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.

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.

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.

So. You've decided to teach Monetary Policy...

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Teaching Monetary Policy?

This is tough. It’s not like you can go into class, say, “This is Monetary Policy”, and move on. There’s so much foundational knowledge that’s required. You have to talk about the Reserve Bank of Australia, the cash rate, the Australian cash market, money supply, domestic market operations…

It’s a lot.

So I’ve created a series to try and help teachers (and their students) build their knowledge about monetary policy. Start with this video here. Links to all the other videos are in the description.

I’d love your feedback on these videos if you use them. How did they go? Valuable? Things to add?

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.

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.




Back to back rate cuts

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July 2019, Sydney: the Reserve Bank of Australia cuts the cash rate for the second consecutive month to 1 per cent.

Just for some context, during the Global Financial Crisis, the lowest the cash rate went was 3 per cent. 

Why did the RBA cut rates again? Let’s look at some highlights from the July statement.

Reason number one: Australian economic growth is weak

In terms of economic growth, the goal is around 2.5 to 3 per cent growth in gross domestic product (GDP) annually.

In the year to the March quarter of 2019, the Australian economy grew by only 1.8 per cent. According to RBA Governor Philip Lowe, “consumption growth has been subdued, weighed down by a protracted period of low income growth and declining housing prices.” 

Let’s analyse this quote. One, consumption is weak which leads to weak economic growth BECAUSE consumption makes up around 60 per cent of GDP. Two, low income growth and falling house prices reduce consumer confidence and their incomes, leading to more saving and less spending (because they are uncertain of the future).

So: cut rates, encourage spending and borrowing, and accelerate economic growth.

Reason number two: There’s a lot of unused or underused labour in the workforce

Dr Lowe also talked about how Australia has made little progress in reducing the amount of spare capacity in the economy. This particularly refers to unused or underused labour; what economists would call unemployment or underemployment.

As a result of the excess supply of labour, wages growth remains low. By cutting the cash rate, the RBA wants to see a fall in the level of underutilisation in the Australian economy (underutilisation rate = unemployment + underemployment).

Reason number three: Inflation remains below the target band

The RBA’s target band for inflation is 2-3 per cent over the course of the business cycle. Australia’s inflation rate hasn’t been within the target band, consistently for some years now (see graph below). 

Inflation hasn’t lived in the target band for some time now.

Inflation hasn’t lived in the target band for some time now.

By cutting the cash rate, the RBA’s trying to boost inflationary pressures in the economy.

Willl this rate cut actually work?

As an economics student, you can question the effectiveness of monetary policy. The RBA’s had an expansionary stance for some years now and there hasn’t been a huge boost to growth or inflation. 

Another point to consider is that fiscal policy could do more, right now, to stimulate the economy. Is it appropriate to run contractionary fiscal policy (move to a surplus) when the RBA is trying to increase economic growth? They’re working against each other. This is a question worth asking. 


Why did the RBA cut rates in June?

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Today, the Reserve Bank of Australia (RBA) cut the official cash rate by 0.25 basis points to 1.25 per cent. Why did they do it?

MY LIVE REACTION TO THE JUNE RATE CUT

You can read the full statement, which I recommend. You can also watch my live reax (on the right).

In short, the RBA cut rates for two main reasons.

1. The RBA cut interest rates to boost employment.

The RBA reckons that Australia’s labour market is pretty soft with substantial “spare capacity”. Spare capacity refers to unused resources, labour in this case, that are sitting around and NOT contributing to the economy.

According to the RBA, unemployment has increased and overall wage growth remains low — all indicators of such spare capacity. The RBA further believes that unemployment can go lower (as Governor Philip Lowe said in his statement, “the Australian economy can sustain a lower rate of unemployment”), and the central bank hopes that the reduced cash rate can help stimulate the economy and create more jobs BY reducing the level of spare capacity.

“Today’s decision to lower the cash rate will help make further inroads into the spare capacity in the economy. It will assist with faster progress in reducing unemployment and achieve more assured progress towards the inflation target. ”
— RBA Governor Philip Lowe

2. The RBA cut interest rates to boost inflation (back into the target band)

The RBA’s target band for inflation is between 2 to 3 per cent over the course of the business cycle. The central bank forecasts underlying inflation, which strips out volatile price changes, will only be 1.75 per cent in 2019, and touch the bottom end of the band at 2 per cent in 2020. By changing the cash rate, the RBA wants to move inflation back into the target band by stimulating consumption (because lower interest rates make it less attractive to save) and investment (because lower interest rates make it cheaper to borrow money and invest).

But why do we want to avoid low inflation? Isn’t high inflation a bad thing?

WHY IS LOW INFLATION BAD NEWS?

Low inflation is a problem for two reasons. One, if prices are low and expected to fall further, people will delay their consumption until prices are cheaper. But if they postpone spending, demand will fall and firms will require fewer workers and unemployment will rise and...it’s a bleak picture.

Two, low inflation relates to low wages growth. And if wages aren’t growing people aren’t spending and their living standards aren’t improving. This is not a great situation either.

