Economic growth is the worst

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A quick summary

  • Economists push the need for more and more economic growth

  • But economic growth has very serious negative consequences

  • But also: economic growth is super important. It boosts people’s living standards and creates the resources to fund a range of economic initiatives

  • The challenge is how to grow in a way that mitigates some of the negative impacts

Don’t be fooled

“Economic growth is terrific.”

You hear this from your teacher or an economist or maybe even a politician.

But I implore you: be skeptical of this claim. Economic growth is terrible*. 

I’ve got four reasons why economic growth sucks. Or, in a more articulate way, there are four negative consequences of economic growth.

(*Please read all the way to the end.)

Economic growth is terrible because it results in higher prices

Let’s say economic growth is rising in an economy. So aggregate demand is rising…however, firms may not have enough time to increase production to match this rise in demand. 

Look at it from this perspective. As the economy grows, consumers’ incomes rise. This means they can afford more goods and services. However, there is limited stock of goods and services. 

“In fact, consumers use their extra income to ‘bid up’ the prices of limited goods and services, which then results in higher prices. I like to think about extra money ‘chasing’ the same amount of goods and services.”
— Mr Symonds

So we would say that the rise in aggregate demand is outstripping aggregate supply (because firms haven’t had time to produce more goods and services). This leads to demand-pull inflation.

[Just remember: aggregate demand affects economic growth in the short term, while aggregate supply affects growth in the longer term.]

But we may also see cost-push inflation. This is because higher economic growth leads to greater demand for the inputs of production, which will lead to higher costs for businesses. 

Think about it this way: economic growth leads to greater demand for labour, which will result in lower unemployment. As firms need more and more workers, they will need to pay higher wages to poach them from other firms (because unemployment is so low). This leads to higher inputs costs (wages) which will result in firms pushing up the prices of goods and services (cost-push inflation).

Also, during a period of economic growth, many firms will demand more inputs to meet the higher demand for goods and services. As a result, the prices of inputs like raw materials will also rise and this will further lead to cost-push inflation.

Learn more about cost-push inflation

Economic growth is terrible because it results in higher prices and then higher interest rates

As we’ve seen in the previous section, higher economic growth generally leads to rising inflation.

If inflation is rising in Australia, the central bank will act. The Reserve Bank will raise the cash rate, the official level of interest rates, to indirectly increase interest rates across the economy and slow inflation.

What’s the issue with the higher rates?

The RBA will act.

Australia’s central bank will adjust the cash rate if inflationary pressures are rising.

Image: RBA

Higher interest rates will result in less investment. This is because higher rates mean higher interest repayments for borrowers. 

Higher interest rates could also result in a higher exchange rate. This is because more foreign investors could be motivated to save their money in Australia as the returns could be higher. A higher exchange rate could make Australian exports less competitive. 

Economic growth is terrible because it results in environmental degradation (and therefore lower living standards)

Economic growth is still highly dependent on the use of fossil fuels. In order to increase output, we need to use non-renewable resources, such as oil and minerals, which reduces the ability of future generations to harness these resources.

The more economic growth, the more pollution.

In addition, the use of fossil fuels leads to higher pollution. This leads to environmental degradation (which may not be fixable) and potentially lower living standards. Think about how pollution could result in poorer air or water quality. This has negative implications for future generations.

Economic growth is terrible because it can worsen income and wealth inequality

This is a trickier point. One view is that economic growth will reduce income inequality as it results in higher wages for lower-income earners. Or that it leads to the unemployed gaining jobs which then leads to them having higher wages. And overall, income inequality is reduced.

There’s another view to consider.

The wealthier people in society own more assets, including shares, homes and investment properties. So if the economy grows and asset values rise, this would deliver greater benefits to those who are already wealthy. They would receive greater dividends, rent and other incomes flows from their assets. According to this view, as economic growth rises, income and wealth inequality could rise.

*But we need economic growth

Yes, economic growth has negative consequences. Quite serious negative consequences in some cases. But we need economic growth.

This blog post has a deliberately sarcastic tone. Don’t start writing essays where you make the case for GDP growth of 0%. This will be unhelpful for your marks.

You see, economic growth delivers so many benefits to a country and its population, including rising living standards and higher wages.

The issue here is how we pursue economic and growth and what do we do with the benefits of economic growth.

For example, could countries try to grow more sustainably, with less of a reliance on fossil fuels? And could countries direct some of their benefits from economic growth to addressing some of the negative consequences of growth? 

We can’t choose not to grow. But we can talk about how economies should choose how they grow.

Australia's inflation rate is rising rapidly

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Quick summary:

  • Australia’s inflation rate is rising rapidly — in the March quarter 2022, consumer prices are rising by 5.1 per cent in annual terms

  • Prices are rising across most sectors of the Australian economy, particularly for food, housing and transport

  • The Reserve Bank of Australia will being raising the cash rate to slow inflation and bring it back into the central bank’s inflation target band of 2 to 3 per cent over the course of the business cycle.

The Reserve Bank of Australia (RBA) has a target for Australia’s inflation rate of between 2 and 3 per cent. In the March quarter of 2022, Australia’s yearly inflation rate was 5.1 per cent. 

“Australia, we have an inflation problem.”
— Mr Symonds, April 2022

What is inflation?

Inflation is a sustained increase in the general level of prices. The important point is “sustained”. We’re not looking for a one-off jump in prices. As economists, we’re looking for price rises that persist for a period of time.

The “sustained” part is crucial because we don’t want to change economic policy for temporary things. For example, if prices rise in one quarter, but fall the next, the RBA may not need to raise the cash rate. But if we see prices rise quarter after quarter, it may be time for a tightening of monetary policy (higher cash rates).

Are you wondering what inflation even is?

Check out my video.

How is inflation measured?

Every quarter the Australian Bureau of Statistics (ABS) publishes the Consumer Price Index (CPI). This measures the changes in prices for the types of goods and services that households spend most of their money on. 

The ABS refers to this as a ‘basket of goods’. These goods and services are weighted based on their relative importance to households. This is because a rise in the price of certain goods and services would have more of an impact than others. For example, a rise in the price of food would be weighted more heavily (have more impact on the CPI) than a rise in the price of Prada sneakers. 

Why? Because the sad truth is more households can afford food than Prada sneakers.

“The sad truth is more households can afford food than Prada sneakers.”
— Mr Symonds, April 2022

The ABS’ ‘basket’ covers eleven groups:

  • Food and non-alcoholic beverages

  • Alcohol and tobacco

  • Clothing and footwear

  • Housing

  • Furnishings, household equipment and services

  • Health

  • Transport

  • Communication

  • Recreation and culture

  • Education

  • Insurance and financial services

What happened to Australia’s inflation rate in the March quarter of 2022?

