Monetary Policy? Refers to the action undertaken by the RBA to affect the price and quantity of money and credit in the economy. ? In Australia, it works through interest rates, which affects the level if private investment and consumption expenditure.? The RBA uses open market operation the buying and selling of government securities to set short-term interest rates.? To contract the economy the RBA raises the cash rate, which then flows onto other interest rates. The cost of borrowing funds for investment increases and this helps to reduce spending in the economy. Monetary policy in this case is said to have tightened.

Fiscal Policy? Refers to the use of govt revenue and expenditure to influence the level of economic activity the level of income, output and employment.? Fiscal policy is implemented through Commonwealth Budget, which now occurs in May each year and is sometime referred to as budgetary policy.? Fiscal policy involves adjusting govt expenditure in areas such as defence, social security, health and education, and altering tax rates such as personal income, company, sales and excise duty.? If the govt wanted to contract economic activity, it would plan for either a reduced budget deficit or an increased budget surplus. This means that in the circular flow model, G is reduced relative to T, which should help to reduce aggregate demand in the economy and thereby reduce national income and output.

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Monetary policy together with fiscal policy are the two primary policies the govt uses to control the macroeconomy by affecting the components of aggregate demand.The economic circumstances in which monetary policy might be preferred? Monetary policy is a more flexible instrument than fiscal policy and for this reason it may be preferred to be used when the govt wishes to fine-tune the economy.? It has in fact played the role of swingman in Australias recent past.? It has the advantage of a very short implementation lag as opposed to fiscal policy.

? The RBA constantly monitors a wide range of economic indicators and then adjust short-term interest rates with a view to conditions sometime into the future.? The RBA does not require the formal consent of the govt of parliament when its sets its policy strategy.? It is a much better instrument for achieving the objective of price stability.? Most central banks around the world believe that the prevention of inflation should be the primary objective of the monetary authority.? Inflation is believed to be primarily caused by excessive growth in the money supply.

? Monetary policy by controlling the financial sector and liquidity in the economy, is therefore seen as being best suited to the goal of price stability.? Works best in boom conditions in contracting the economy rather than in times of recession. ? When the economy is growing at a fast pace, credit restrictions and/or increases in interest rates are an effective method to help curb spending.? In times of recession however, monetary policy is not very effective in stimulating spending. The phase pushing in a piece of string is often used to illustrate the ineffectiveness of monetary policy when the economy is recessed.? Often seen to be more politically palatable than fiscal policy and there may be times when the govt would prefer to use monetary policy to slow the economy rather than cutting govt expenditure or increasing tax.The economic circumstances in which fiscal policy might be preferred? While fiscal policy suffers from a long implementation lag, its effect lag is much shorter than for monetary policy.

? It is more direct policy tool than monetary policy.? A change in govt spending or taxation will work quickly to affect the level of economic activity through the multiplier.? Monetary policy, however, is more indirect.

Changes to short term interest rates take time to work through the financial system. The effect of private spending is much less certain and may take a considerable amount of time before economic activity is affected.? Thus if the govt wishes to turn the economic quickly it may want to rely more on fiscal policy introduce a mini-budget.? Preferred when the economy is in recession and needs to receive a kickstart in order to boost economic activity.? An increase in govt spending and/or a decrease in taxation will be much more effective than a lowering of interest rates, especially if business confidence is low.? It is also more effective when the govt is pursuing the goals of full employment and external balance.

? Interest rates can have an adverse effect on the exchange rate. For example: when the economy is growing, imports increase and the current account deficit worsens. Raising interest rates to slow demand will attract foreign investment increasing both the capital account surplus and the current account deficit. ? Fiscal policy for this reason is the preferred instrument for targeting external balance.Strengths of monetary policy? Very flexible (greatest strength), can be made and implement very quickly.? Has greater political neutrality. Higher interest rates affect every sector and ppl tend not to see the policy as particulary aimed at them.

? Very effective during boom period. Higher interest rates are more direct effect on economic decisions than do lower rates.? Most effective under floating exchange rate.

Weakness of monetary policy ? Not very effective during recession.? Time lags (recognition lags, action lags, implementation lags, effect lags)? Can be circumvented? Not effective under a fixed exchange rate. A cut in interest rates will reduce capital inflow. This will lead to a balance of payment deficit and a reduction in the money supply, which will push interest rates back up again. The fixed exchange rate will work against interest rate changes.Strengths of fiscal policy? Reinforces the operation of automatic stabilisers? Very direct? Controls a spending tapWeakness of fiscal policy? Time lags (recognition lags, action lags, implementation lags)? Budgets are fairly inflexible? Political constraints? Unintended impacts eg: crowding out? Other level of govt.

A contractionary budget at federal level may be offset it state govts or semi govts authorities do not also follow similar policies.? The need to have an overall approach.


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