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

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.

Why did the RBA cut rates in June?

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.

Test students on the Balance of Payments categories

Here’s a useful question from the 2017 NSW Economics HSC exam about the Balance of Payments.

I think this is a great revision exercise after you’ve looked at the BoP categories in a bit of detail. Click through for the whole exam paper. I don’t love the suggested answers, so I reckon you’re best served by developing some ideas yourself.

I’ve also done a walkthrough on this question (see below). This could help students see some useful ways to approach this question.

Distinguish between income and wealth

This is a pretty typical examination question. For me, it’s the kind of question where I’m like, “Yeah, of course I can do that.” But when someone asks me to sit down and write this for two marks, I’m like…

via GIPHY

Let’s get this straight once and for all.

Income is the amount of money, financial rewards or benefits that flow to individuals or households. Income is received for a person’s contribution to the production process (so wages for labour, rent for land) or as a payment from the government (transfer/welfare payments).

Wealth is different.

Wealth is the value of the stock of assets held by individuals. This could include property, shares, superannuation, fancy art and so on.

To get a little technical, income is a flow concept and wealth is a stock concept. A stock concept is a measure of how much you have a thing at a particular point in time (the value of your assets on a certain date). Stock is like a snapshot. A flow concept is measured over a period of time, such as the value of your salary over a period of a year.

Here’s some extra info about the difference between the two.

Something valuable to add could be the link between income and wealth. Put simply, it is easier to build wealth with a higher income. This is because higher income earners do not spend all their income on living costs. They can afford to save their money and use it invest, buy assets and build wealth.

So a higher income doesn’t guarantee greater wealth...but it sure helps.

As they like to say: “wealth begets wealth”.

Annotate exam questions properly

Want to do better in exams? Here’s the easiest way to improve: do a thorough job of annotating the question.

Exams can be stressful situations. You need to maximise your chances of success in a tough environment.

So, spend some time and break each question down.

What do I mean?

Here’s an example of how I annotated a subsidy question from the 2016 NSW Economics HSC Examination (Q21, part a). Link to exam and marking guide.

On first look, I was confused. Every time I bring it up in class, the students are confused. So, after many instances of confusion, I decided to record a video on HOW I would annotate it properly — see below.

When you annotate, use the following principles:

• What the key terms in the question?

• What do I know about the question?

• What do I know about the question that is relevant?

• What are some traps or pitfalls in the question?

You can (and SHOULD) annotate every type of question.

What if tax cuts don’t get people spending?

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!

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.
  

The difference between fiscal and monetary policy

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

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

Understanding automatic stabilisers

This is a tough one. But, rather than explain it to you with words, I’m going to explain it to you with pictures.

This video about automatic stabilisers is one of the first Eco videos I created. Audio’s not great, but stay tuned for the hilarity.

Once you’ve seen the videos, answer the questions in the sheets. Super helpful for consolidating your knowledge about this weird concept.

Questions in the comments pls.

Why are Australia’s macroeconomic policies fighting?

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