In late April, the ABS published the March quarter CPI. This covers January, February and March 2022. 

Australia’s CPI rose by 2.1 per cent in the March quarter compared to the December quarter. By way of comparison, the CPI rose by 1.3 per cent in the December quarter of 2021 compared to the September quarter of 2021.

So: inflation is clearly on the way up.

Moreover, the annual rate of inflation has increased substantially. If we compare the March quarter of 2022 with the March quarter of 2021, the CPI has risen by 5.1 per cent.

Your quick summary of Australia’s complex inflation picture. You’re welcome.

Which prices are rising fastest in the Australian economy?

You can see the main contributors to the rising inflation rate in the graph below. 

Let’s focus on a couple of the areas.

Food and non-alcoholic beverages (up by 2.8 per cent in the March quarter)

  • According to the ABS, prices across ALL food and non-food grocery products in the March quarter

  • This was due to the cost of COVID-related supply chain disruptions (reducing stock and pushing up prices), rising transport costs (related to the rising cost of fuel) and challenging weather conditions such as floods


Housing (up by 2.7 per cent in the March quarter)

  • Australia’s housing market was relatively strong in the quarter which led to higher prices for homes and rents

  • In addition, there are rising construction costs for new home builds and renovations. Builders are passing on these costs to home owners, resulting in rising prices


Transport (up by 4.2 per cent in the March quarter)

  • The price of petrol rose by 11 per cent due to the a spike in global oil prices following Russia’s invasion of Ukraine

  • Petrol prices have also risen as COVID-related travel restrictions have eased and people are demanding more fuel as they travel greater distances

  • Car prices have also been rising as supply chain disruptions have restricted the arrival of new cars into Australia (less supply combined with strong demand leads to higher prices)

Just look at this chart of how fast petrol prices have risen in the Australian economy. Businesses are passing these costs on to consumers; this then results in cost-push inflation.

Petrol prices are really pushing p…rices higher.

Headline versus underlying inflation

Australia’s headline inflation rate includes all prices changes in the economy. Australia’s underlying inflation rate excludes one-off or volatile price changes in the economy.

The RBA focuses on underlying inflation. This is because when the central is deciding whether or not to change the cash rate, it wants to respond to ongoing trends in the Australian economy and NOT one-off price shocks that might quickly dissipate.

The RBA looks at two measures of underlying inflation — the trimmed median and weighted mean. Don’t worry too much about what they’re called. Just know this: the RBA’s preferred measures of inflation show that Australia’s underlying inflation rate in the March quarter 2022 is around 3.45 per cent — above the central bank’s target band of 2 to 3 per cent.

Read more about the RBA’s measures of inflation.

What are the impacts of Australia’s rising inflation rate?

The key impact is that the cash rate will soon rise. This could happen as early as 2 May when the RBA holds its next board meeting to discuss the cash rate.

This means Australia’s monetary policy will have a contractionary stance and wil slow the level of economic growth.

At the same time, Australia’s fiscal policy — the federal budget — is still having a large expansionary impact on the Australian economy. Read about it here.

Four graphs that explain the 2022 Federal Budget

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QUICK SUMMARY

  • The 2022-23 Federal Budget was handed down in March 2022

  • The Morrison Government is forecasting ongoing budget deficits (government spending exceeds government revenue)

  • However, the Morrison Government forecasts that the size of the budget deficits will shrink over the next decade

  • The most important factor: the reduction in government spending and increase in tax revenue as the economy improves during the COVID-19 pandemic.

 

Graph one: The budget balance

This graph (labelled Chart 3.2 below) shows how the budget deficit will shrink to approach a balanced budget by 2032-33.

Overall, this graph shows the size of the budget balance as a percentage of GDP. If the number is positive, Australia has a budget surplus. If the number is negative, Australia has a budget deficit. If the number is zero — the budget is balanced.

Look at the black line. Before COVID, the federal budget was balanced and potentially returning to surplus. Once the pandemic hits, the government significantly increases spending to help ease the effects of COVID. As a result, the black line plummets and Australia’s budget deficit peaks at around 6 per cent of GDP (the -6% number).

Then follow the blue line. This is the Morrison Government’s forecasts for how the budget balance will change. The point: the government expects the budget deficit to shrink. 

In economic terms, this is known as “fiscal consolidation” or “fiscal repair”, where the government is running contractionary fiscal policy to reduce the budget deficit and return to a balanced or surplus budget.

So the government is forecasting an ongoing improvement in the budget balance to approach a balanced budget in 2032-33. Note: the further out the forecasts, the less certain we can be about them.

Graph two: Total government payments (spending) and receipts (revenue)

This graph (labelled Chart 3.8 below) shows that Government spending spiked during 2021 and is substantially falling as the temporary COVID-related spending decreases or ends.

The red line is government revenue, which mainly comes from individual and company tax. The blue line is government spending, which is dominated by spending on welfare payments. 

Focus on the left hand side of the graph. You can see that the blue and red lines intersect. This shows us that spending was equal to revenue and the budget was balanced. 

As the pandemic starts, government spending significantly increases. You can see that government spending peaks at around 32 per cent of GDP as the Morrison Government tried to offset the worst impacts of COVID. This included significant spending on Job Seeker and Job Keeper programs that aimed to keep people employed, even as businesses had to temporarily close or restrict trading, and stop unemployment rapidly rising.

At the same time, revenue decreased at certain points — but not as significantly. This was due to lower tax revenue as more people were unemployed and companies earned lower profits (because they were forced to shut during lockdowns). 

Take a look at the period from 2022-23 onwards. Pandemic-related spending is projected to substantially fall. At the same time, as the Australian economy is forecast to recover and grow more rapidly, government revenue is projected to increase. This will shrink the difference between government spending and government revenue.

This, in turn, will shrink the size of the budget deficit. 

So the reason why the government is forecasting smaller budget deficits is because:

  1. Less spending on programs that were designed to protect the economy from the effects of COVID

  2. More revenue as the Australian economy recovers from COVID.

This is evident from the graph — the shrinking distance between the blue and red lines.

Graph three: Size of Australian Government debt

According to the 2022 Federal Budget, the Morrison Government forecasts that the size of federal government debt will shrink more quickly than previously thought.

This chart (labelled Chart 3.1 below) shows the size of the federal government’s debt.

