Fiscal And Monetary Policies In Australia Economics Essay

It can be said that Australia’s fiscal budget is sound and stable and may actually be envied by many major world economies. Its balance sheet is one of the strongest in the world1. In order to have a general idea of this, Australia’s current budget deficit is $57.4 billion (about 4,9% of GDP). Comparing to other countries, current US budget deficit is about 10,6% of GDP [1] and Spain’s is around 11,4% of GDP.

This enviable situation is not only true now, but also at pre-crisis situation where its GDP deficit in 2008 was 2.9% compared to 4% of Spain’s and 3,2% of USA’s.

Due to the world wide economic recession (in Australia’s case mainly caused by lower commodity prices) a controlled economic deficit is not only needed but also inevitable. However, due to the current economic slowdown, in February 2009 and in order to provide confidence and regain economic power, Australia’s government committed to,

Achieve budget surplus by 2015-16

Keep tax rates as share of GDP below 2007-08 levels

Improve government net financial worth over the medium run.

In order to achieve surplus by 2015-16, Australia is keen on stimulating the economy by being more permissive in taxes, increasing spending, and support the current job force. At the same time, it is committed to maintain tax rates below 2007-08 rates (in 2007-08 tax rates as percentage of GDP was 24%, and current tax rate as percentage of GDP is 22%). A combination of decreased tax rates with incremented government spending and support for current jobs, would most probably lead to economic recovery by 2015.

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A strategy for a change from a deficit situation to a surplus situation is needed, and this would be managed by keeping low tax levels in order to stimulate the economy and let the tax levels to progressively recover as the economy recovers always maintaining below 2007-08 rate levels.

Monetary Overview

In 1993 the Reserve Bank of Australia adjusted its strategy and established a target of 2-3% consumer price inflation per annum. By having this as medium term strategy, the Reserve Bank reduces the risk of cost pull or demand pull inflation. Inflation peaked in 2008 (see appendix 1) and the RBA tightened its monetary policy accordingly by raising interest rates. In February 2008 the RBA set its cash rate at 7%, up by 25 basis points [2] . Only a month later the RBA added another 25 basis points, with consumer demand outpacing economic production and thereby raising prices. Inflation at this point was at 6.5%, well above the target rate. In September 2008, the RBA reduced the cash rate by 25 points again. Short term rises in the CPI were expected as oil prices were very high, but in the long term aggregate demand was sufficiently weakened for inflation to fall leading to further cash rate reductions cumulating in a low of 3.00% in April 2009. The RBA set itself the target of reaching target inflation by mid 2010. With Australia having weathered the economic crisis very well, the RBA is starting to raise interest rates again. The cash rate currently stands at 4.25% [3] . After having neglected to issue bonds with a view regulating monetary supply, the Australian Office of Financial Management, plans to have issued treasury indexed bonds with a value of $150 billion by mid 2010, up from $6 billion just one year earlier [4] .

Exchange Rate Policy

Since 1983 Australia has a floating exchange rate on its currency, meaning that the rates are determined by the markets. The decision to move from a pegged and fixed rate system to a floating one had several benefits for the Australian economy, including improving their exporting competitiveness and reducing the risk of speculative currency devaluations. As Australia’s economy is relatively small yet very open, the floating system has enabled the country to reduce their exposure to the often quite violent fluctuations in the ASEAN region. Had they kept to the fixed rate the Australian government would have had to resort to manually adjusting the value of the Australian dollar, at a considerable risk of either being too late or too early and picking the wrong rate. By letting the market adjust the rate for you, any economic shocks can be easily absorbed with generating the inflationary or deflationary pressures that accompany the fixed rate systems.

Despite a 5% drop in Australia’s current account deficit [5] between 2008 and 2009, the last two quarters of 2009 saw a 20% increase in the current account balance compared to the previous year, which is a cause for concern for economists and signifying that Australia’s trading position worsened significantly at the end of last year. Economists are even predicting a 1.3% reduction in economic growth for Q4 2009 as a result [6] . However with the Australian dollar having depreciated recently in line with lower inflation and with a global economic recovery pushing demand for commodities (Australia’s prime export) the deficit should shrink in the coming months. However the deficit points to possible structural issues domestically. The fact that Australia was running a deficit during an export boom points to a dependence on imports. With the currency having depreciated recently and only just starting to recover, there is a risk of inflationary pressures building up as the increased cost of procuring the imports is passed on to the consumer.

