Sarah Street
Mr White’s class
Government and the Economy
Instability in the Business Cycle
Word Count: 1,663
The Australian government’s management of market failure in the economy has been effective in stabilising the business cycle. One macroeconomic policy the government has employed to stabilise growth is monetary policy, which has been effective in curbing unsustainably high growth during boom periods and allowing growth to continue in periods of low growth.
Monetary policy (MP) is the manipulation of the cash rate by the Reserve Bank of Australia, who act on behalf of the government to influence the cost and availability of money and credit in the economy. In it’s simplest form, MP is the changing of interest rates.
Within monetary policy, the RBA has three objectives: full employment, low inflation, and stability in the business cycle. Despite, in 1996, the government adopted ‘inflation targeting framework’ which prioritised low inflation over the two other objectives, the government has still been successful in using monetary policy to manage unstable fluctuations in the business cycle.
Two main examples of effective management of market failure in the form of instability include the rise of the cash rate during the resources boom in the mid 2000’s, and the slashed cash rate after the GFC hit in 2009. Both times the government employed monetary policy to influence interest rates and the level of economic growth, insuring the economy is stable and preventing recession.
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015)
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015)
Macroeconomic policies—or counter-cyclical policies—are employed by the economy to prevent market failure in the form of instability in the business cycle. Unstable economic growth is a form of market failure because the fluctuations in the business cycle can lead to periods of downturn that are increased by instability, which can lead to a recession—a sub-optimal outcome for society. Alternately, when growth is increasing and continues to increase, it ultimately becomes unsustainable.
The Australian government has experienced a period of 26 years of consecutive growth, the longest of any developed country in the world. This reflects how the Australian government, combined with the Reserve Bank of Australia (RBA) have done an effective job in managing unstable growth in the business cycle.The RBA was established by the government to conduct macroeconomic policies without being influenced by political considerations as it operates independently from the government.
http://www.skynews.com.au/news/top-stories/2017/06/07/australia-breaks-world-economic-growth-record.html
The Reserve Bank of Australia. Monetary Policy. Retrieved August 10, 2017 from http://www.rba.gov.au/monetary-policy/Transmission Mechanism of Monetary Policy. Retrieved August 10, 2017 from http://www.bankpedia.org/index.php/en/128-english/t/23385-transmission-mechanism-of-monetary-policy-encyclopedia
http://www.skynews.com.au/news/top-stories/2017/06/07/australia-breaks-world-economic-growth-record.html
The Reserve Bank of Australia. Monetary Policy. Retrieved August 10, 2017 from http://www.rba.gov.au/monetary-policy/
Transmission Mechanism of Monetary Policy. Retrieved August 10, 2017 from http://www.bankpedia.org/index.php/en/128-english/t/23385-transmission-mechanism-of-monetary-policy-encyclopedia
fig. 1: GDP Growth 1999-2015
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015)
The above graph demonstrates the fluctuations of the business cycle over the last 18 years. It is clear that from 2003-08 the economy was experiencing a period of high and unsustainable growth, due to the resources boom that began in 2003. The governor of the RBA at the time, Glenn Stevens, called the boom the ‘greatest expansionary shock’ that Australia’s economy had experienced in over fifty years. Average commodity prices increased by 300% between 2003-11 and in the same period, national income increased by 15% due to the change in terms of trade. At this point, economic growth was peaking at over 5%. In order to dampen the inflationary pressure that was caused by such high growth, the RBA raised the cash rate was raised to 7.25% in 2008. This rise in the cash rate curbed the spike in economic growth as banks were forced to raise interest rates to protect the profit margin. This occurred via the transmission mechanism, a process by which interest rates are affected as a result of changes in monetary policy.
Once the cash rate has been raised, banks must pay more money for their own funds, which causes them to raise interest rates in order to protect the profit margin. GDP growth fell rapidly after the rise in interest rates, because higher interest rates lead to a decrease in both consumption and investment. When interest rates are increased, consumers become more likely to keep their savings in the bank and less likely to borrow money for spending. Households with variable mortgage rates would also have to make higher repayments, reducing their disposable income. Because of this process (the transmission mechanism), economic activity is reduced effectively and the government is able to manage instability through simply changing the cash rate.
