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Annie Unsworth - Economics Notes Topic 4.Docx[1]

Annie Unsworth - Economics Notes Topic 4.Docx[1]

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Published by: Liz May on Oct 14, 2011
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Economic NotesTopic 4: Economic Objectives and PoliciesMacroeconomic Policy
The recent GFC foregrounded a reordering of Australia’s economic priorities
Currently, the Principe concern for the Australian economy is high levels of economic growth, with low unemployment (which is a derived demand)
The aim for economic growth is 2-3% p.a. over the full business cycle, whilstthe desired position of unemployment is “full employment”
within the current economic conditions, GDP has recorded 2.7% , whilstunemployment measures 5.3%
The remaining economic objectives are somewhat lesser, however, with themost recent IR rise; the Reserve bank has clearly raised concern of potentialfuture inflation, (aim 2-3% over the course of the business cycle), whichcurrently measures 2.9% yet has the potential to increase
Also, residual concern lays upon the environment (ESD), income distribution(equitable) and the current accountMonetary Policy
Monetary policy refers to the manipulation of interest rates toinfluence the level of economic activity
2-3% inflation
full employment
growth between 2-3%
Historic Inflationary Targeting saw interest rates rise to 7.25% inMarch 2008
However, priorities have been redirected towards growth andunemployment with their fall to 3.0% in April 2009
However have raised to 4.50% in May 2010
Domestic market Operations
Are conducted between the RBA and financial institutions and banksin the Short Term Money Market
The short term money market fives financial institutions access todeposit and lending facilities to settle debt between themselves throughtheir exchange settlement account
The cash rate is the price of borrowing from the STMM
To increase the cash rate (tighten monetary policy), sells commonwealth governmentsecurities to the banks this decreases liquidity (availability of funds)
To decrease the cash rate (loose) it purchases CGS to increase liquidity and decreasecompetition for cash and therefore decrease the cash rate
Cash rate movements are passed on in a competitive bankingenvironment in order to ensure products and due t their competitivenatureKeynesian Transmission Mechanism
Consideration should first go towards the RBA’s contractionary policy. TheyKeynesian Transmission mechanism diagram is an economic theory used toexplain how monetary policy affects the economy
See diagram next page
In the case of contractionary monetary policy, the following impacts apply
Economic Notes
If the RBA uses DMO to sell back T notes(S to S1), it decreases liquidity inthe official cash market (shift from r to r1), causing short term yields andinterest rates to increase (R to R1) due to the competitive banking structures
As interest rates increase the marginal efficiency of capital (determined by therate of profits compared with interest rates) increases causing a decrease inautonomous investment from I to I1
There is a certain quantity of investment for which it is no longer  profitable, due to increased interest rates
As demonstrated by panel 2, the increase in investment shifts AD from Ad1 toAd2. As autonomous investment decreases, the level of national income andemployment decreases via the multiplier effect
The RBA can use monetary policy to bring about price stability,through reducing the inflationary gap
Expansionary policy can reduce unemployment, through increasingaggregate demand, which increases the demand for resources includinglabour 
Contractionary policy can decrease output due to increased productioncosts and decreased future sales
Recently, the RBA has increased the cash rate from 3-4.5% between October 2009 and May 2010
Concerned with external inflationary pressures, and that Australia hadremained resistive to the GFC (lower unemployment than expected, positivegrowth), the RBA pre – empted future inflation
Exchange rate (not related to diagram)
Changes in domestic interest rates affect the exchange rate
An increase in Australian interest rates relative to overseas will attractan inflow of foreign capital, increasing demand for $A and causing anappreciation of its value
This reduces the competitiveness of export firms and of importcompeting firms resulting in a decrease in output
An increase in interest rates also decrease consumption and imports,which decreases the supply of $A increasing $ALimitations
Interest rates cannot target specific parts of the economy
A ‘blunt instrument’ since an increase in interest rates affects allsectors of the economy irrespective of other government policies
Can adversely affect all types of spending, even if the problem isexcessive spending in only one area, such as housing
Interest rates cannot deal with cost-push inflation
Monetary policy can influence demand-pull inflation, inflationaryexpectations and imported inflation, but is not good at dealing withcost push inflation
Higher interest rate = higher repayments – higher costs = higher inflation
Economic Notes
Investment is based upon other factors
Stock levels, excess capacity, sentiment, future expectations
The transmission from the cash rate to interest rates
Increase in cash rate by 0.25% saw Westpac increase I.R by 0.4% dueto overseas costs
The main advantage is the relatively short time lag
 Normally takes 6-9 months for an interest rate increase to affectaggregate demand and the level of national income, whereas fiscal policy can take 24months Fiscal Policy
Fiscal policy refers to the use of the sixe and pattern of taxation andgovernment spending
A key component of the current policy mix is its extensive deficit inthe fiscal balance
Contractionary stance
Increased budget surplus (T>G) or a decreased budgetdeficit
Blanced Budget
Occurs when G =T
Exanisiornary Stance
Increased Budget deficit (G > T) or a decreased budgetsurplus
Fiscal policy can be broken down into two key components – structuraland cyclicalExpenditureAD1 = C + I + G1 + X-MASAD = C + I + G + X-MExpansionaryAD2 = C + I + G2 + X - MContractionaryIncome
The effect of budget stimulus can be seen in the above figure
A budget deficit leads to an increase in aggregate demand from AD to AD1
This leads to increasing demand for resources and income via the multiplier effect until a new equilibrium is achieved at a higher level of national income,which indicates growth
An increase in NY sees and increase in investment in new productive capacityand therefore an increase in output

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