GROUP REPORT ASSIGNMENT
25555 – MACROECONOMIC THEORY AND APPLICATIONS
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CONTENTS
1
Executive Summary ...........................................................................................................................................2
2
Introduction .......................................................................................................................................................3
3
Australia’s current economic situation .............................................................................................................4
4
Fiscal Policy ........................................................................................................................................................8
5
Monetary Policy...............................................................................................................................................10
6
The RBA’s August decision ..............................................................................................................................12
7
Conclusion .......................................................................................................................................................14
8
Bibliography .....................................................................................................................................................15
9
Turnitin Report
10
Marking Rubric
2
EXECUTIVE SUMMARY
This essay will evaluate the RBA’s decision not to change interest rates at the August ’10 monetary policy
meeting.
This analysis was made by exploring the Australian economic climate, analysing the current
macroeconomic mix and by applying these to the RBA’s monetary policy goals. In light of the Global Financial
Crisis (GFC), Australia has performed comparably well. Current GDP growth rate to this quarter is 3.2%, whereas
as most other OECD economies have recorded negative growth, the US recording negative growth of -2.4%.
Fiscal and Monetary policy have created and developed a positive economic climate by targeting any symptoms
of a pervading recession through copious government spending and loosening monetary policy. In spite of its
apparent stability, Australia’s economy is still fragile. Interest rates have been held at 4.5% for the past three
months to maintain this delicate balance. A further reduction in interest rates may have increased growth at
the cost of increasing inflationary pressures. An increase in interest rates may have dampened consumer
confidence too soon. Thus, the RBA’s decision to maintain interest rates is in line with its goal of maximizing
non-inflationary growth.
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INTRODUCTION
A country’s economic situation is determined by both factors out of the control of its governing body and factors
implemented directly through macroeconomic policy. This report aims to describe Australia’s current economic
landscape and outline the Macroeconomic policies its governing bodies have implemented to try and maintain a
level of sustainable growth. It then strives to analyse the reasoning behind the Reserve Bank Australia’s (RBA)
choice to maintain the current cash rate at 4.5% this month. This report seeks to illustrate the current relative
stability of the Australian economy as driving the current macroeconomic stance, a combination of a mildly
contractionary fiscal and neutral monetary stance. The paper proposes to analyse the RBA’s decision to take a
cautious monetary stance benefit to the Australian economy in light of its slow recovery post the economic crisis
and the potential inflationary pressures a fall in interest rates could cause.
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AUSTRALIA’S CURRENT ECONOMIC SITUATION
Australia’s economic condition is arguably one of stability and economic recovery. Despite global economic
uncertainty, Wayne Swan states that the Australian economy remains in a strong position with a positive
economic future (Australian Government, 2010).
Australia is recording a 3.2% annual growth rate in GDP to this quarter1 (The Australian Bureau of Statistics,
2010). This is equal to the 30 year average growth rate and above the 2009 forward estimate to for this year
(see Figure 1: Real GDP Growth) (Australian Government, 2010).
Figure 1: Real GDP Growth
Australia’s GDP is predicted to increase to 3.75% to 4% during the 2011-2012 financial year, though may be an
unreasonably high GDP prediction, given the fragility of the recovery (Reserve Bank of Australia, 2010; Brinsden,
2010).
4.1
EXTERNAL COMPARISON
Australia has maintained continuously impressive GDP growth relative to other comparable countries since the
Global Financial Crisis (GFC) began in 2007. Australia managed not to fall into a technical recession 2, achieving
1% positive growth in the 2008-2009 financial year where much of the OECD was in recession.
Figure 2 (Australian Government, 2010; Reserve Bank of Australia, 2010; Bureau of Economic Analysis, 2010)
highlights Australia’s relative economic success.
1
To second quarter 2010.
2
Two quarters of simultaneous negative GDP growth.
