The ‘medium term framework’ of fiscal policy and its relation to government finances
The main element when managing public expenditure is the allocation of resources in relation to the economic priorities. This is the main idea behind the establishment of the medium term framework in reference to fiscal policy that is aimed at regulating all government’s policies related to spending, revenue and debts (Loayza et al, 2005). Peston’s Theory of Macroeconomic policy states that the main purpose of this framework is “to enlighten the public, government agencies and market agents hence creating a stabilized environment which improves on the rationality of policy making” (Loayza et al, p. 67).
The most outstanding economic factors addressed by public expenditure, management are maintaining average taxes, setting GDP targets that are not too high, reducing the budget deficit and responding adequately to huge current accounts deficit. This enables the government to maintain a balanced budget throughout the economic cycle and also to retain the budget surpluses over the years. As Langdana (2002, p. 12) explains. “The result of this is a stabilized economic outlook and an improvement in the economy’s net worth in the long term”
This frame work has gained popularity in most of the developing countries owing to its convenience and effectiveness in the establishment of economic growth plans. Dornbusch et al (2008, p. 15) provide a number of reasons for this, which include:-
“ (1) the rigidity experienced in the formal development plan which was restricted to government investment outlay, (2) the discovery made on the possibility of adjusting expenditure and implementing fiscal policies in the middle term, (3) introduction of the rolling public investment planning by the international financial institutions and (4) the indications of the medium term policies which illustrated that the continuous implementation of the existing policies paved way for the further expansion in the economy”
The middle term fiscal framework is also considered to be flexible and more sustainable owing to the fact that it allows the government’s estimates in terms of expenditure, revenue and debts to be updated annually on a rolling basis. Unless recordings are well updated, governments like any other economic person could find itself entangled in debt. Accountability measures are critical in managing any financial concern. This is because, often when it comes to money, there are many risks and challenges. It is for the foregoing reasons that a middle term fiscal framework is critical. Such a framework has to be flexible but most critically accountable enough. This makes a provision for earlier mistakes to be corrected hence the development of an almost perfect policy framework in the long run.
A properly formulated middle term fiscal framework determines the effectiveness of the budgeting process since the budget is directly developed from the framework. This process involves two steps, the first one being the “evaluation of the changes that have taken place in the economy and the proposed policy responses and the second one, addressing the unresolved dilemmas in the middle term fiscal framework” (Langdana, 2002 p. 19).
In the absence of the framework, the budgeting process is a complicated one since it has to begin with the appraisal of the entire economy and the figuring out of the expenditure items to include in the budget while the information is usually updated annually in the middle term fiscal framework. This concept is also related to government finances through its control on the current account deposits, one of the major determinants of the level of government savings and investment.
Link between the fiscal policy approach and monetary policyapproach. The actions of the Reserve Bank of Australia in 2009 and 2010 in regard to monetary policy
The fiscal and monetary policies are both important elements in the determination of the economy’s growth prospects. The monetary policy regulates the amount of money in circulation while the fiscal policy regulates government’s spending, revenue and debts. Loayza et al explains the relationship between these two policies by asserting that a “budget deficit can mainly be financed through either a change in the money base or a change in bonds. A pure fiscal policy is financed through changes in bonds issued with the money base remaining constant. A pure monetary policy, on the other hand, can be defined as “a change in the money base compared to the change in government’s bonds in the opposite direction” (Langdana, 2002, p. 8).
Another link between the monetary and fiscal policies is in their effects to the aggregate demand. Monetary policy motivates the components of aggregate demand that respond to the changes in interest rates which includes investment and consumption. Fiscal policy on the other hand influences aggregate demand through the various components such as the type of goods and services purchased by the government and the taxation policy implemented. The interrelationship between the two policies result into the crowding effect “which comes up when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment” (Gruen & Shrestha, 2000, p. 22). A simple explanation to this is that government spending overpowers private spending when the interest rate is raised by the reserve bank.
In the period preceding the 2009 – 2010 financial years, the bond market in the Australian economy had been deteriorating and the level of national debt was on the rise at a very high rate. In order to eliminate these adverse economic conditions, the reserve bank of Australia decided to raise interest rate which led to an increase in the level of investment. This action brought about a considerable change in the economic condition of the country since the employment level indicated a significant rise (Runcie, 1997).
Other indications that the economy was at its best during this period include willingness of lenders to lend more cash, a steep increase the level of investment especially in the resource sector and an increased demand for credit facilities. The rate of inflation declined and led to the reduction of the prices of commodities in the market. The reserve bank of Australia therefore went ahead and reduced the amount of economic stimulus that had been incorporated at the time when the economy seemed to be at stake. The resources that had been directed to the economic stimulus program could now be used in other capacities of economic development (Tisdell, 2004).
The most effective policy option in stabilising the economy
The current exchange rate in the Australian economy is a floating one. The reserve bank has the freedom to alter the monetary conditions in the country without disturbing the effect of capital flows on the currency. The result of this is a financial market that is more stable as opposed to the unpredictable conditions experienced under the fixed rate regime. This however does not imply that capital flows are no longer important. It only means that the economic problems arising from capital controls have been minimized. Under this regime, the monetary policy is the most effective in stabilizing the economy since the elements of fiscal policy are self regulating (Runcie, 1997).
When the reserve bank of Australia took to the decision to float the currency, the country had experienced an enormous upsurge in the level of capital inflow to the extent that it was unable to absorb it. This happened to be one of the best actions in the economy of Australia since it led to the liberalization of the monetary policy, which earlier on was being hampered by the capital flow. This also enabled Australia to withstand the economic shock that hit the Asian region in the recent past owing to the fact that the economy had already assumed stability in the monetary system by achieving an expansionary monetary policy (Tisdell, 2004).
The main reason why the exchange rate is considered an important element in monetary policy is because it plays a major role in transmission mechanism. “It safeguards the economy from external shocks, such that monetary policy can concentrate on stabilizing the rate of economic growth and the domestic price levels” (Gruen & Shrestha, 2000 p. 34). The most widely used instrument of monetary policy is the open market operations whereby the reserve bank purchases government bonds and securities from the commercial banks, which in turn receive credit in payment for these securities. This implies that the banks end up increasing their reserves level in the reserve bank as well as their lending capacity. When commercial banks have increased capacity to lend, an economy becomes more fluid as individuals and organizations are able to access finances as needed.
Dornbusch, R., Fischer, S., Startz, R., & Wang, Z., 2008. Macreconomics. Dongbei University of Finance & Economics Press: Dalian.
Gruen, D. W. R., & Shrestha, S., 2000. The Australian Economy in the 1990s: Proceedings of a Conference. Reserve Bank of Australia: Sydney.
Hackett, J. W., 2007. Social and Economic Conditions in Australia. Society of the Arts: London.
Langdana, F. K., 2002. Macroeconomic Policy: Demystifying Monetary and Fiscal Policy. Kluwer Academic Publishers: Boston.
Loayza, N., Oviedo, A. M., & Serven, L., 2005. Regulation and Macroeconomic Performance. World Bank, Development Research Group, Growth and Investment Team: Washington, D.C.
Mayer, T., 1990. Monetarism and Macroeconomic Policy. E. Elgar: Aldershot.
Peston, M. H., 1975. Theory of Macroeconomic Policy. Wiley: New York.
Runcie, N., 1971. Australian Monetary and Fiscal Policy; Selected Readings.University of London Press: London.
Tisdell, C. A., 2004. Australia’s Economic Policies in an Era of Globalisation.School of Economics University of Queensland: Brisbane.