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Fall

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08 10

25555 - Macroeconomics: Theory and Applications

Question: a) Describe the Australian current economic situation and support your claims with economics indicators and variables. b) Outline the approaches taken by the Australian government (fiscal policy) and the central bank (monetary policy) and how they relate to the global financial crisis and the apparent recovery. c) The RBA has decided to put the cash rate of 4.5% on hold this month; why could this be a reasonable response given the issues and prospects facing the Australian economy?

UTS

Table of Contents 1. Table of Contents ..2 2. Executive Summary...3 3. Introduction4 4. Australian current economic situation5 4.1 Unemployment.5 4.2 GDP and Consumption expenditure.6 4.3 Inflation7 5. Fiscal and Monetary policy in the Global Financial Crisis8 5.1 Government approaches...8 5.2 RBA approaches...8 6. The cash rate.11 6.1 Australian GDP growth..11 6.2 Global GDP growth13 6.3 Inflation targets..13 7. Conclusion14 8. References15

2. Executive Summary This report seeks to examine the successes and failures of both the Australian government and the Reserve Bank of Australia (RBA) in their quest to usher the Australian economy away from the Global Financial Crisis (GFC). An examination of economic variables and measures revealed that in essence, the Australian economy has functioned in line with RBA expectations. The RBA has thus maintained a 4.5% cash rate for the third consecutive month in light strong economic conditions; growth levels that continue to function close to trend and continued drops to inflation. The economy is deemed to be functioning so effectively that the RBA did not adjust its rates to account for instable global markets, specifically with respect to the debt crisis in Greece and planned fiscal downturns in China. In keeping with the maintained cash rate and government relaxation of fiscal initiatives, it becomes apparent that Australia is successfully withstanding GFC pressures.

3. Introduction The Australian economy has seen considerable strengthening borne from fiscal and monetary policy developments; however, the extent to which this has taken place lies in an analysis of the actions made by key economic players. In an effort to discover this, the report first investigates economic indicators and variables to reveal a strong economic climate characterized by significant levels of growth. Secondly, it points to the manner in which the Australian government and the RBA effectively exercised expansionary fiscal and monetary schemes, respectively, to inhibit the economy from falling into a global recession. Thirdly, it explores the way in which the RBA has employed a target cash rate to maintain low levels of inflation and sustainable growth, as well as reveal that its influence extends beyond the immediate flow off effect on interest rates, rather creating the base on which such rates are built on.

4. Australian current economic situation The Australian economy, in the context of the GFC, has seen a period characterized by sound economic management. We have seen a fluctuating unemployment rate cause inflationary pressures, with flow-off effects on investment, net exports and consumer sentiment. Furthermore, functioning in a period of limited access to credit, these variables have faced, and will continue to face, instability. In spite of this, we have seen significant increases in GDP growth (Statement of Monetary Policy, 2010, pp.36). This section seeks to explore the fluctuations in these indicators and variables, and what they reveal about the way in which the economy has successfully functioned within the GFC. 4.1 Unemployment First, the unemployment rate stands as an obvious testament to the stability of an economy. The GFC saw unemployment rates rise by 1.8% in 2008, fall 0.34% in 2009 and then fluctuate at 5.1% in early 2010. As shown in Graph 1, the employment rate increased by 0.7% in June and as of recently, most of the growing up trend has been in the full-time employment (Statement of Monetary Policy, 2010, pp.36). Moreover, Australias unemployment rate stands as one of the lowest among advanced economies, with predictions that it is to go down further to sit at 4.34% in 2011-2012 (Swan and Tanner, 2010, pp.45). Graph 1 Source: RBA (2010)

Graph 2 Source: RBA (2010)

4.2 GDP and Consumption expenditure The first quarter of 2011 saw real GDP increase by 0.5%, with increases set to continue to reach 2.7% and real GDP forecast to increase by 3% in 2011 and continue to rise by 3.75% between 2011-2012 (Swan and Tanner, 2010). Consumption expenditure saw marginal increases in 2009-2010, attributable to the flow-off effects of the government stimulus payments (Statement of Monetary Policy, 2010, pp.3). Graph 3 details the 0.1% and 0.8% increases to the retail sales rate over the first and second quarters of 2010 respectively (Statement of Monetary Policy, 2010, pp.29). The first quarter of the year saw total consumption increase by 0.6%; rising 3.1% in the year while motor vehicle sales to households grew over 10% in 2010. (Statement of Monetary Policy, 2010, pp.29). Motor vehicle sales thus recovered there 20% fall and overall total consumption increased. There are however still problems in falling export prices, holding negative effects in decreased profit earnings (Swan and Tanner, 2010, pp.45).

