Re: XAO Analysis
Such delays reduce the flexibility of fiscal policy prompting many, including the Business Council of Australia, to suggest the creation of an autonomous government body. Similar to the Reserve Bank of Australia, this body would have the powers to make small across the board adjustments to tax rates within one or more major tax areas. This is a minority view. (John, 2002). It is however, hard to know the impact of tax cuts, if seen as temporary they might be saved, furthermore, the cuts could be spent on imports, thus it is hard to predict the multiplier.
Another major source of debate, pointing to the impracticality of fiscal policy in the medium run is shown below in figure 1.
An increase in government spending leads to an increase in demand, leading to an increase in output. As output increases, so does the demand for money, leading to an upward pressure on the interest rate, moving the equilibrium point form A to A' in the ISLM model graph. The increase in the interest rate, which makes domestic bonds more attractive, also leads to an appreciation of the domestic currency, represented by the movement along the interest parity cure from point A to A', reflecting the same change in the interest rate from the ISLM model graph.
Both the higher interest rate and the appreciation decrease the domestic demand for goods, off setting some of the effect of government spending on demand and output. (Blanchard, 2000). This effect, known as the “crowding out” effect, is not experienced for some time after the initial change in government spending, further making it difficult for policy makers to accurately and successfully implement counter-cyclical macroeconomic policy.
Successful macroeconomic management involves a process of continual reassessment of the state of the macro-economy. Among many things that policy-makers would like to know about the current state of the economy is the extent to which the level of aggregate economic activity exceeds (or falls short of) the economy’s productive capacity. (Gruen, 2002, p1). The gap between actual output and the economy’s potential output, is the output gap. This output gap, must however, be able to be measured with relative accuracy in real-time, not only in hindsight. It is difficult to measure the output gap either in real-time or in hindsight, simply because the level of potential output on which they are based is unobservable, including problems such as the uncertainty pertaining to the true structure of the economy and hence the relationship between potential output and economic data on actual output and inflation etc. (Gruen, 2002). On a paper written by Gruen, Robinson and Stone: Output gaps in real time: are they reliable enough to use for monetary policy?, it has been concluded using results from 121 vintages over a period of 30 years, from 1971 – 2001, that estimates of the output gap in real-time are relatively accurate. (Gruen, 2002). Gruen however, also states common logic in his paper, there remains an irreducible degree of uncertainty associated with output gaps generated in real time. The problem of ‘not knowing the future’ is still an important one and there will always be times when the best available estimates of the output gap made in real time will turn out, with the benefit of hindsight, to have been badly flawed. (Gruen, 2002, p32).
Furthermore, estimates of quarterly national accounts are a useful guideline for the implementation of macroeconomic counter-cyclical policy. However, an RBA discussion paper written by Stone and Wardrop states: Initial mismeasurement has also frequently been quite persistent, often largely remaining even several years after the period being measured. (Stone, 2002, p21). Thus, quarterly measurements of the national accounts cannot be taken seriously when implementing monetary policy due to time lags in the attainment of accurate information, as shown with the use of the Taylor Rule at the time of monetary policy implementation and using the same formula with numbers gained from hindsight. Orphanides pointed to this flaw in the Taylor rule and further states in relation to the use of quarterly national accounts figures, they indicate ‘the profound importance of appreciating the information problem for successful policy design’. (Stone, 2002, p21). Finally, it is of paramount importance to remember that uncertainty pertaining to the economy is not only derived from the difficulty of measuring future paths of key economic variables such as aggregate output, but further, in knowing where those variables are now, and where they have been in the past. (Stone, 2002).
A recognition time lag is observed when implementing monetary policy, in that data simply gives a “rearview mirror” through which to view the economy. An impact lag is further evident, in that there are several quarters between a cut in interest rates and the response on aggregate demand.
It is estimated output growth falls by 1/3 of a percent in the first and second years, and 1-6 of a percent in the third year, after a 1 percent increase in the short term interest rate (IR). (Gruen, 1997). Therefore, the majority of the effect on growth occurs more than a year after a change in the IR. IR changes further have a lagging effect on the exchange rate, further complicating counter-cyclical macroeconomic policy.
For example, a fall in the IR is supposed to raise the cost of foreign goods, in that it deprecates the Australian dollar (AUD), however it may take a while before domestic buyers switch from imported products to domestic products.
Furthermore, we do not know the "natural rate of unemployment," which is the rate below which we would start to experience increasing inflation. We further, do not know the exact relationship between interest rates and aggregate demand. (King, 2003). This is known as model uncertainty. The combination of model uncertainty and time lags makes a mockery of the notion of "fine tuning" the economy to always be at optimum performance. (King, 2003).
A research article published at the RBA agrees with the notion it is impractical to fine-tune the business cycle and states: “These relatively long lags, combined with the problems inherent in forecasting economic growth more than a year into the future, point to the difficulty of trying to use monetary policy to iron-out fluctuations in the business cycle.” (Gruen, 1997, p24).
Furthermore, monetary policy aims to achieve medium-term price stability. While output is a leading indicator of inflation, success in the persuit of medium-term price stability does not depend on being able to “fine tune” the business cycle. (Gruen, 1997). “Prolonged swings in output can and should be avoided, but the policy lags are long enough, and uncertain enough, that it is futile to try to use monetary policy to finetune the business cycle.” (Gruen, 1997, p24).
A practical example of why time lags lead to ineffective counter-cyclical macroeconomic policy when interacting with the complexity of the domestic economy and global shocks (both demand and supply side), is the example of the recession in Australia during 1990/91.
Australian recession 1990/91 – firstly the United States experienced a recession, as it is the largest economy in the world, this dramatically impacted negatively on the Australian economy, as both Australian and US Gross Domestic Product (GDP) generally interact very closely. Further, in 1988 the Australian economy was growing rapidly, inflation was already high and there were fears of it growing further due to demand pressures. The RBA began to increase interest rates. However, as part of the general move towards financial deregulation, the link between base money and broader monetary aggregates broke down. (McTaggart, 2002, 767). Illustrated in Figure 3). M3 continued to grow whilst the money base contracted, meaning contractionary effects of monetary tightening weren’t felt for some time and the economy continued to grow. Figure 4) illustrates the recession Australia felt in 1990/91. The recession was caused by a decrease in both aggregate demand (AD) and aggregate supply (AS). AD fell due to the slowdown in the US economy, leading to a fall in exports and a slowdown in the growth rate of the quantity of money, leading to an increase in the IR and a decline in investment. Hence, to a leftward shift in AD from AD0 to AD1. AS decreased because the money wage rate continued to increase throughout 1990 at a similar rate to that of 1989. Shown by a shift of the AS curve to Short-Run Aggregate Supply 1 (SAS1). Note: Long-run AS curve is not shown. The combined effect was a fall in real GDP of $3 billion, from $451 billion to $448 billion and an increase in the price level from 88 to 90.
During the recession, real wages rose and so did unemployment as shown in Figure 5). This was due to the Accord, with wage increases being granted on expected future outcomes, however the rapid fall in inflation due to monetary tightening in 1988 was unexpected, hence although money wage increases were moderate, the real wage rose rapidly as the price level hadn’t risen nearly as high as expected. (McTaggart, 2002).
Figure 3) Figure 4)
Figure 5)