MACROECONOMICS: THEORY AND APPLICATIONS (25555)
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Figure 2: International GDP Growth
4.2
AUSTRALIA’S ECONOMY BY COMPONENTS OF GDP
GDP is the aggregate final domestic production of goods and services. It consists of consumption (C), investment
(I), net government fiscal activity (G) and net exports (X-Q), as delineated by the following equation:
Equation 1: GDP
𝑮𝑫𝑷 = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑸)
Any accurate description of Australia’s current economic situation must factor in changes in the components of
GDP.
4.2.1 CONSUMPTION
Consumption is a major indicator of a country’s economic situation. Australia’s retail spending increased in June
to reach an overall 0.8% increase in volume over the June quarter (The Australian Bureau of Statistics, 2010).
This marks a trend of modestly increasing confidence in Australia, with both business and consumer confidence
greater than the long-run average.
However, as a result of the recent economic crisis, Australian consumers are now generally more conservative
(Gruen, 2010). This is marked through an increased household savings rate, up 1.3% in May 2010 (Reserve Bank
of Australia, 2010).
This consumption growth contributes more than 1.5% of Australia’s GDP growth (Reserve Bank of Australia,
2010).
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4.2.2 INVESTMENT
There has been growth in net investment, driven by mining. There was an expectation that the mining tax would
reduce investment from overseas, but investment in the mining industry rose by 29% in the June quarter, as
compared to the same quarter last year, and almost 50% above expectations (Pascoe, 2010).
Furthermore, there has been recorded a mildly optimistic investment outlook (Pascoe, 2010).
4.2.3 NET GOVERNMENT EXPENDITURE
Government expenditure rose dramatically in response to the GFC, but is slowing due to fears of overstimulating
the economy, crowding out private investment and placing too great a debt burden on Australia. For more, see
section 4, below.
4.2.4 NET EXPORTS
Net exports have positively affected the GDP, with the current account deficit falling from 16 billion in the first
quarter of the year to less than 6 billion currently (Helyar, 2010). Australia is now running a trade surplus (which
is not common for Australia) that has added .4% to the June quarter’s GDP growth (Stutchbury, 2010). This has
largely been caused by increased Southeast Asian demand for Australian mineral exports. Export quantities are
set to dramatically increase next year due to capital investment easing capacity constraints on Australia’s mining
industry.
4.3
UNEMPLOYMENT RATE
Australia’s unemployment rate increased in response to the GFC in 2009, peaking above 6%. Since then, it has
begun to fall and was at 5.1% in June (Minutes of Monetary Policy, August 2010). There is some evidence that
shows that some of this decrease in unemployment rate is due to a decreasing participation rate, which fell to
approximately 65%, due to hysteresis and discouragement of the long term unemployed in the labour force
(Reserve Bank of Australia, 2010). Overall, Australia’s unemployment rate is much lower than most OECD
countries, with the US at 9.5% (United States Bureau of Labor Bureau of Labor Statistics, 2010). This bodes well
for the Australian economy.
4.4
INFLATION
Australia’ underlying inflation rate is currently at 2.75% (Minutes of Monetary Policy, August 2010), which is the
first time in nearly three years it has been under 3%. Australia’s headline Consumer Price Index was at 3.1%.
The upwards pressure on inflation can be explained by the GDI outpacing the GDP due to increased Asian
demand (primarily from India and China) for Australian minerals. This has been offset by passive consumer
demand in recent times, lower wage growth in 2009, the appreciation of the Australian dollar, retail price
discounting as well as a decline in domestic holiday accommodation pricing and little increase in utility prices in
the last quarter.
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4.5
EXTERNAL STABILITY
Whilst Australia’s net exports are growing fast, Australia still has a problem with external stability: a rising
Australian dollar is decreasing the international competitiveness of Australian exports and foreign debt servicing
counterbalances Australia’s positive net exports to bring Australia into a growing current account deficit. Whilst
the Australian dollar has not yet dampened demand for Australian primary exports, there has been increased
outsourcing of secondary and tertiary production due to their relative cheapness. Whilst Australia’s current
account deficits, and the level of private foreign debt, are high, investors remain calm, since the CAD is
decreasing at record rates (Martin, 2010).