Graph 3 Source: RBA (2010)

4.4 Inflation Over the last year the underlying inflation rate has stayed steady as per the expectations of the RBA. Of significance is that CPI inflation was over 3% in the past year (Statement of Monetary Policy, 2010, pp.2). This was caused by the result of the rising tobacco tax (Statement of Monetary Policy, 2010, pp. 2). In addition, many retailers have been reducing sales growth to react this regime (Statement of Monetary Policy, 2010, pp. 2). It is forecast that underlying inflation will stand at 2.34% throughout the next year (Statement of Monetary Policy, 2010, pp.2). Threatening this however are increases in the tobacco tax and cost of utilities. Such could cause CPI inflation above 3% in the next year (Statement of Monetary Policy, 2010, pp.2). However, the current inflation rate is low and is exspected to remain that way over 2012 (Statement of Monetary Policy, 2010, pp. 2). Graph 4 Source: RBA (2010)

5. Fiscal and Monetary policy in the Global Financial Crisis Fiscal Policy is a procedure where the government manages government expenditure (G), transfer payment (TR) and tax (t) to control the aggregate demand (AD) of the economy. This policy is necessary to toughen the financial system, increase production capacity and prevent high levels of unemployment. Monetary Policy is a procedure where the central bank manipulates the level of interest rate (i) in order to retain the stability of the economy. This policy controls the supply of money and its availability as well as its cost, the interest rate (i). 5.1 Government approaches With the economy still under recession, the Government is spending $4.2 billion where $12.7 billion were to be given to a low and medium income earner and the other were spent for schools, roads, housing, energy efficiency and infrastructure as well as reducing tax for small business. This is designed to create jobs which will be that will be in demand over the coming years (Coorey, 2010, pp.1). Such means that unemployment will be decreased. When the Government is increasing their spending and this spending is autonomous, the aggregate demand curve will shift up by $4.2 billion, causing income to increase up to $950 for low to middle income earners. Since GDP is driven by aggregate demand and the AD curve is shifted up, this means the GDP is also increased. This is illustrated in Diagram 1 below, showing the effects of government expansionary Fiscal policy. 5.2 RBA approaches During the recession, economic activity has progressed slowly and thus interest rates have seen cuts by the RBA by 1 percentage point. (Coorey, 2010, pp.1) This suggests that demand for money has increased and accordingly, bond demand would be decreased. Furthermore, the increment for the demand of money will lead the LM curve to shift to the right. When the interest rate sees decreases, individuals within the economy will hold more cash making household spending and business investment more likely. When household consumption and business investment is increased, GDP also increases. This is seen in diagram 2 below.

Diagram 1 Changes in Growth Source: RBA (2010)

Diagram 2- Changes in Interest Rates Source: RBA (2010)

During the GFC the Government supported the economy by allowing the budget economic stabilizer to take control (Swan, 2010, pp.67). The economic stabilizers were designed to counteract the fluctuations in economic activity without any direct intervention by policymakers. Tanner (Combating the GFC An Australian Perspective, 2008, pp.1) states that the unemployment rate fell 0.1% to 5.7% during the GFC. To maintain economic stability, the Government effectively deformed the competitive 9

nature of the banking industry. This action included higher cost of debt, a reduction in lending and credit rationing (Liddy, 2009, pp.2). Implications include that regional banks have been reduced to three main players, as the big four increase market share and pricing power. Since the Commonwealth Bank and Westpac took over St. George and Bank West respectively, these main players increased their share of the retail deposit market from 61.5% to 72% (Liddy, 2009, pp.3). Other institutions such as the Bank of Queensland, for example, are forced to operate with a higher funding cost and higher fees for wholesale funding guarantees to survive. This leaves an ever-present threat of takeover. With a start to development of international wholesale funding markets that were triggered by the GFC, the availability of credit in the money markets is beyond achievable for financial institution (Liddy, 2009, pp.5). As financial institutions struggled to obtain funding at the heart of the GFC, fiscal policy only further frustrated the oligopoly major banks held over the industry in a context where policy aimed at increasing funding access in investing $16 billion to the RMBS market (KPMG, 2009, pp.8). However, the cost of the policy has prevented smaller institution from offering price-based competition. Bad debt expenses on business loans have also increased in the GFC climate and thus lead to a fall in profit in the banking industry. During the economic recovery, the Government pulled back stimulus measures to consolidate its fiscal position. Also, the government continues to deliver its deficit exit strategy, forecasting the return of a budget surplus by 2013 (Swan, 2010, pp.8). In light of fiscal policy withdrawals, it can be said that the economy will be self-sustaining over the coming years of recovery. This essentially means that the Government had allowed for economic stabilizers to take charge of ensuring the economy attain economic stability.