A quick note about debt and deficit. The budget deficit means that there is a discrepancy between government spending and revenue. Government spending exceeds government revenue. This creates a deficit of funds in the federal budget because the government is spending more than it earns.

And if the government has a deficit, it needs to find the funds to pay for its extra spending. To fund the gap between spending and revenue, the government will borrow money from overseas. That is, it will incur more debt.

Have a look at the left hand side of the graph. Pre-pandemic, the government’s debt was relatively flat around 30 per cent of GDP. COVID hits, the Morrison Government starts spending to try and protect the Australian economy and stop unemployment soaring. To pay for this extra spending, the government borrowed increasing amounts of money from overseas.

The three lines show us that, over the past three years, the government has forecast that the amount of funds it needs to be borrow will be less and less. For example, in the 2020-21 budget, the Morrison Government forecast that government debt might get to around 55 per cent of GDP. However, as the Australian economy has improved and the budget deficit is projected to shrink, the amount of debt is also expected to shrink. Now, the government expects debt will fall to around 40 per cent of GDP by 2032-33.

Here’s the key thing: as the budget deficit shrinks, the government will need to borrow less money to fund the gap between spending and revenue. This means the size of government debt will also fall.

Graph four: Australia’s government debt compared to other advanced economies

The Australian Government’s debt (as seen in Chart 3.9 below) can be considered comparable or low compared to other developed economies.

The graph above shows how all G7 economies have increased spending and their debt levels because of COVID. However, this graph shows that the size of Australia’s debt levels is either similar to or substantially lower than the debt levels of G7 economies.

For example, in the US, government debt levels exceed 100 per cent of GDP. And these levels are even higher in Italy and Japan.

The important thing to think about is that the larger the amount of debt, the longer it will take to repay and the greater amount of interest payments required to service these loans. This could be an issue as global interest rates are expected to rise over 2022.

One last thing

Here’s a small summary table from the 2022 Federal Budget that shows how the Morrison Government expects the budget deficit to shrink over the next five years. These numbers are great to have handy for essay questions on fiscal policy.

 

And here’s a short explainer on how changes in the federal budget then affect the Australian economy.

Your favourite businesses are raising prices. Here's why

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The quick version:

  • Cost-push inflation is when rising input costs lead businesses to raise retail prices

  • Rising input prices include higher wages, energy and rent costs (these higher costs push up retail prices)

  • Cost-push inflation is happening in Australia in 2022. According to the National Australia Bank, business purchase costs are at record levels. This is leading to higher inflation in the Australian economy.

Cost-push inflation is rising in Australia.

 

What is cost-push inflation?

Cost-push inflation is a cause of inflation. It occurs when higher input costs for businesses PUSH UP prices across the economy.

Basically firms face higher input costs and, rather than absorb these costs and reduce profits, they pass on higher costs to consumers. 

The end result: consumers pay higher prices.

An example of cost-push inflation

As of April 2022, Australia’s unemployment rate is a very low 4 per cent. This means that businesses may find it hard to secure workers as many people are already employed. To attract workers, firms may need to pay higher wages. And wages are a cost for businesses.

A firm could absorb the higher wages cost. But this would reduce their profit (as profit = revenue - costs). Instead, the firm will pass on the cost of higher wages to consumers in the form of higher prices. Consumers will ultimately pay for the higher employee wages. 

When prices rise, inflation rises. In our example, input costs (wages) have pushed inflation higher.

Other sources of cost-push inflation could be higher energy prices (electricity or petrol), more expensive food and higher rental costs.

How cost-push inflation works

Cost-push inflation in the Australian economy in 2022

National Australia Bank (NAB), one of Australia’s big four banks, publishes a monthly business survey. According to the survey, firms’ purchase costs (the cost of their inputs) rose by 4.2 per cent in the March quarter.

[The March quarter covers January, February and March.]

This 4.2 per cent rise is a record for the NAB survey. The survey also found that labour costs — as discussed in our example above — rose by 2.7 per cent in the March quarter. This was another record rise.

NAB Chief Economist Alan Oster said that many industries were experiencing rising input costs. This is what the survey calls ‘purchase costs’.

“Purchase costs reached records with elevated oil prices adding to existing supply chain issues, and labour costs are also rising as businesses hire more workers in a very competitive labour market,” Mr Oster said.

These rising input costs are leading directly to higher prices. According to the NAB survey, retail prices rose by 3.7 per cent over the March quarter of 2022. This is a record level for the survey.

Why does cost-push inflation matter?

Rising cost-push inflation is another sign that Australia’s inflation rate is rising (potentially rapidly) . This adds to the likelihood that the Reserve Bank of Australia will soon begin raising the cash rate to try and control inflation. The RBA meets monthly and many economists believe the cash rate could be raised as soon as June 2022.

When we talk about the RBA raising rates, we’re discussing monetary policy. Check out this article for more about this important macroeconomic policy.

The circular flow of income: problems with the model

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As part of your Economics study, you’ve probably done the Circular Flow of Income Model. This is also known as the Five Sector Model or the Five Sector Circular Flow of Income Model. 

Here’s my explainer on the model. I’ve also written about how the Circular Flow of Income Model helps us understand economic growth.

The Five Sector/Circular Flow model is useful. I like it a lot, I use it all the time. But it’s not perfect. Here are some limitations you should be aware of.

A general limitation: The model heavily simplifies the economy

An economy is an extremely complicated thing. Can we really simplify something so complex into five sectors and 10 flows? 

Just think about the household sector. Do all individuals within households act in exactly the same way? What about firms, or financial institutions? It’s hard to lump all these groups into one category and assume they will all take identical actions.

In addition, central banks play a huge role in the economy. They affect the supply of funds, which then indirectly affects the level of interest rates (this is Monetary Policy). This is absent from the model.

A specific limitation: The model excludes households borrowing money from banks

Take a look at the financial sector, which includes banks. According to the model, households deposit their savings with the financial sector. 

But where is household borrowing?

The model does show the financial sector investing in businesses — lending firms funds so they can expand and grow. However, the model does not show households borrowing money from banks.

This is a huge flow in the economy. For example, according to the Australian Bureau of Statistics (ABS), in December 2021, households took out nearly $33 billion of new home loans — either to buy a property to live in or to rent out. This is a massive injection into the economy but is excluded from the model.

Likewise, household loan repayments — an ongoing leakage — are also absent.

Another specific limitation: The model excludes firms buying imports

The model shows households buying goods and services from overseas (imports). You can see the flow of money going from households to the international sector. Yet, the model does not show firms buying imports.