The RBA continues to stress that external global uncertainty, especially from Europe, remains an issue. Further,
Australia’s reliance on Asian growth and demand (see Figure 2: International GDP Growth, above) for mining
exports are making Australia’s economic future fragile (Reserve Bank of Australia, 2010).
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5
FISCAL POLICY
Since the late 2008, the approaches taken by our central macroeconomic bodies have been directed by
increased volatility of world markets due to the GFC, a world recession due to the shortfall of liquidity of
investment banks in the United States. As a result, macroeconomic policies have been implemented with a view
to negative the GFC’s effect on the Australian economy whilst still providing for adequate exit strategies can be
executed once stability returns.
Fiscal Policy is the mechanism by which government alters their spending, either in the form of government
investment (G) and/or transfer payments (TR), or their collections through the taxation rate (t) to reduce
fluctuation in the business cycle and lessen the output gap.
5.1
DISCRETIONARY FISCAL POLICY
Australia’s current fiscal stance is mildly contractionary with a Budget Deficit of 40.8bil (2.9% of GDP) for 201011 compared to 2008-09 deficit of 57.1bil (4.4% of GDP) (James & Sebastian, 2010).
For the past two years,
however, the Australian Government has been applying expansionary fiscal policy through a $42bil Stimulus
Package to ward off recession symptoms due to the GFC (Parliament of Australia, 2010).
This stimulus
comprised of Government Investment expenditure and Transfer Payments to influence the level of aggregatedemand and output, thereby increasing equilibrium income and GDP.
The equilibrium position of the economy lies where AD=Y; as illustrated by Eq1.
Eq1
𝑌∗ =
1
1−𝑐(1−𝑡)
̅̅̅̅ + 𝐼 ̅ + 𝐺̅ + ̅̅̅̅
[𝐶̅ + 𝑐𝑇𝑅
𝑁𝑋]
Discretionary strategies outlined by the Stimulus Package include government investment expenditure on
large-scale infrastructure projects and microeconomic reform initiatives. $14.7billion was spent on school
halls extensions, $10.5billion for residential building projects and ceiling insulation for homes, and $890million
for road constructions (Gittins, 2009). This has resulted in job-creation, increased activity in the construction
sector and will continue to improve AD in the medium term. $2.7billion has been spent on business tax-breaks
encouraged risk-averse businesses to continue their activities (Gittins, 2009). This is in accordance to the
simple Keynesian model; output (Y) rises proportionately to the change in G as a product of the government
expenditure multiplier3.
The government plans to return the budget to surplus by 2012-13 a few strategies are being put in place to
slowly withdraw the expenditure. This includes confining annual real growth to 2% until the budget surplus
reaches 1% of GDP (Parliament of Australia, 2010) by limiting expenditure, and increasing revenues through
*
3
dY
1
i.e. the change in government expenditure effects a change in equilibrium income on a

dG 1  c(1  t )
greater than 1:1 basis because of its further effect on reducing taxes and increasing consumption.
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Super Profits Tax (12billion in tax revenue in four years) and higher excise on alcohol and cigarettes (Swan &
Rudd, 2010).
The Stimulus Package also includes $12.7billion in TR, a one off tax free cash-handouts of up $950 to income
earners, single income two-parent families earning up to $150,000, families with schoolchildren, students and
apprentices, and drought affected famers (Gittins, 2009). The initiative encouraged individuals to spend
money (increase consumption) thereby providing an immediate stimulus to the economy. These results
correspond to the theoretical notion (Eq1), that an increase in TR will directly affect the consumption function
(Eq2) hence resulting in an increase in AD.