6. The cash rate

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The RBA exercises manipulations to the cash rate in an attempt to reduce inflationary pressures and keep economic growth on target. The decision to maintain the 4.5% rate was made for the third consecutive month with three key considerations in mind. First, that within the current monetary policy framework, Australian GDP growth is expected to stay close to trend (RBA, 2010, p.30). Second, to account for the uncertainty in global GDP growth, specifically, as planned fiscal contractions begin to take place in trade partner nations including Asia and Europe. Thirdly, that inflationary pressures have kept within RBA targets at 2.75%, and expectations that underlying inflation will continue to stay in the 2-3% preferred target till mid 2011 (RBA, 2010, p.30). Accordingly, it appears befitting that the cash rate stay on hold, and continue on hold, until global outlook becomes more apparent or inflation increases beyond suitable levels. 6.1 Australian GDP growth Central to the RBA decision was that growth rates were increasing, and looked to continue increasing, around trend pace despite fading fiscal stimulus. As a result of significant growth in capital stock; specifically within the resources sector, as well as the labour force; centered on an increasing participation rate, graph 5 points to a 0.5% increase in real GDP in March to a 2.7% increase over the year (RBA, 2010, p.31). In the context a broader global economy, Australia is one of few to record higher investment in GDP, with a 2.5% increase in output compared to the September 2008 peak (RBA, 2010, p.31). These investments to the resource sector coupled with employment growth then flow on as increases in income, and in turn, demand. Accordingly, household spending has seen marginal increases throughout 2010, reflecting the affectivity of expansionary policy as well as increased levels of household savings. Graph 6 points to the June quarter that saw the start of a pause on fluctuations in the cash rate experience a 0.8% increase in retail sales, following a 0.1% rise in the March quarter (RBA, 2010, p.32). This is further evidenced in the 10% increase in motor vehicle and services retail sales in the June quarter, allowing the sector to recover from the 20% dip during 2008-2009 (RBA, 2010, p.32). A central consideration in the RBA decision to maintain rates would be concerns that a pre-emptive tightening of monetary policy would destroy confidence and demand. However, in the event that increases in saving and modest spending do not continue as forecast, significant inflationary pressures would arise, specifically in keeping with the downward trending 11

unemployment rate (RBA, 2010, p.32). Graph 5 Source: RBA (2010)

Graph 6 Source: RBA (2010)

Another foundation on which the RBA decision was based was continued growth in business investment, and the way in which that would continue to drive growth in domestic demand (Swan, 2010, p.10). Such is in view of the positive outlook that tax incentives for equipment spending provided the business sector (Swan, 2010, p.10). And furthermore, the expected increases to resource exports to flow on from maintained increases to Engineering investment, such as in the $43 billion Gorgon LNG project and its associated expansions in capacity (RBA, 2010, p.45). However, of importance in RBA considerations is that in the event that such private demand does not occur in the

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forecast period, and does not substitute now contracting fiscal investments, the very fiscal initiatives that sought to increase the growth rate would do the opposite. In keeping with the inherent uncertainty that governs large-scale investments, the forecast reliance on the strength of growth rates becomes problematic. 6.2 Global GDP growth The volatile nature of the global financial market saw equity prices and bond yield levels decline, a decrease in the issue of bonds and significant movements in the exchange rate, specifically attributable to the European sovereign debt crisis and high growth rates in China (RBA, 2010, p.50). In play within the RBA decision were strong stress test findings for European banks and the implementation of polices seeking to curb inflationary pressures in China (RBA, 2010, p.50). Such lessened domestic inflation pressures as the May and June quarters of 2010 have seen banks regain funding access in domestic and international markets. However, there exists a possibility of continued concerns in Europe and associated adoption of risk aversion strategies that could slow the global economy, decreasing inflation rates beyond forecast levels and colliding with the RBA decision (RBA, 2010, p.50). Furthermore, that Chinas contractionairy policies may result in decreased commodity prices with flow off effects on resource investment (RBA, 2010, p.50). 6.3 Inflation targets This control of capacity utilization, demand pressures and an appreciating exchange rate have resulted in underlying inflation decreasing from 4.5% in the September 2008 quarter to 2.34% in the June quarter, with expectations that underlying inflation remain as is (Swan, 2010, p.22). While the CPI jumped 0.6% in the June quarter, 0.4% was attributable to the increase in tobacco prices (Swan, 2010, p.22).

7. Conclusion It can be said that an analysis of current economic indicators, trends and policy

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decisions point to a mutual fact; that with proper economic intervention the Australian economy has proven resilient in view of the GFC.

8. References

Coorey. P, 2010, It may be costly but itll work, viewed 30 August 2010, https://online.uts.edu.au/webapps/portal/ frameset.jsp?tab_id=_2_1&url= 14

%2fwebapps%2fblackboard%2fexecute%2flauncher%3ftype%3dCourse%26id %3d_1462_1%26url%3d

KPMG. 2009. Regional banks, credit unions and bulding socieies. KPMG Financial services- Banking. [online] March, pp. 1-5. Available from <www.kpmg.com.au/Portals/0/2009_regionals_update.pdf> [Accessed April 20].

Liddy, D. 2009. Managing Director Presentation. Unprecedented times in financial services. Keynote address. April 6. Australia: The Retired Westpac Officers Club.

Liddy, D. 2009. Managing Director Presentation. The GFC, Australian banking industry, and Bank of Queensland. Keynote address. June 26. Australia: Brisbane Young Club Young Executive Committee.

Reserve Bank of Australia (2010), Statement of Monetary Policy, August, 2010, Sydney. Reserve Bank of Australia (2010) Minutes of the Monetary Policy Meeting of the Reserve Band Board, Sydney, 3 August, 2010. Swan. W, 2010, Economic Statement, viewed 30 August 2010 http://www.budget.gov.au/ 201011/content/economic_statement/download/ES_Consolidated.pdf

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