Structural Overview

From a structural point of view, it can be said that during the “hardest” years of the world economic recession, Australia followed opposing monetary and fiscal policies as from a fiscal point of view, government was expansive, decreasing taxes and trying to continue promoting full employment while at the same time increasing government spending in order to stimulate the economy. From a monetary point of view, the actions followed by the Australian government were of restrictive in nature, mainly trying to maintain inflation low.

Prior to the world economic recession (Australia suffered some of its effects due to a considerable decrease on commodity prices), Australia historically has followed contradicting and opposite to their current policies, where from a fiscal point of view, their policies were restrictive and their monetary policies were expansive. This was mainly because of decreased government spending, increased tax rates and an increased inflation rate (higher than present but still low).

Australia can serve as a clear example of a supply side economy as believing that tax rates should be maintained low and the government should regulate the work force in order to achieve full employment and the economy “moving” is a clear indicator of a supply side type economy. However, some people might ague that there is little correlation between low tax rates and full employment. At the same time, people might argue that while having a tax reduction, people might actually be encouraged to work less as they are receiving more income with same work.

Australian Immigration as key to its economy

Immigration in Australia has always been a subject for debate. Since 1996 until 2008, immigration has always been welcomed and to some extent encouraged by the government since its small population size (a little over 21million) compared to its large size (only slightly smaller than the United States) [7] . This means that there is a constant need for a supply of the labor force in order to make Australia more competitive. This becomes specifically meaningful, when seeing that 85% of Australia’s immigrants are under age 40 [8] . However, in recent years, due both to a response in the world economic crisis and constant worries that Australia might be achieving its immigration full capacity , its immigration levels have decreased over the last year (see Appendix 3)9.

Different Future Scenarios

1 – The return of inflation and an increasing current account deficit

Australia announced an ambitious economic stimulus package at the beginning of 2009 and with the economy showing great resiliency much is left unspent. If the government were to follow through on its plans the economic stimuli combined with the solid growth rate of the economy could push up inflation beyond the target levels. This in turn would lead to the RBA raising interest rates further. With the recovery still it its very early stages in other developed economies, investors could see Australia as place to park funds thereby potentially driving up exchange rates, which had been falling up to February this year. A strengthening of the Australian dollar would undermine the competitiveness of Australia’s exports. As an economy that relies on two principal exports namely tourism and commodities, a strong currency could be detrimental to the Australia’s continued growth.

2 – Going back to pre world economic recession strategies

One possible scenario for future years is where Australia goes back to its pre world economic recession fiscal and monetary strategies, with restrictive fiscal policies and moderate restrictive monetary policies. This would mean that the government would decrease government spending with GDP growth increasing (decreasing more than present rates, but still managing it considering to market sentiment). At the same time, this would allow the government to let tax rates reestablish themselves to target levels. Inflation would be managed and maintained at low target levels in attempts to keep increasing the economic increase from a supply side economic point of view.

Recommendations:

Even though it can technically be said that Australia has not severely suffered the impact of the current economic crisis, there has been issues such as decrease in GDP growth and slight increase in unemployment, which Australia had to deal with.

As of today, Australia’s economy is rapidly recovering from these issues and we would recommend the government to manage its economy in a very conservative manner. We would recommend to decrease government spending as Australia is already with GDP growth and maintain interest rates low causing a slight increase in inflation (due to its exchange rate tradeoff). However, since inflation is slightly increasing, and GDP is also increasing, unemployment would be low as well. At the same time, we would slowly increase interest rates to target levels and maintain them at pre-crisis levels, slightly increase in tax rates due to the improvement of the economy (and in order to work towards a budget surplus goal). At the same time, we would recommend the government to slightly increase Consumer Price Indexes (CPI) and allow increase inflation yearly (but always maintaining them at targeted levels), just as long as the economy shows significant improved GDP growth rates.