Just think about all the goods and services Australian businesses purchase from overseas:

  • a restaurant purchases fancy cheese from Italy

  • an outdoor recreation store (like Anaconda) purchases stock from overseas to then sell to local customers

  • a school buys online products — such as access to the Google or Microsoft suite of products — and this involves money leaving Australia.

These purchases represent a huge flow of income. According to the ABS, in the September quarter of 2021, imports of capital goods (which are mainly done by businesses) totalled around $1.4 billion.

Do these limitations matter?

If we’re using this model to understand the basics of the economy, then no. It helps us understand the mechanics of how money moves around an economy and how the sectors interact with each other.

But like all models, it’s got limitations. We need to know its limitations so we don’t ask the Circular Flow of Income to do too much.

Scared consumers save more

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Consumers can save or spend their income. This comes back to the identity Y=C+S.

Yes, consumers have to pay tax. And yes, consumers can use their savings to invest. The key part is that, when consumers receive their pay, they can either spend it now or put it away for later (savings/investment).

My point: the level of savings depends on consumer confidence, and consumer confidence is substantially affected by the economic outlook.

Let’s explain with the use of a graph.

The graph above comes from the Australian Bureau of Statistics from the June quarter national accounts 2021. 

Focus on the time frame from around June 2013 until June 2019. You can see that the household savings ratio varies between around 5ish to 9ish per cent (very precise!). This means that, on average, for every $1 of income households earn, they are saving somewhere between 5 and 9 cents. They’re generally spending MOST of their incomes.

Now focus on March of 2020 — see how the savings ratio spikes? This was the first wave of COVID-19 and consumer confidence plummeted. How did consumers respond? By saving a larger chunk of their incomes. In fact, in the June quarter of 2020, the household savings ratio rose to 22 per cent — meaning households were now saving 22 cents for every $1 they earned.

This all comes down to consumer confidence. When the economy is going well, consumers feel confident in the future. They feel confident to spend their money because they believe that the good times will continue and their ability to earn income, to continue spending, will, well, continue! 

(You could also think about how their marginal propensity to consume would be higher during ‘good’ economic conditions).

When consumers fear for the future, such as during the height of the first wave of the pandemic, they’ll reduce spending. They don’t know what the future holds. They want to hang on to their funds because they are unsure whether they can continue to earn the same level of income.

(You could think here about how the marginal propensity to save would be higher.)

I’ve annotated the above chart to summarise this info.

I think the household savings ratio is an extremely important statistic. It gives us, as economists, a good indication of consumer confidence. This also has implications for economic growth. This is because savings is a leakage and represents a withdrawal of funds from the economy. The higher the level of saving, the lower the level of consumption, which will put downward pressure on GDP.

I’ve also got a video on the topic you can check out below.

Is a current account surplus a good thing?

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Let’s start with my point: the current account balance is neither ‘good’ nor’ bad’. 

(Okay, I’ll clarify. The current account deficit can be considered too large, if it hits around 6 plus per cent of GDP.) 

But, in general, the government doesn’t label the current account balance as ‘good’ or ‘bad’. The Australian government doesn’t try to achieve a particular current account balance. You won’t see ScoMo on the news talking about how only his government can achieve a current account surplus (CAS).

This is because the government has limited control over the factors that drive the current account balance. The government can’t change the amount of exports or imports companies and people buy (trade balance). The government can control how much it borrows from overseas, but it cannot control how much private companies borrow from overseas (this affects the size of capital inflows and then the net primary income balance as a result).

I recently had some students comment on my YouTube channel about the advantages and disadvantages of a current account surplus. I wouldn’t think of it as having specific pros and cons. 

I also wouldn’t talk about the government “should” reduce the current account deficit (CAD) or “should” achieve a CAS.

Instead, I would focus on the consequences of the current account balance. It’s a different perspective.

I would divide my thinking up between the consequences of a current account surplus (CAS) and deficit (CAD). If you’re writing about this in 2021, the focus is on the CAS.

Consequences of a CAS

In Australia we’re now talking about current account surpluses. What are the consequences of this?

Let’s think about this from the trade balance and then net primary income (NPY). This is because net exports and NPY are the key drivers of Australia’s current account balance.

Trade balance

  • If the trade balance is improving, Australia is selling more exports which is increasing GDP and the government’s revenue. This revenue can then be used on a range of functions across society to improve people’s standard of living.

  • If the trade balance is improving, Australians may be purchasing fewer imports. This could lead to greater purchases of domestically produced goods (maybe) which could boost GDP. The issue I have with this: Australia doesn’t produce the same goods as we import.

NPY

  • If NPY is shrinking, Australia has a greater stock of domestic funds (as these funds are not needed to service foreign debt). This could boost domestic savings and allow more projects to be funded domestically WITHOUT the need for foreign borrowing. Essentially Australia could shrink its savings-investment gap.


Consequences of a CAD

Your textbook will have a whole list of these. You can also see my video for help.

One thing to note: in the past, the world hasn’t seemed too concerned about the level of our CAD. As recently as 2015, Australia’s CAD was around 5.4 per cent of GDP. This did not spark a mass selling off of the $A!

In terms of positive consequences of a CAD? We could think about points such as:

  • If the trade balance worsens, maybe Australians have greater access to imports and this improves their standard of living

  • If the trade balance worsens, maybe Australian businesses have had a greater opportunity to purchase capital equipment for their operations and this could boost productivity and output for the economy

  • If the net primary income deficit increases, this means Australian individuals and businesses have been able to borrow more funds which could be used for productive purposes across the economy.

Here and here are some extra resources you can check out.

5 observations on the 2021-22 Federal Budget

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The 2021-22 Federal Budget was handed down on 11 May 2021. Here are my five quick observations. 

1. The Federal Budget is HIGHLY expansionary

Yes, the size of the budget deficit is shrinking. This means that the budget stance, technically, is contractionary between 2021-22 and 2024-25. 

For instance, in 2021-22, the budget deficit is forecast to be $106.6 billion. In 2024-25, it’s forecast to be $57 billion. 

But, don’t get it twisted. The budget is still in deficit. The government is still planning to spend substantially more than it earns in revenue (mainly tax revenue). Therefore, the overall impact of Fiscal Policy is expansionary...even if the stance is contractionary between the years.


2. The Federal Budget is about more than stimulating aggregate demand

A major part of the budget involves a large increase in spending on the aged care sector. This is in response to the Royal Commission into aged care which found deficiencies in a number of areas.

This is increased government spending, but it’s not about boosting AD or increasing productivity. After all, this spending is going towards older Australians who are in nursing homes or receiving full-time care at home. 

