Interest Rate - Up again

On August 8 2007, the Reserve Bank of Australia (RBA) announced an increase of 0.25% on interest rate to 6.5%. It was unwelcoming news to everybody who has debt in hand, particularly those with standard variable rate arrangement.

A lot of angry family now feeling the pinches a little more harder on-yet-to-heal bruises inflicted by the previous rise of interest rate on last November at the same rate.

Every government has its own fiscal policy to manage their country's economy. Fiscal policy has 2 main components; tax and government spending. Like many governments in the world, Australia has RBA to champion the F1 of economy. In responding to many complex subcomponents that make up the taxes and government spending, a fiscal policy can expand or contract accordingly. Hence the Expansionary Fiscal Policy and Contractionary Fiscal Policy.

When do Fiscal Policy contracts? It is when there is a need to dilute the economy of a country. Expansionary Fiscal policy is the direct opposite. How do they dilute the economy? Simply raise the tax and lower the government spending (less road improvement, less hospital, less benefits, etc) - again the opposite for expansionary fiscal policy.

By now you might guess, Australia has been adopting Expansionary Fiscal Policy. Where tax has been lowered consistently over the years and the government spending are increased. Here is a simple formula to make it clearer.

                                        Y = C(y-t) + I + G + NX where
                                       Y = GDP
                                       C = Consumption Spending
                                       y = net income or GDP
                                       t = tax
                                       I = Investment
                                       G = Government Spending
                                       NX = Net Export

Assuming everything else remain the same, expansionary fiscal policy will generally make a prosperous economy more prosper. With t, tax lowered and, G, government spending increased will see an economy, Y or GDP grow.

I think you are beginning to see that the 'real' purpose of tax cuts. They are not meant out of generosity for the people. It is meant to stimulate the economy and the people have indirectly benefited from it. How you may ask? Look at the formula where C(t-y) = disposable income = income after tax = net income. The more you have, the more you spend, it is human nature in broad spectrum. The more the people spend, the bigger subcomponent C gets, hence a stimulated GDP is being introduced. The current ruling government of Australia, the Liberal party announced tax reform in year 2000, where tax cuts are being envisaged to occur for the next four years on every budget year. Tax cut has only one main purpose that is to stimulate GDP.

Australian Prime Minister was in the cooking pot and quoted after promising keeping the interest rates at record low in his previous election campaign "I would say to voters...[Liberal is better in] finely balanced in challenge of economic management and economy policy at a time of great prosperity". Australian can't blame him for the rise of interest. It is because he not the man who has the say on interest rates movement. The problem was he was not telling the 'whole' truth that it is the RBA who runs the interest rate blockbuster. Many people do not know that. So Australians do need to know simple Macroeconomics than believing any politicians promising the upcoming days of prosperity.

So how does interest rate come into the picture? Behind the attempt to stimulate the economy, Expansionary Fiscal Policy hike up interest rate as well. Mr John Howard is telling the some truth that things will get more expensive, that it is a cost of being prosperous nation. If things get expensive directly related to inflation? Yes and no – for now as things become costlier, the demand for money grows. As people need more money when it is scarce - they will get loans to finance their growing consumption. More demand for money will stimulate the rise interest of interest rate.

More coming on later edition.