The RBA has acted in June to stimulate consumption, boost employment and guide inflation back to more healthy levels. And the central bank isn’t finished yet! In a speech tonight, Governor Lowe suggested rates could go as low as 1 per cent, depending on economic conditions.

The difference between fiscal and monetary policy

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It can be tricky to distinguish between fiscal and monetary policy.

Let’s try and make it a bit easier.

Fiscal policy is all about the federal government’s use of the federal budget. It’s about the government changing government spending (an injection, the symbol is G) and taxation revenue (a leakage, the symbol is T) to affect the level of economic activity…and achieve other economic objectives.

Fiscal policy is budget policy.

Monetary policy is different.

Monetary policy involves the Reserve Bank of Australia’s (RBA) actions to alter the value of the cash rate to control the level of inflation (and affect economic growth). The RBA changes the cash rate to create changes in the general level of interest rates (set by the commercial banks) to deal with inflation and growth and employment and other challenges.

Big thing to note: monetary policy is government policy. But the government does not implement monetary policy.

Monetary policy is implemented by the independent RBA, on behalf of the government.

Fiscal policy: think about the budget.

Monetary policy: think about interest rates and the RBA.

Hope this helps. Try this video too.

The RBA gets its hands dirty

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Australia has a floating exchange rate. This means that the market forces of demand and supply determine the value of the $A. No-one can set an exact value for the $A.

But people still try to change the value of the $A.

The Reserve Bank of Australia (RBA), Australia’s central bank, intervenes in foreign exchange markets (the markets where foreign currencies are bought and sold).

Let’s take two scenarios. Let’s say the RBA thinks the $A is too high. The value of the $A is making exports too expensive (as buyers must purchase $A to buy Australian exports) and so they are less internationally competitive.

[International competitiveness is the ability of a nation to effectively sell its exports on world markets. If your exports are cheaper, it’s easier to sell them and so you are more internationally competitive.]

So, the RBA thinks the $A is too high. In this case, it will sell the $A and buy foreign currency instead. This will increase the supply of the $A and cause the currency to depreciate, hopefully to the level the RBA desires.

The second scenario is where the RBA thinks the $A is too low. In this case, the RBA will buy $A and sell foreign currency, which will increase demand for the $A and cause the currency to appreciate.

In this process, the RBA is intervening in the ‘clean float’. In economic terms, the RBA is ‘dirtying the float’. This represents direct intervention by the RBA to change the value of the $A.

Here’s a limitation. To dirty the float, the RBA needs large foreign currency reserves to push up the $A. This is because of the massive amount of $A traded each day. If the RBA’s reserves run dry, the central bank might struggle to support the value of the $A and the value of the local currency could fall rapidly.

Check out my video on this issue too.

AS A STUDENT, HOW CAN I USE THIS INFORMATION?

  • Be clear that Australia does not have a perfectly clean float

  • When you’re talking about exchange rates, make sure you mention that the RBA intervenes (when needed) to affect the value of the $A...and that this process is known as dirtying the float

  • Be ready to discuss the limitations of dirtying the float, namely the large amount of foreign currency reserves required to affect the value of the $A

Why are Australia’s macroeconomic policies fighting?

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At 2:30pm today, the Reserve Bank of Australia kept the cash rate on hold at 1.5 per cent. Economists weren’t sure what the RBA would do: would it cut rates further? Would it keep them steady? . So the decision surprised some. But this isn’t the most interesting thing.

What I find most interesting is the conflict between Australia’s macroeconomic policies.

[See my instant reaction video about the RBA’s decision.]

As a quick refresher, macroeconomic policies are policies that affect the whole economy, not just one sector. The major macro policies are monetary policy (the RBA’s influencing the general level of interest rates in the economy) and fiscal policy (the use of the Federal Budget).

These macro policies can be used to speed up or slow down the economy. In terms of achieving goals, it’s helpful if they’re working in the same direction and not against each other.

But check this out. Monetary policy is wildly expansionary. It is at historic lows, in an attempt to increase Australia’s pretty average economic growth rates. At the same time, fiscal policy is contractionary. That is, the government is trying to create a budget surplus (a situation where government revenue, a leakage, exceeds government spending, an injection).

Put simply: monetary policy is trying to expand the economy, fiscal policy is actually working to slow it down.

Why are they working in opposite directions? Part of it is the federal government’s attempts to quickly return the nation’s budget back to surplus. The RBA is independent of government, so it’s pursuing a different plan.

It gets even more complicated, though. The federal government is planning to run a budget surplus...but it is planning to implement major tax cuts (an injection) if it wins the upcoming election. So, even within fiscal policy, the government is trying to achieve competing goals.

AS A STUDENT, HOW CAN I USE THIS INFORMATION?

  • When you’re writing about Australia’s use of macroeconomic policies, discuss the conflicts between the policies themselves

  • You can also discuss conflicts WITHIN fiscal policy, where different measures are working to slow and expand the economy simultaneously

  • Make sure to mention that fiscal policy is controlled by the federal government, while the independent RBA handles monetary policy