Monetary Policy Through An Interest Rate example essay topic

Monetary policy is the manipulation of interest rates to influence economic activity, whilst fiscal policy is the use of the government budget (variations in the level and composition of taxation and spending) to influence the economy. Both these instruments have a role to play in the Federal Government's policy mix to achieve key economic objectives. Historically, these objectives have been 'internal balance' (achieving price stability and low unemployment), 'external balance' (keeping the CAD, foreign liabilities and exchange rates at a sustainable level), and economic growth to improve the material standard of living in the medium to long term. Along with microeconomic reform, fiscal and monetary policy are the three instruments used to meet these objectives. The traditional policy mix (used since the Hawke / Keating Labor government) has been to use monetary policy to address internal balance, fiscal policy to achieve external balance, and microeconomic reform to assist in achieving faster rates of sustainable growth. However, the policy mix has changed slightly under the new Howard government, especially in the role played by fiscal policy.

Monetary policy remains the most important economic management tool, and since the early 1990's has played the central role in the management of economic growth and inflation in Australia. For the past decade the RBA has conducted monetary policy with the main aim of achieving its 'inflation target' of 2-3 per cent over the course of the economic cycle. Whilst low inflation is not an end in itself, the RBA believes that keeping price growth within the target range is the key to achieving the goals of sustainable economic growth and low unemployment. Under the Howard government however, fiscal policy has taken on a less active economic role. Fiscal policy is no longer actively used to influence the level of economic growth nor to achieve external balance. In fact, the objective of external balance is no longer directly pursued by the current government.

Instead, fiscal policy is a supplementary demand management tool, with the main aim being to achieve budget balance over the course of the economic cycle. This goal of fiscal balance ensures that the government does not draw from the savings pool and 'crowd out' the private sector (thereby indirectly assisting external stability), as well as having other political advantages. The RBA needs to take many factors into account when conducting monetary policy. Theoretically, interest rates are raised to exert contraction ary pressure on an overheated economy, and lowered to promote growth when economic activity is stagnant. Whilst MP is relatively quick to implement (the RBA Board convenes every month), changes to interest rates often take 12 - 18 months to have an impact on the economy. This time lag needs to be taken into account when conducting MP, and the RBA often needs to act preemptively and forecast where the economy will be positioned in the business cycle when the impact of MP changes are seen.

At present the RBA has kept interest rates steady at 4.75 per cent for more than a year, yet many economists are forecasting that rates will fall in the second half of 2003. According to the RBA formula, when inflation is within the target band, then an interest rate level below 5.5% is considered expansionary. Therefore, the current interest rate should be having a mildly stimulatory effect on economic activity, supporting the fact that Australia's current growth rate (2.9% in March 03) is below the long term sustainable rate of 3.5 to 4 per cent. The RBA also did not react to the fact that for a brief period in early 2003 inflation rose outside of its target band to 3.4 per cent in March. This reflects the fact that the inflation target is not an 'electric fence', but rather a goal to be achieved as an average over the course of the business cycle. This frees up monetary policy to be used for demand management in the short term.

There is increasing pressure on the RBA to ease monetary policy through an interest rate cut due to the less than promising outlook for the world economy. In addition, the domestic growth rate is well below its sustainable average, still suffering from the effects of the drought. Also, by reducing the interest rate differential between ourselves and the rest of the world (current interest rates are only 1% in the US and 0% in Japan), this would reduce upward pressure on the Australian dollar and lessen the negative impact of the weak global economy on our export markets. However, the RBA has also expressed its concern about the continuing boom in home building and property prices, being fuelled by a growth in credit.

This reflects the fact that monetary policy is a relatively blunt economic instrument. A change in interest rate has an effect on every aspect of the economy, making it difficult for the RBA to move rates in either direction. Ideally, monetary policy should be used hand-in-hand with fiscal policy to achieve economic objectives, as FP can be more highly targeted to specific areas in the economy. For example, expansionary fiscal policy could be used to address the current situation of slow economic growth, whilst leaving interest rates steady as not to over-stimulate the property market. However, the fact that the government no longer uses fiscal policy as a serious macro-economic instrument means that this would be difficult to achieve. In reality, the Budget is now used mostly as a political instrument due to the public misconception that balanced budgets are a reflection of sound economic management.

Balanced budgets also prevent the political opposition from being able to use any surplus funds should they come to power. It seems that the Government's political agenda has rendered fiscal policy close to impotent in terms of its macroeconomic impact in the economy. In 2003, fiscal policy will exert a very mildly expansionary pressure on the economy, even though macroeconomic concerns no longer feature highly in the fiscal strategy. The underlying cash surplus has shrunk form 0.5 per cent to 0.3 per cent of GDP (from $3.9 bn to $2.2 bn). The budget contains income tax cuts and overall spending increases which are likely to provide some stimulus for the Australian economy in the face of a relatively weak global environment. However, the fiscal loosening is slight enough that it will not put undue pressure on inflation or the Current Account.

The government attempts to ensure that it is not 'living beyond its means'. Fiscal policy attempts to maintain macroeconomic stability and encourage private investment through the entrenchment of low levels of public debt, meaning that the Current Account is simply a reflection of private saving and investment decisions. This is in line with the Twin Deficits theory which states that the government should attempt to avoid fiscal deficits which put pressure on the national savings pool and can crowd out private investment. All these fiscal policy objectives are supplementary to the role of monetary policy, which is the primary tool for macroeconomic management in the Government's policy mix.

Whilst fiscal policy still has some role to play in the economy, the fact that the government also uses it to achieve political objectives means that the present policy mix is unable to deal with the current economic conditions in the most effective way.