduce inflation, slow down
economic growth, increase unemployment
RBA aims for:
o Stability of $A maintaining low inflation to minimise currency fluctuations
o Maintain full employment reducing the level of unemployment
o Promote economic prosperity and welfare encouraging sustainable growth

15.3 Inflation targeting

Monetary policy is particularly suited to fighting inflation, which is related to monetary factors
Interest rate movements can be distorted by political pressures e.g. keeping interest rates
low during election
o Giving independence to a central bank helps minimise such political distortions
In 1990s, RBA hoped to sustain low inflation and avoid the higher interest rates (and higher
unemployment) that may be necessary to reduce high rates of inflation. Also, by targeting
inflation, RBA will reduce speculation, hence expectations which would contribute to inflation
RBA targets 2-3% of inflation, not putting into account one-off factors e.g. carbon tax, GST.
At such times, RBA looks at underlying inflation, instead of headline inflation
RBA considers several indicators in its implementation of monetary policy:
o Inflation rate
o Inflationary expectations
o Wages growth
o Rate of unemployment
o Rate of economic growth
o Interest rates
o Exchange rate

o Commodity prices
o Terms of trade
o Global economic growth
E.g. if wages growth>productivity it can lead to cost-push inflation
E.g. depreciation of $A adds inflationary pressures through higher prices for consumer imports
and imported inputs to the production process
E.g. strong economic growth, reductions in unemployment can add to inflation as economy is
approaching its supply capacity (NAIRU)

15.3 Implementation of monetary policy

Monetary policy involves influencing the cost and availability of money:
o Control of money supply (monetary targeting): currency in the hands of the public
and RBA deposits in financial institutions
o Influence of interest rates through short-run cash rate (rate-setting monetary policy)
Monetary targeting was used during 1970-80s however was not successful as monetary targets
were regularly missed and the money supply figures were distorted by the movement of funds
from banks to other financial institutions that were not subject to RBA regulation and control
Monetary targeting was abandoned mid-1980s. Monetary policy is implemented through
interest rate instrument where RBA sets short-run cash rate to influence general level of
market interest rates
How DMO work
Cash rate interest rate paid on overnight loans in the STMM
The cash rate is determined by market forces of supply and demand, but RBA can increase or
decrease supply of funds in the STMM through DMO thus target the cash rate
RBA influences cash rate by Exchange Settlement Accounts (ESA)
o Banks need to hold a certain proportion of their funds with the RBA in ES accounts in
order to settle payments with other banks and RBA
DMO: RBA buys or sells securities to a financial institution

15.4 Impact of changes in interest rates

Main effect of a change in interest rates is to change the demand for credit (borrowings)
Transmission mechanism: explains how changes in the stance of monetary policy pass through
the economy to influence economic objectives such as inflation and economic growth
o A fall in the level of interest rates should encourage borrowing by both businesses and
consumers, leading to rising consumption and investment demand in the economy,
thus increasing the level of spending and raising the level of economic activity

Reducing interest rates also reduces the cost of servicing existing loans, hence leading
to additional spending
o Fall in interest rates discourages financial inflow leading to a depreciation of $A,
making Australian goods more competitive in both domestic and overseas markets.
This unintended consequence of a fall in the level of interest rates also has the effect of
stimulating AD and economic growth, adding inflation
o Increase in AD will also lead to either higher output and employment or will spill over
into higher prices and wages if the economy is close to full employment
o Increase in aggregate spending that results from lower interest rates, will increase
demand for money, , which will be accommodated by RBA raising the supply of
money so that (demand = supply)
Monetary policy can either be tightened or loosened depending on whether the government
wishes to dampen or boost economic activity:
o Tightening of monetary policy: DMO increasing interest rates, reducing consumer
and investment economic activity, lower economic growth, lower inflation, higher
unemployment
o Loosening of monetary policy: DMO decrease interest rates, increasing consumer and
investment economic activity, increasing economic growth, falling unemployment,
and higher inflationary pressure
Although changes in monetary policy can be immediately implemented, monetary policy can
have a time lag of somewhere between 6 to 18 months before the full impact of interest rate
changes are felt in the economy. For this reason, RBA might be stimulating growth when
dampening is required

15.5 Current stance of monetary policy

Interest rates have varied over time as monetary policy has responded to varying economic
conditions
RBA has been successful in controlling inflation averaging 2.7%, aside from the one-off
impact of the GST, which pushed inflation to 6%
There are 5 main factors that help to explain the stance of monetary policy:
o Lower inflation objective: 2-3% of inflation goal
o Inflationary expectations: if expected low inflation, prices will plan lower price
increases and unions will push for lower
wage rises. RBA will increase interest rates
to reduce inflationary expectations
o Labour costs: because its
one of the most significant determinants of
inflation
o Economic growth and
lower unemployment: once RBA believes
there is low inflation, it will reduce interest
rates to maximise employment.
Furthermore, level of growth and
unemployment indicate whether economy is
close to its supply constraints, where further
increase in economic growth will lead to
inflation
o External factors: when
global economic conditions deteriorate,
Australia experiences slower economic
growth and higher unemployment, and
lower interest rates are an important part of
the policy response