Instead, this measure is largely about improving the quality of life of older Australians. This is an important goal of the government, but it’s more social than economic. 

3. The Federal Budget’s boost on childcare spending is an economic measure

The government is offering larger childcare subsidies for parents. The goal here is economic; the goal here is twofold.

One, give people more disposable income by reducing the costs of childcare. (FYI: childcare is very expensive). Parents will spend less on childcare, spend more on consumption...and this will in turn boost AD.

Two, by making childcare cheaper the government is encouraging more parents to use it. The government is actually increasing demand for childcare. This means more parents will be able to work more hours, or potentially return to the labour force. According to Treasury, this will boost the number of hours worked in the Australian economy by 300,000 hours. 


4. Fiscal Policy and Monetary Policy are working in tandem

In the past, FP and MP have worked in opposing directions. The RBA had cut the cash rate extensively, however the Morrison Government was keen to protect its goal of a budget surplus and so did not adopt an expansionary stance.

Now both MP and FP are highly expansionary. By working together, it’s hoped their impact on stimulating aggregate demand will be enhanced. 

Also, some economists have discussed that the very low cash rate — 0.1% since November 2020 — means that future cuts would not have a major economic impact. If the RBA cuts from 0.1% to 0%, would that dramatically increase consumption and investment? Just remember, the cash rate might be zero but interest rates would not be. The banks would still be looking for a profit margin.

Instead, FP is helping to take up some of the slack.


5. The Federal Government has committed to a return to fiscal discipline

Fiscal discipline or fiscal consolidation is all about moving from a budget deficit back to balanced or surplus budget outcome. The Morrison Government has told us that, yes, we’re in large deficits and, yes, this will persist for some time...but the size of the deficit will be shrinking and there is a target for a return to less expansionary fiscal policy.

The target? When unemployment falls below 5%.


Overall thoughts

In terms of a ‘conclusion’, I really like this article by economist Steven Hamilton. His point of view is that budget deficits are necessary, for now, to drag Australia along the road to recovery. But they cannot persist forever and the government has committed to turn off the expansionary setting once UE falls below its target.

What's an interest rate?

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In an economy, interest rates serve really important purposes.

Firstly, interest rates represent the cost of borrowing funds. When you want to borrow money from the bank, you’ll have to pay an interest rate and this will determine the size of the repayments on your loan.

And if you think about it: higher interest rates, higher repayments, so people are less willing to borrow big stacks of money.

Secondly, interest rates are the reward for saving money in the bank. When you deposit savings in your bank account, the bank gives you an incentive for this behaviour — paying you interest, on your savings, at an interest rate.

Think about this one. The higher the interest rate on savings, the more likely people are to save their money. In terms of their incomes, people can spend or save (and pay tax). Generally, the more they save, the less they can spend (because people’s incomes are generally fixed at a point in time). Think about the identity Y=C+S, where Y is income, C is consumption and S is saving.

So in an economy interest rates function as a cost and a benefit. And, as I’ve suggested, interest rates influence people’s behaviour and the level of economic activity.

Let’s take an example here. In the Australian economy, the official level of interest rates is reduced. This means that interest rates, generally, are lower across the whole economy. This will discourage saving as people earn a lower interest rate on their savings; as a result, they will spend more. In addition, lower interest rates mean lower repayments...so there will be more borrowing and investment in the economy.

As a result, the economy is likely to grow.

Tough times for the Australian economy, says RBA

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Four times a year, the Reserve Bank of Australia (RBA) shares its assessment of current economic conditions for Australia and the world. This document is called the Statement of Monetary Policy (SOMP). The SOMP for May 2020 sets out some serious challenges for the Australian economy.

I think, as a student, the most important section to focus on is Section 6: Economic Outlook. 

I discussed this section in a previous post that looked at the RBA’s three potential scenarios involving the Australian economy’s recovery from COVID-19.

In this post, I’ll take a look at some specific economic forecasts from its May SOMP.

Economic growth

According to the RBA, the Australian economy is “expected to record a contraction in GDP of around 10 per cent over the first half of 2020”. Considering Australia’s GDP grew by around 4 per cent in the first half of 2019, this is a huge turnaround — in a negative sense.

Why is GDP expected to plummet? Well, social distancing means people aren’t going to the shops and spending. The RBA forecasts household spending to fall by 15 per cent in the June quarter this year. In addition, consumers are saving more, as people tend to do in times of uncertainty. 

Australia is also not receiving international visitors and their tourist spending. This is classified as export revenue for Australia, and a component of aggregate demand (AD). Less exports mean less economic growth for Australia.

On the flip side, Australians are expected to spend much less on imports. 

 

Unemployment

The RBA estimates that total hours worked in the Australian economy will fall by around 20 per cent in the June quarter (the three months to June 2020). In addition, the RBA says unemployment could rise to around 10 per cent by the same point in time. 

Considering the unemployment rate was 5.2 per cent in March 2020, this could represent a near doubling of the number of Australians out of work.

But here’s the thing: while the unemployment rate may not increase by this much, we should still be concerned.

This is because of what’s called “the discouraged worker effect”. This is when an individual gives up looking for work because they don’t believe they will be able to get a job. If people give up looking for work, they’re not considered unemployed and they’d join the hidden unemployed. 

(In Australia, to be considered unemployed, you must be out of work and actively seeking a job.)

So Australia’s unemployment rate may not increase by the expected amount, but the economy would still have lost substantial labour resources.

Inflation

Australia, for some time pre-COVID-19, has recorded relatively low inflation rates. This has been part of the reason why the RBA had steadily cut official interest rates. 

Due to the pandemic, the RBA expects inflation to turn negative in the June quarter. So: Australia would record deflation. 

Why would this happen? Two main reasons. One, fuel prices have fallen dramatically. Just have a look at this chart of unleaded petrol prices in Sydney and how they’ve fallen this year.

Source: PetrolSpy

Source: PetrolSpy

Two, the Federal Government is providing free childcare to families. So the price of childcare has fallen from something to, well, nothing. These two factors will drag down headline inflation.

Three roads to recovery: The RBA's scenarios for the Australian economy (COVID-19)

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Four times a year, the Reserve Bank of Australia shares its assessment of current economic conditions for Australia and the world. This document is called the Statement of Monetary Policy (SOMP). The SOMP for May 2020 sets out some serious challenges for the Australian economy.

I think, as a student, the most important section to focus on is Section 6: Economic Outlook. This is the section that I’ll be discussing in this post. 