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au
The graph below shows the changes in cash rate implemented by the RBA to influence economic activity:
fig. 2: Australia Cash Rate 1990-2016
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html
Another of the government's most effective managements of instability in the business cycle occurred in 2008 when the economy experienced a quarter of negative growth (-0.8%) in the wake of the GFC. During this time, economic growth fell to it’s lowest point since 2000, at 1.8%. Household wealth across Australia fell by almost 10%, causing consumer confidence to falter and consumption rates to plummet.
The graph above shows the changes that the RBA made to the cash rate in order to influence the changing of interest rates and consequently, the rate of growth.
The government was forced to take a highly expansionary stance in order to stimulate economic activity during this time of extremely low growth, and as well as injecting a fiscal stimulus package of $42 billion, the RBA slashed the cash rate from its peak of 7.25% to just 3% by 2009 (shown in the graph above). Due to the RBA’s effective use of monetary policy in slashing the cash rate, economic growth picked up and Australia’s economy managed to avoid a recession by just 0.4% in the first quarter of .
The government’s use of monetary policy in stimulating growth also helped unemployment increase from 4% to only 5.8%, rather than the predicted 8.5%.
Decreasing the cash rate had the desired effect on the Australian economy, as banks reduced interest rates and consumers were became more incentivised to take out loans from banks to invest. Because of lower interest rates, households with variable mortgage rates had to pay less on repayments and therefore had more disposable income.
http : / / RBA . Gov. Au (2015) Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . l http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html
It is evident that the Australian government’s management of instability in the business cycle has been efficient and effective. Through monetary policy and its transmission mechanism, the RBA’s ability to manipulate levels of economic growth through the changing of the cash rate has been successful in managing growth during times of both negative and unsustainably high growth. Bibliography
Websites:
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html
Pickering, C. The Australian. Has monetary policy failed Australia’s economy? Retrieved August 7, 2017 from http://www.theaustralian.com.au/business/business-spectator/has-monetary-policy-failed-australias-economy/news-story/43369a25a81a846d6072974f87d6f8da
Parsons, M. Current Economic Statistics. Retrieved August 7, 2017 from http://matthewparsons.com/base/stats.html
Sky News. Australia breaks world economic growth record. Retrieved August 10, 2017 from http://www.skynews.com.au/news/top-stories/2017/06/07/australia-breaks-world-economic-growth-record.html
The Reserve Bank of Australia. Monetary Policy. Retrieved August 10, 2017 from http://www.rba.gov.au/monetary-policy/
Transmission Mechanism of Monetary Policy. Retrieved August 10, 2017 from http://www.bankpedia.org/index.php/en/128-english/t/23385-transmission-mechanism-of-monetary-policy-encyclopedia
Graphs:
http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html http : / / RBA . Gov. Au (2015) Australia Cash Rate . Html
Reserve Bank of Australia (2015) GDP Growth. Retrieved August 7, 2017 from http://www.rba.gov.au/speeches/2015/images/sp-dg-2015-09-09-graph7.gif
Reserve Bank of Australia (2016) Australia Cash Rate 1990-2016, Retrieved August 7, 2017 from https://edge.alluremedia.com.au/uploads/businessinsider/2016/12/rba-cash-rate-preview-dec-2016.jpg
Websites:
Pickering, C. The Australian. Has monetary policy failed Australia’s economy? Retrieved August 7, 2017 from http://www.theaustralian.com.au/business/business-spectator/has-monetary-policy-failed-australias-economy/news-story/43369a25a81a846d6072974f87d6f8da
Parsons, M. Current Economic Statistics. Retrieved August 7, 2017 from http://matthewparsons.com/base/stats.html
Sky News. Australia breaks world economic growth record. Retrieved August 10, 2017 from http://www.skynews.com.au/news/top-stories/2017/06/07/australia-breaks-world-economic-growth-record.html
The Reserve Bank of Australia. Monetary Policy. Retrieved August 10, 2017 from http://www.rba.gov.au/monetary-policy/
Transmission Mechanism of Monetary Policy. Retrieved August 10, 2017 from http://www.bankpedia.org/index.php/en/128-english/t/23385-transmission-mechanism-of-monetary-policy-encyclopedia