Relative Importance of Fiscal Policy & the Floating Exchange Rate on the Australian Economy

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  • Topic: Inflation, Monetary policy, Macroeconomics
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Review the relative importance of the floating exchange rate and fiscal policy on the Australian Economy in the past twenty-(20) years.

Introduction The Australian economy is one of the most stable globally and the floating exchange rate has played an important role in maintaining that stability. This essay seeks to assess the relative importance of the floating exchange rate and fiscal policy on the Australian economy over the past fifteen-(15) years. In order to do so, it looks at the history of the Australian economy over that period, how it has performed and what has changed significantly. Then it reviews the history of fiscal policy over that time and its contribution to the economy. Following on from that it assesses the role that the floating exchange rate has played, including the contribution of monetary policy. Finally, it will assess the current context of the Australian economy, with particular emphasis on the two-(2) speed economy and the relative importance that the role of fiscal policy and exchange rates play in maintaining economic stability and prosperity.

Overview of the Australian Economy (1995-2010) The Australian economy has prospered over the past fifteen-(15) years, achieving average GDP growth of 3.2% (Appendix 1). This equates to a 160% increase in GDP from $502 billion to $1.3 trillion. (RBA, 2010) The main drivers of economic growth have been the Financial/Insurance Services and the Mining Industry, together contributing approximately 18.5% of the growth to the economy over that period (Appendix 2). It is also important to consider the relative importance of each component of GDP: Consumption, Government Spending, Investment, Exports and Imports. The most significant changes over the past fifteen-(15) years, as a % of GDP are as follows (Figure 1): 1. Decline in Consumption from 60% to 55% 2. Increase in Investment from 22% to 28% 3. Average Government Expenditure of 22% 4. Significant variation in the contribution of Exports from 17% up to 23%. 5. Little variation in Imports, averaging 21%

1

GDP - Contribution per Com ponent (1996-2010)

60%

50%

40%

30%

20%

10% 1996

1997

1998 1999

2000

2001

2002

2003 2004

2005

2006

2007 2008

2009

2010

Consumption

Government

Investment

Exports
Figure 1 (Source: ABS)

Arguably a key factor in Australia’s economic success has been the fiscal policy applied by the Federal Government. In short, the focus has been on maintaining the budget in surplus. This not only limits government debt, but it also limits upward pressure on inflation and hence, interest rates that would otherwise occur with excessive government spending. Another very important contributor to recent economic prosperity and stability has been the Reserve Bank of Australia (RBA) and their application of Monetary Policy. Since 1993, the key objectives of the RBA have been to maintain price inflation within the range of 2 to 3 % per annum and to control the money supply across the economy (RBA, 2010). This policy has been applied with great effect since its inception, particularly in the past decade, and it has provided significant stability in the economy (Appendix 3). In recent times, another key contributor to economic growth has been the export demand for Australian resources, particularly from China. Mining exports account for 39.4% at present and prices are at historic highs (innovation.gov.au, 2009). As a result, Australia’s terms of trade has appreciated significantly since the early to mid 2000’s (Appendix 4). Finally, and arguably, the most significant factor for economic performance has been the floating of the exchange rate. Enacted in 1983, the floating exchange rate has acted as a key automatic stabilizer for the economy. It has come to play a critical “counter-cyclical role by rising 2

and falling in response to various external events that otherwise might have had the potential to destabilise the domestic...
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