Eq2
̅̅̅̅ − 𝑡𝑌)
𝐶 = 𝐶̅ + 𝑐(𝑌 + 𝑇𝑅
5.2
NON-DISCRETIONARY FISCAL POLICY
Other, non-discretionary fiscal outcomes include the effect of automatic stabilisers. As less tax receipts are
received by the Government during periods of lower output, leakage caused by income circulation reduces i.e.
when Y decreases, tY falls. Hence consumption inevitably rises (Eq2) and so do outputs (Eq1). During periods
of economic recession, uncertain employment prospects and inconsistent income-flow result in rises in
welfare benefit payments.
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6.1
MONETARY POLICY
CURRENT MONETARY POLICY STANCE
Monetary Policy is the instrument used by the Reserve Bank (of Australia) to influence inflation and output.
Prior to the GFC, the main function of the monetary policy was to manage economic growth and maintaining
target inflation of 2-3% by subtly raising interest rates to slow the economy or lower rates as a stimulus. Since
2007, monetary policy has been somewhat contractionary, but has now plateaued at 4.25% (ABC News, 2010).
6.2
MONETARY POLICY IN R ELATION TO THE GFC
The Reserve Bank of Australia loosened monetary policy over the last year or so in attempt to rectify the loss
of consumer and business confidence caused by the GFC. This was achieved by reducing interest rates and
increasing the money supply in the economy thereby increasing consumption by individuals, business
investments and hence output .
The RBA’s cutting of the cash rate was gradual; an over 4% drop was made within 6 months (Fig3). The cash
rate of 7.25% held from Mar-Aug 08 down to a 49-year low (AAP News, 2009) of 3% by April 2009. This
interest rate was held for a 5 month period, only rising slightly to 3.25% in Oct 09 (ABC News, 2010)
6.3
EFFECT OF MACROECONOMIC POLICY
The policies and strategies imposed by the RBA and Australian Government have been successful in combating
the GFC preventing recession and leading to our apparent recovery. This is illustrated through Australia’s
current economic environment (see section 3), which is characterised by increases in levels of consumption,
investment, and reductions in unemployment which have reflected favourable on AD and the national output.
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Figure 3 CPI
The overall effect of expansionary fiscal and monetary policy has resulted in a GDP growth rate of 0.9% in
Dec09 quarter from -0.8% in Dec08 (ABC News, 2010). According to Treasury Reports, without the stimulus
the economy would have contracted at a rate 0.7% (Gittins, 2010).
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7
THE RBA’S AUGUST DECISION
The RBA must use monetary policy to address the following considerations:
Limiting “consumer price inflation [to] between 2-3%; the stability of the Australian currency; the maintenance
of full employment within Australia; and the economic prosperity and welfare of the Australian people” (Reserve Bank of Australia, 2007; Reserve Bank Act , 1959)
The primary goal of monetary policy, since 1993, is to maintain stable price levels (Reserve Bank of Australia,
2007). This must be balanced against the goal of “economic prosperity” and “full employment”. Together,
these goals have been interpreted as maximising sustainable economic growth, with the requirement for
“sustainability” encompassing consumer price inflation.
As such, all monetary policy decisions, including the August 2010 decision not to raise interest rates above
4.5%, must have been made in light of the above considerations in order to be valid.
7.1
SUSTAINABLE ECONOMIC GROWTH
Section 3.2, above, discussed the relative strength of Australia’s GDP growth, as shored up by mining exports,
investment, increasingly positive consumer sentiments and government expenditure (see section 4, above).
As such, and in consideration of the predicted high rates of growth for the next few years, the reserve bank
does not really have to use monetary policy as an expansionary economic tool.
Reducing interest rates would act strongest on consumption spending (due to reduced mortgage costs
increasing disposable income). Consumption is already on a steep rise, with increased consumer sentiment
said to translate into even higher consumption in the next year or so. Consumer spending has increased by
0.7% and household spending by 1.1% in the Dec 09 quarter since the recession. As such, this would be overstimulating the consumption component of the GDP, potentially creating inflationary pressures.