Three scenarios for recovery

An important part of May’s SOMP is that the RBA has set out three scenarios for Australia’s recovery from COVID-19. 

Let’s start with the RBA’s “baseline scenario”. I think we can characterise this as the forecast where things steadily improve. Here are some elements of this scenario:

  • Australia’s social and business restrictions continue to be relaxed and are mostly removed by the end of September 2020

  • The spread of COVID-19 in Australia remains limited

  • GDP growth turns around in the September quarter and the Australian economy steadily improves.

Next, is the RBA’s more optimistic scenario. Here, Australia is more successful in containing the virus’s spread; restrictions are eased much more quickly (well before September); and business and household confidence is not as damaged and can therefore recover more quickly. 

Finally, we have the RBA’s more pessimistic scenario. Here, the outbreak persists or flares up again, which would prolong restrictions and delay the reintroduction of activities such as international travel. This situation would result in greater damage to business and consumer confidence, with more jobs being lost and businesses failing. 

There are big differences in outcomes between the three scenarios. Have a look at the graph below.

A couple of things to note. The value of GDP in December 2019 is given an index value of 100. So, if GDP falls below the December 2019 level, the index will dip below 100; if GDP rises above the December 2019 level, the index will be above 100. 

Under the RBA’s baseline situation (pink), Australia’s GDP will grow beyond its December 2019 levels in around late 2021. In the optimistic situation (yellow), Australia’s GDP could turn positive by early 2021. And in the pessimistic scenario (the sad brown colour), Australia’s GDP will still be below the December 2019 levels going into 2022.

You can see the same thinking for unemployment in the graph below. Just look at the difference between optimistic and pessimistic situations. (With unemployment, the measure is the unemployment rate, so a lower number is better).

So what actually happens? Which scenario really takes place? We’ll have to wait and see. 

Monetary Policy? Start here.

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Monetary Policy is an extremely important but often complex part of Economics. 

I think the most challenging part of learning Monetary Policy is that so much of the content builds on more content and it only really makes sense at the end of the process.

This is often frustrating for students (and teachers). 

So, where do you start? If you’re an absolute beginner and you’re keen on learning the process of Monetary Policy, I’ve created a series of videos to take you step-by-step through the process.

Start here. This will set you up on a solid foundation. There’s also links in the description for the next videos in the series.

Monetary Policy update: October 2019

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Australia’s cash rate is now 0.75 per cent. If this seems low, it’s because it absolutely is.

Think about it this way. During the worst of the Global Financial Crisis in 2008/09, the LOWEST the cash rate reached was 3 per cent. 

Is Australia in a worse position than during the GFC? I’m not sure this is correct. The global risks (the ‘downsides’ to global economic growth) don’t seem as bad as during the GFC. But there still are risks to domestic and global economic growth.

Let’s have a look at three reasons why the Reserve Bank of Australia decided to cut the cash rate to 0.75 per cent in October 2019. They’re taken from the RBA’s statement following the October decision.

Reason one: the RBA is worried about the state of the global economy

In its decision to cut the cash rate in October, RBA Governor Phillip Lowe stated that the risks to the global economy “are tilted to the downside”.

Part of the reason? The current trade war. As Dr Lowe says: “The US–China trade and technology disputes are affecting international trade flows and investment as businesses scale back spending plans because of the increased uncertainty.”

The fear is that the global economy growth will slow and this will drag Australia’s economic growth lower. Cutting the cash rate is a move to support domestic growth in this uncertain environment.

Reason two: the Australian economy is growing slowly

Here’s Dr Lowe’s concern: “The Australian economy expanded by 1.4 per cent over the year to the June quarter [2019], which was a weaker-than-expected outcome.” Given this, the RBA believes it’s appropriate to have a more expansionary monetary policy stance to speed up the economy.

But, overall, the RBA identifies a number of elements that are positive for Australia’s economic growth. “The low level of interest rates, recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some established housing markets and a brighter outlook for the resources sector should all support growth,” Dr Lowe said.

So. Some positive signs, but not enough to keep interest rates on hold.

Reason three: the RBA thinks domestic unemployment is too high

The RBA is worried about rising unemployment and low wages growth. 

As Dr Lowe said: “forward-looking indicators of labour demand indicate that employment growth is likely to slow from its recent fast rate. Wages growth remains subdued and there is little upward pressure at present, with increased labour demand being met by more supply.” 

By cutting the cash rate, the RBA is hoping to stimulate aggregate demand, boost the demand for goods and services and thereby boost the demand for labour (aggregate demand).

So what happens next?

Not sure. The RBA is likely to stay on hold in November but some economists expect another rate cut before the end of the year. 

Also, what about fiscal policy? Many economists are calling for the federal government to move fiscal policy to an expansionary stance to match the RBA’s expansionary monetary policy stance.

Conflicts between economic objectives

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Economics is all about choices, it’s about scarce resources and unlimited wants. You can’t have everything you want, and governments can’t achieve all of their economic objectives at the same time.

In the context of the NSW Higher School Certificate (HSC) Economics course, there are six economic objectives that are examined:

  • Economic growth

  • Price stability (inflation)

  • Full employment (unemployment)

  • External stability

  • Income and wealth distribution

  • Environmental sustainability

Let’s consider three key conflicts in terms of economic objectives.

Conflict one: Economic growth and environmental sustainability

In our economic system, countries mainly use non-renewable resources to fuel their economic growth. They also have a habit of clearing away forests and animal habitats to make way for development. And, in the process of achieving growth, a negative externality (an unintended consequence of production) is pollution.

The more rapidly countries pursue economic growth, the more rapidly they deteriorate the environment. You can think of it as a trade-off. By this logic, lower growth would preserve the environment...but this may also reduce material living standards.

Conflict two: Price stability and full employment

This is a classic economic conflict. In fact, it’s so famous that there’s a graph to describe this precise conflict. The graph is called the Phillips Curve and it looks like this:

Source: Lumen Learning

Source: Lumen Learning

The Phillips Curve shows that, in the short term, as inflation rises, unemployment will fall. This makes sense as higher inflation is generally a sign of stronger economic activity, including greater consumption and investment (part of aggregate demand), which will lead to greater demand from consumers for goods and services and therefore greater demand from firms for labour (known as derived demand). 

Likewise, when we reduce inflation, we slow aggregate demand (by slowing consumption and investment) thereby reducing firms’ demand for labour and increasing unemployment. 

In the long-term, this trade-off may not exist. But I’ll leave that to your uni lecturers to explain.

