Business Cycle

Introduction

The article: "Rates: RBA warns Costello" by Paul Cleary of the Australian Financial Review refers to the use of monetary policy and fiscal policy to stabilise the economy. The article points out that the Commonwealth government has produced lower than expected budget surpluses considering Australia has had economic growth for the past nine years. Such loose fiscal policy is mainly due to Tax Reform. The Reserve Bank of Australia (RBA) warned the government that loose fiscal policy may well result in tightening monetary policy.

The upcoming election may start a tax-cut "bidding war". Fiscal policy works well in theory, but in reality it is also greatly influenced by politics. The warning from the RBA may deter loose fiscal policy in the fear of being blamed for interest rate rises (Mitchell 2000, pp1&6).

The macroeconomic issues in this article are the uses of monetary and fiscal policy in order to stabilise the levels of economic activity. Economic growth, inflation and interest rates are the economic indicators that will be focused

on in relation to these policies.

Fiscal Policy

What is Fiscal Policy?

Fiscal policy is the government's use of its budget to fulfil its economic objectives (Parry & Kemp, 1997, p170). Such objectives would involve dampening the fluctuations that occur during the business cycle (Parry & Kemp 1997, p171). The Government's yearly budget outlines the areas of spending, tax and transfer decisions (McTaggart, Findlay & Parkin 1999, p25.4). The budget referred to in the relevant article is the Commonwealth government's annual budget.

Dampening the business cycle

The business cycle is a fairly regular pattern of business activity. Shown below are the phases of the business cycle (Parry & Kemp 1997, p31).

Level of

Economic

Activity

Time

Mr Ian Macfarlane, the Governor of the RBA, said he was disappointed that the governments have not been running larger surpluses to match previous deficits. Surpluses should be occurring due to nine years of economic growth. The concerns surrounding the budget outcomes are due to the fact that they should follow the level of economic activity in order to stabilise the economy. For example, deficits should occur in downswing and recession phases, and surpluses should result in upswing and boom phases. There are two types of stabilisers:

1. Automatic Stabilisers, and

2. Discretionary Stabilisers (Parry & Kemp 1997, p172).

Automatic stabilisers dampen fluctuations in the business cycle by increasing leakages from the circular flow when the economy is expanding. In strong economic conditions, tax revenues increase due to the progressive tax system. The more people earn the higher the marginal tax rates. Import spending tends to increase and there are higher levels of domestic savings. Unemployment during these periods is reasonably low which in turn reduces welfare payments and increases taxation revenues. Higher demand for labour in this phase may increase wages and salaries, increasing tax revenues further (Parry & Kemp 1997, pp171-172). Wages are fairly sticky so the effects of wages and salaries may take a while to adjust depending on the regulations surrounding them (McTaggart, Findlay & Parkin 1999, p31.13). The opposite tends to happen in an economic downturn (Parry & Kemp 1997, p172)

An example of automatic stabilisers in action is in the1993-1994 budget deficit. The projected budget for that period was -$16 billion but due to strong economic activity it was reduced to about -$13.6 billion ('National financial markets: Australia' 1994).

Discretionary stabilisers are the deliberate government expenditures designed to reduce business cycle fluctuations (Parry & Kemp 1997, p171). These stabilisers are the focus of the article. Automatic stabilisers occur without any government intervention but discretionary stabilisers require government action. The following diagram illustrates the stablilisers' effects (Parry & Kemp 1997, p172).

Level of

Economic

Activity

Time

Contractionary Fiscal Policy

Surpluses are meant to have a dampening effect on the economy to avoid overheating. This is also known as contractionary fiscal policy. The current state of the economy in the article requires the government to produce surpluses in order to prevent rapid growth and inflationary pressures (McTaggart, Findlay & Parkin 1999, p25.23). By reducing government expenditure, aggregate expenditure is also decreased:

AE = C + I + G + (X- M) (Parry & Kemp 1997, p24).

Price Level 45' line

Real GDP

Price Level LAS

Real GDP

The diagram above illustrates that initial equilibrium is above full employment. This