Consumption spending has experienced a modest increase, despite a higher level of household savings and
low credit growth. Most economists expect that domestic demand will increase over the next twelve months,
but given the current cautious sentiment, keeping interest rates on hold may encourage positive intertemporal substitution. Similarly, the current monetary stance coupled with the stabilization of business credit
should encourage investment and development in line with the expected increase in demand. The labour
market has picked up, with unemployment falling to 5.1% in June and average work hours have increased,
although levels are still far from those reached in 2008.
Further, a decrease in the interest rates would also reduce Australia’s interest rate differential, potentially
reducing foreign investment in Australia by reducing the risk-free level of growth.
Underlying inflation had continued to fall to 2.75% below 3% for the first time in three years, and is now within
the RBA’s target band. The CPI is at 3.1%, which is partly due to the increases in tobacco taxes earlier this year
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and maintenance price of utilities. This rate is expected to remain steady over the next twelve months while
underlying inflation is expected to increase to 3% due to supply constraints being reached with the expansion
of the resources sector. Due to these inflationary pressures reducing the RBA’s cash rate would not have been
a logical choice.
Despite the Bank’s expectations for global growth to be about trend for the coming year, expansion has been
uneven. Most advanced economies have experienced moderate rates of growth, and key economic indicators
suggest that China is shifting to a more sustainable rate of development. However the overall strong growth in
Asia and Latin America has led to an increase in the price of Australia's two largest exports, iron ore and coal.
As a result, terms of trade have again risen to the historically high levels experienced in 2008 and economists
expect this to be sustained over the next few years.
7.2
MAXIMUM EMPLOYMENT
Unemployment, though reducing from its all-time high of 5.8% (The Australian Bureau of Statistics, 2010)
October 09 to 5.1% in June 10 (The Australian Bureau of Statistics, 2010), is slowly recovering (with
approximately 200,000 jobs being added to the workforce in since last August). This may be explained by the
hysteresis4 brought about by the pro-cyclical nature of output and participation rate, and labour productivity
keeping the unemployment rate up in spite of the increase in income.
Whilst reducing the interest rate might increase employment, the unemployment rate is low enough, and
close enough to the natural rate of unemployment, that targeting this with monetary policy would have
diminished returns, and would directly increase inflationary pressures.
7.3
EXTERNAL STABILITY
External stability is a secondary goal of the RBA’s monetary policy. Australia’s relatively sound external
stability (excluding her massive private international debt): a high Australian dollar, increasing terms of trade
and growing net exports (see s3.3.3 above) would be inappropriately targeted by monetary policy.
The goals of monetary policy are clearly delineated. There is high, almost peak non-inflationary growth, the
unemployment rate is falling as the participation rate is increasing and Australia is enjoying record external
stability. As such, the RBA’s decision to keep cash-rates as-is is sound, protecting current growth without
adding inflationary pressure.
4
Hysteris is cyclical unemployment becoming long-term unemployment or a reduction of the participation rate
via deskilling or workers no longer “willing” and “actively seeking” employment.
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CONCLUSION
Evidently, there are a multitude of factors that determine Australia’s current relative economic stability. This
report primarily identified that Australia was able to avoid being unduly affected by the global economic
recession due to its government expenditure bolstering consumption, and a healthy export sector bolstered by
increasing commodity prices. These factors have led to Australia’s economic resurgence leaving Australia in a
good position to lead the global economic recovery. This report stresses a neutral monetary stance will
benefit the Australian economy as increasing the cash rate may simmer Australia’s feel consumption demand
whilst a reduction in the cash rate could see the reappearance of inflationary pressures. Maintaining the cash
rate served the RBA’s goals, and are, thus, a reasonable response to the economic climate.
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