Conflict 2a: Economic growth and inflation

This is very much an extension of the points in conflict 2. Put simply, the higher the economic growth rate, the higher the inflation rate is likely to be.

Conflict 3: Economic growth and external stability

This is one of my favourite conflicts, maybe because it’s a bit trickier. Think about it this way: if economic growth is strong, then consumers have higher incomes. They would spend part of this extra money on goods and services, including imports. 

If demand for imports increases, this would likely negatively affect the Balance on Goods and Services in the Current Account of the Balance of Payments (recall that BoGS is equivalent to net exports, or X-M. And in this scenario, the volume of imports are increasing). As a result, the CAD could increase and worsen Australia’s external stability.

To reduce the CAD, and improve Australia’s external stability, a government may need to reduce the demand for imports by slowing the rate of economic growth. This is known as the balance of payments constraint. Hence, higher growth could conflict with external stability.

Yes, there are more conflicts. These are just a few of the more common ones you could refer to.


What is quantitative easing?

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Quantitative easing, or QE for short, is complex. Let’s try and simplify it for everyone.

A quick caveat: I’m just taking an overview here. This isn’t the deeply in-depth description your uni professor might be looking for. This is aimed at a high school economics audience.

We’re starting with central banks. If a central bank wanted to speed up or slow down an economy, to achieve its goal of price stability (keeping inflation low, often within a target band), the central bank would affect money supply in the overnight markets. This would lead to changes in the general level of interest rates, economic activity and inflation.

For instance, if an economy has very low inflation, the central bank there might cut the official interest rate (in Australia this is the cash rate; in the US this is the Fed funds rate). But what if the central bank runs out of ammunition and doesn’t have room to cut rates further? What if rates are 0%, or even negative, and the economy hasn’t responded?

Let’s use an example taken from The Economist. During the Global Financial Crisis (or Great Recession for our American readers), America’s Federal Reserve and the UK’s central bank, the Bank of England, slashed rates to spark economic growth. But! Despite rates reaching close to zero, their economies didn’t respond. 

This is where quantitative easing (QE) comes in.

When monetary policy is not effective enough, central banks think about QE.

Here’s the broad process of QE:

  • Conventional monetary policy is not working

  • Central banks buy securities, such as government bonds, from banks (outside of regular monetary policy transactions)

  • This increases money supply in the economy which will push down the general level of interest rates

  • The lower interest rates will encourage individuals and firms to borrow more, save less, and increase consumption and investment (components of aggregate demand)

  • Economic growth and inflation will increase.

(Again, please note, I’m simplifying this just to share the main concepts at work. If you want to go deeper on this process, particularly how buying bonds will actually reduce the general level of interest rates, try here and here.)

Does QE involve central banks ‘printing money’? Where does the money come from for central banks to buy assets from the banks? This is complex and will be covered in a future blog post. Let’s keep it simple for now.

In September 2019, the European Central Bank (ECB, the EU’s central bank) implemented a form of QE. From November 2019, the ECB will buy €20bn worth of bonds every month — with NO end date to the policy. 

Does Australia need to introduce QE? Reserve Bank of Australia Governor Phillip Lowe has said that the RBA would consider cutting official interest rates to zero AND introducing QE...but he believes that at this stage, as of September 2019, it is unlikely.

And another thing worth thinking about. QE is unconventional. It’s not typical, it’s like an extreme form of monetary policy. So, if central banks are thinking about taking extreme action on monetary policy, why aren’t governments doing the same with fiscal policy?

Inflation is really low in Australia. Why?

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Reserve Bank of Australia (RBA) Governor Philip Lowe did a great thing for Eco students everywhere. He very clearly answered this question: Why is inflation so low in Australia? 

I suggest you read the speech and his full text. But I’ll also give you the gist.

(Gist: the substance or general meaning of a speech or text.)

Essentially Governor Lowe cites three reasons for Australia’s low inflation rate (as of July/August 2019). These points are also in the video on the right.

First, Dr Lowe talks about the effectiveness of credibility of monetary frameworks. This is a delicious piece of jargon if I ever encountered one. When we talk about monetary frameworks, what we mean is the inflation targeting part of monetary policy. So, in Australia, the monetary framework involves the RBA’s efforts to keep inflation to between 2 to 3 per cent over the course of the business cycle. 

Importantly, the RBA’s monetary framework is CREDIBLE. This means that people believe the RBA will act to keep inflation in the target band. In this way, people expect low inflation so they will act in a way that causes low inflation. Or, in another sense, they DO NOT expect high inflation, so they won’t yell for higher wages or cause price-wages spirals. Most of the time.

Second, Dr Lowe talks about the presence of spare capacity in the Australian and global labour markets. This means that there is unused or underutilised labour in the Australian economy. So, if firms do need more workers, they can hire from the existing pool — they do not need to bid up wages to attract workers. This keeps wages down and keeps a lid on inflation.

On this point, Governor Lowe talks about how aggregate demand is not growing fast enough to require more workers and reduce the underutilisation rate (the unemployment rate plus the underemployment rate). Faster domestic growth would be helpful to improve the labour market.

Third, Dr Lowe talks about how globalisation and improvements in technology have reduced prices around the world. In Australia, online shopping has increased competition and pushed retail prices down. Better technology means companies can produce more efficiently and reduce prices for consumers. All these factors will result in lower inflationary pressures.

But this doesn’t mean the RBA’s given up on trying to boost inflation back into the target band. Dr Lowe and the RBA have been very clear that interest rates will remain at low levels for some time to try and stimulate the economy (see quote below). 

From the RBA’s August statement after keeping the cash rate on hold. Interest rates low for some time yet.

From the RBA’s August statement after keeping the cash rate on hold. Interest rates low for some time yet.




Talk like an economist

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Economics has its own language. In general, I have mixed feelings about jargon. It’s nice to have subject-specific terms that convey a very particular meaning. But jargon also makes things unnecessarily complex.

Either way, jargon is part of economics. And students are expected to understand and apply key economic terms in their written responses. Though it’s not easy. 

I mean, many students get a handle on expansionary/contractionary okay. How about fiscal or monetary easing? What about inflation targeting (or an inflation targeting regime)? And, even worse, what about jawboning?

As a teacher, I wanted my students to feel more confident with this language to ensure they used it in their responses. To this end I recorded a video — split in two parts — that goes through some key (and confusing) vocab.

This is how I’d suggest using this in class.

  • Give students this list of terms covered in the video. I cut them up and laminated them for future use.

  • Ask students to try and work out the meaning of the terms. Try and avoid them Googling — this defeats the purpose of the task. Put them in teams, resort to pen and paper only. 

