Monetary and Fiscal Policy in 2008/9

Monetary and fiscal policy in 2008/9

Both monetary and fiscal policy have been used in an attempt to keep the economy from moving into recession. Events have also highlighted the problems discussed on pages 302-305, and 307-308 that are encountered in using these policies.

Consider fiscal policy first. This involves the government increasing its expenditure and/or reducing taxes. The main impact has been on government expenditure. At end of 2008 the government gave a ‘Christmas bonus’ of $10 billion to families and to welfare recipients in order to increase consumer expenditure and hence boost aggregate demand. This had some effect but estimates suggest that perhaps a third of the payments were used to pay off debts or increase savings. Further one-off cash bonuses amounting to $12 billion were announced in February 2009.

Also in February 2009, the government announced a $28 billion increase in its expenditure on goods and services. The great bulk of this will go on infrastructure expenditure, notably on schools. One difficulty with using infrastructure spending to stimulate the economy is that there are few projects sitting on the shelf, ‘shovel ready to go’. Thus it is difficult to increase expenditure by a great deal in the first 6-12 months as planners, architects and engineers develop projects. There is a further difficulty that, when the main expansionary effects of infrastructure spending are felt in one or two years, the economy may already have started to grow anyway. For this reason some have argued that permanent tax cuts should have had a part to play. The problems of timing are discussed on pp.304-5.

The result of increases in government expenditure along with lower than expected tax revenues due to the stagnant level of activity means that the budget has moved from a surplus in 2007/8 to an expected deficit in 2008/9 and 2009/10. There is nothing wrong with this. It is the correct response to an incipient recession.

We now discuss monetary policy which is the responsibility of the Reserve Bank of Australia. The main instrument of policy is the overnight cash rate. As late as February 2008 the Reserve Bank still saw inflation as the main danger and increased the cash rate (for the eleventh consecutive time) to 7%. Some of the reduction in the rate of economic growth in late 2008 was due to the delayed effect of the February 2008 increase in the cash rate.

In the latter part of 2008 as it became increasingly clear that many advanced countries were moving into, or towards recession, the Bank moved on several occasions to reduce the cash rate. By February 2009 the cash rate had fallen to 3.25%, its lowest level since 1964. As the cash rate falls so does the whole set of interest rates (see page 306).

The governor of the Reserve Bank explained the February 2009 decision, which was announced on the same day as the government package described above, as follows:

At its meeting today, the Board decided to reduce the cash rate by a further 100 basis points, to 3.25 per cent, effective 4 February 2009.

There was a significant deterioration in world economic conditions late in 2008. The effects on household and business confidence of the financial turmoil following Lehman's collapse, and continuing strains on major financial institutions, saw a significant downturn in demand around the world. As a result, the major advanced economies contracted sharply in the December quarter, as did a number of emerging market economies. The Chinese economy, though still growing, has slowed markedly. Global inflation, having reached high rates during the middle of 2008, is now declining.

Measures to stabilise financial systems have contributed to an improvement in the functioning of credit markets over the past couple of months. This, in conjunction with expansionary macroeconomic policy measures being taken around the world, should assist in promoting global recovery over time. But the near-term outlook for the global economy is the weakest for many years.

Economic conditions in Australia have also been affected, though less than in other advanced economies. Australia's financial system remains in a strong condition and large interest rate reductions over recent months have been passed through in substantial measure to end borrowers. Nonetheless, the combination of last year's financial turmoil, a severe global downturn and substantial falls in commodity prices has had a significant dampening effect on confidence, and therefore on prospects for growth in demand. Inflation has begun to moderate and, given recent developments, it is likely to continue to decline.

In these circumstances, the Board judged that a further sizable reduction in the cash rate was appropriate, to give further support to demand. In making its decision, the Board took into account the package of measures announced by the Government earlier today. The combination of expansionary monetary and fiscal policies now in place will help to cushion the Australian economy from the contractionary forces coming from abroad.

Unfortunately, monetary policy is much less effective in stimulating an economy than it is in restraining the rate of growth (see top of page 309). Monetary policy is a “string”: you can pull on it to reduce the rate of growth but it is hard to push on it to stimulate growth.

The changes to monetary and fiscal policy described above are, by any standards, very substantial.