  • After they’re done, get students to check their understanding through the videos — part one and two.

  • Ask the students to evaluate how they performed. Where were the gaps in their understanding?

I don’t make sure students know all the terms before I start. Just throw them in, make them struggle! You might need to leave out some terms. For instance, when I did this activity recently, I left out the term ‘crowding out’. If you try this activity, let me know how you go.


Economic policies aren't perfect

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You’re a government. And you’ve got problems. Economic problems. Serious economic problems that require serious solutions. So you want to use your policies: fiscal, monetary and microeconomic. But wait! They’ve all got limitations.

Limitation one: Time lags

No policy has an immediate effect. 

Here, we’ll distinguish between the implementation and effect of policies. The implementation refers to how long it takes to change a policy; effect is all about how long it takes the policy to affect the economy (change economic growth, inflation, etc).

Fiscal policy? It can be generally implemented once a year during the federal budget. And it can take effect quite quickly. Think about tax cuts: as soon as they are passed through Parliament, consumers will change their behaviour.

Monetary policy? The Reserve Bank of Australia meets once a month (except January), meaning the cash rate can be changed every month if required. So this policy can be implemented once a month. However, in terms of effect, monetary policy takes around 6 to 18 months to flow through the economy. So, longer than fiscal policy.

Microeconomic reform? It’s super complicated and expensive, so it can a long time to implement. And it could take decades to finish and have an impact on the economy. So long-term for both implementation and effect.

“Another thing to think about: governments want to be re-elected. So, they may not make tough policy decisions and be limited to safer, less controversial policies (which may not be the best for the economy).”

Limitation two: Political considerations

For fiscal policy and micro reform, the government might have to pass its changes through Parliament. If the government doesn’t have a majority in the Senate (ask me about this in the comments), they might have to compromise and scale back their plans to get them passed. This could limit the types of policies they can implement.

Another thing to think about: governments want to be re-elected. So, they may not make tough policy decisions and be limited to safer, less controversial policies (which may not be the best for the economy).

Monetary policy is conducted by the independent RBA so is free from political considerations.

Limitation three: Global factors

Governments may also face limitations in terms of what policies they can implement due to global conditions.

What do I mean?

One: there is a kind of global focus on specific policies, such as free trade, deregulation (labour markets, financial flows), free floating exchange rates and privatisation of government businesses. A government may face ‘peer pressure’ to follow these policies, even if wants to pursue an alternate policy.

Two: global economic conditions might dictate policy options. For example, there might be pressure on individual governments to run budget deficits during global downturns to support consumption and investment. This could risk plans for budget surpluses. 

Um, discretionary and non-discretionary fiscal policy, much?

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Let’s turn our attention to fiscal policy. Fiscal policy is budget policy, it’s how the government adjusts government spending and revenue to meet economic objectives. The government might be trying to rev up the economy or achieve a surplus. And within fiscal policy, there are things the government can and can’t control.

Let me explain.

Fiscal policy consists of discretionary and non-discretionary factors. Discretionary signals ‘discretion’, as in choice. Will you get in trouble? It’s up to the discretion of your teacher.

When it comes to the budget, discretionary factors (also known as structural factors) are the deliberate choices a government makes. This could include expenditure measures like building a new hospital or buying a new fleet of tanks for the Defence Force. On the revenue side, the government could make a deliberate choice to cut tax rates.

It all depends on what the government wants to achieve.

But the budget also contains non-discretionary (or cyclical) factors. These are the factors that are not controlled by government, also known as automatic stabilisers. These factors, such as unemployment benefits and taxation revenue, depend on the level of economic activity. They work in a counter-cyclical way, without the government doing anything.

For example, in boom times, unemployment benefits will fall and tax revenue will increase, thus slowing down the economy. This happens without the government doing anything!

“Fiscal policy has its own brain. (Not like an actual brain, like a metaphorical brain.)”

I put it like this to my students: fiscal policy (non-discretionary fiscal policy) has its own brain. It decides what to do, without even consulting the government. It just operates automatically.

So just to recap:

  • Non-discretionary (cyclical) factors are not controlled by the government. They depend on the level of economic activity. Examples include unemployment benefits and taxation revenue (see ‘quick note’ below)

  • Discretionary (structural) factors are deliberate decisions made by government.


A quick note

If the government cuts tax rates, this is a discretionary choice. The government sets the tax brackets and can seek to change them as it sees fit.

The government cannot control the amount of tax revenue collected. This is non-discretionary. This is because, while the government can set tax rates, it cannot control the level of people’s income. So the overall amount of tax revenue collected is a cyclical factor.


What if tax cuts don’t get people spending?

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Economic theory states: tax cuts are stimulatory. They will boost aggregate demand and support economic growth. But what if they don’t?

Let’s rewind a step. In terms of people’s incomes, there are three things that happen with their money. They can spend their money, they can save it and they have to pay tax. Sigh. This relationship is neatly summarised by:

Y=C+S+T

(Where Y is income, C is consumption, S is saving and T is tax.)

After Saturday’s election in Australia, the Morrison Government has been re-elected and it’s now figuring out how to implement its proposed tax cuts. Under the tax cuts, people earning up to $126,000 will get $1,080 back at tax time. This potential economic stimulus is so large that it could be equivalent to TWO Reserve Bank of Australia rate cuts, each of 25 basis points (according to the Commonwealth Bank of Australia’s economics team).

"The RBA [may] refrain from taking the cash rate lower because they know that household consumption will pick up in the second half of 2019 courtesy of the tax relief,” says CBA senior economist Gareth Aird.

But what if consumer don’t spend their extra income? What if they save?

In recent years, the size of the average Australian mortgage has been rising (mortgage payments now make up 34% of household incomes). At the same time, Australia has relatively low household savings rates (see graph below). If households are given a bunch of extra money, they could save it, depending on their marginal propensity to save or spend.

The marginal propensity to save (MPS) or spend (MPC, C for consumption) is what proportion of every extra dollar in income will be spent or saved.

Australia’s household savings ratio — peep that decline!

Australia’s household savings ratio — peep that decline!

My point here is that, as economists, we need to factor in the possibility that the government’s policies may not have their intended impact. Or they may not have as large an impact as the government would like.

How can you use this information?

  • When you’re talking about fiscal policy for 2019-20, mention the Morrison Government’s tax cuts and their impact according to economic theory. But also include the possibility that households will save, not spend.

  • Mention the potential impact of these tax cuts: equivalent to an RBA rate cut of 25 basis points. So, very stimulatory.