This Selected Issues paper examines the role that government policy in Australia plays in influencing household saving, both directly through its own saving and the structure of the tax, social security and welfare systems, and indirectly through the influence of the policy environment on factors that affect saving such as economic growth. The determinants of household saving in a sample of 21 OECD (Organization for Economic Cooperation and Development) countries are also investigated, using both cross-section and panel estimation techniques.


This Selected Issues paper examines the role that government policy in Australia plays in influencing household saving, both directly through its own saving and the structure of the tax, social security and welfare systems, and indirectly through the influence of the policy environment on factors that affect saving such as economic growth. The determinants of household saving in a sample of 21 OECD (Organization for Economic Cooperation and Development) countries are also investigated, using both cross-section and panel estimation techniques.

III. Recent Approaches to Institutional Reform of Monetary and Fiscal Policy In Australia1

A. Introduction

1. This chapter discusses the evolving approach to institutional reform of monetary and fiscal policy in Australia and contrasts this with recent reforms in other industrialized countries, particularly New Zealand. The reforms to monetary policy have been motivated by the desire to lock in low inflation, following the sharp reduction in the early 1990s that resulted from the 1990/91 recession and international competitive pressures. Further, given Australia’s poor track record on inflation in the 1970s and 1980s, the challenge facing the reforms was to strengthen the credibility of monetary policy in maintaining low inflation. Reforms to the fiscal policy framework were motivated by the steady increase in net Commonwealth debt in the early 1990s, and growing concerns about low public and national saving. Moreover, there has been an increasing focus on the fiscal implications of an aging population.

2. Australia’s institutional reforms of monetary and fiscal policies encourage the implementation of sound policy, with a strong medium-term focus, by emphasizing transparency and accountability. Medium-term objectives for monetary and fiscal policy have been established, but these objectives (or rules) leave significant flexibility for discretionary countercyclical policy action over the business cycle. For monetary policy, a target of achieving underlying inflation of between 2 and 3 percent, on average, over the cycle has been established. For fiscal policy, a Charter of Budget Honesty proposes broad principles to promote sound fiscal policy and, consistent with these principles, the government has stated the objective of achieving underlying budget balance on average, over the cycle.

3. The chapter first discusses monetary policy reform before discussing reform to fiscal policy. In each case, a brief historical background is presented before discussing the recent reforms in some detail. The institutional reforms are then compared with other industrialized countries, particularly New Zealand, which introduced far-reaching reforms in these areas over the past decade. The Australian authorities have benefited from the experience with reform in other countries, particularly New Zealand, and have refined the approach to meet their objectives.

B. Monetary Policy Reform

4. The framework for the operation of monetary policy is set out in the Reserve Bank Act 1959,2 which requires the Reserve Bank of Australia (henceforth the Reserve Bank) to conduct monetary policy in a way that will best contribute to the objectives of:

  • stability of the currency of Australia;

  • the maintenance of full employment in Australia; and

  • the economic prosperity and welfare of the people of Australia.

5. The Act does not specify quantitative targets for monetary policy but rather sets the broad objectives within which monetary policy is operated.

Reserve Bank independence

6. The Reserve Bank Act gives the Bank independence to formulate and implement monetary policy. However, the Reserve Bank did not achieve a significant degree of effective independence until the mid-1980s when financial market deregulation left the Bank in control of the most effective monetary policy instrument—open market operations (Box 1). The recent reforms to monetary policy did not involve any changes to the Reserve Bank legislation as the authorities believe that the Bank has sufficient independence to pursue its objectives. Moreover, in a joint statement by the Treasurer and the newly-appointed Governor of the Reserve Bank in August 1996, the government recognized the independence of the Reserve Bank and its responsibility for monetary policy matters as provided by statute. Further, the statement noted that the Bank is required to inform the government of the Bank’s monetary policy, but that the government would no longer make parallel announcements when the Reserve Bank implements monetary policy adjustments. The motivation for this change was to “enhance the perception, as well as the reality, of the independence of the Reserve Bank’s decision making” (Costello and Macfarlane, 1996).

7. Some international comparisons of central bank independence suggest that Australia ranks among the more independent central banks. Two of the more widely quoted studies (Grilli and others (1991) and Cukierman (1992)) rank Australia’s central bank independence among the top half of the OECD countries covered. Grilli and others (1991) rank Australia relatively high on the basis that: (1) the Governor is appointed for seven years; (2) the Reserve Bank Act requires the Bank to pursue currency stability; (3) the Act strengthens the position of the Bank in the case of a difference of views with the government; and (4) the Bank has control over the extent of monetary financing of the budget deficit and the setting of the official cash interest rate. However, Grilli and others (1991) do not rank the Reserve Bank’s independence as high as some other central banks because: (1) the Governor and board members are appointed by the government; (2) the board is not appointed for greater than five years; (3) the Secretary to the Treasury is on the Reserve Bank Board; and (4) the Reserve Bank is responsible for bank supervision.

8. A further study by Nolan and Schaling (1995) ranks Australia’s central bank independence relatively low. This assessment is based on the grounds that: (1) final authority does not rest with the Reserve Bank; (2) there is a government official (the Secretary to the Treasury) on the Reserve Bank Board; and (3) that appointments to the Reserve Bank Board are not made independently of the government.

9. The degree of independence of the Reserve Bank of Australia is greater than suggested by Nolan and Schaling (1995), and is more fairly reflected in the study by Grilli and others (1991).3 The Nolan and Schaling (1995) study does not take account of the effective degree of authority that the Reserve Bank has over decisions. While it is true that final authority for monetary policy decisions rests with the government and not with the Reserve Bank, as the government has the power to override the Bank’s decisions, the override procedures are highly public and politically demanding. These procedures have never been used, which reinforces the Reserve Bank’s independence.

10. Moreover, in assessing the independence of a central bank it is useful to distinguish between two forms of independence: goal independence and instrument independence.4 Goal independence allows the central bank to choose the goals of monetary policy while instrument independence lets the central bank pursue its goals in the manner it deems most appropriate. Making this distinction implies a relatively high degree of indepence for the Reserve Bank. The Reserve Bank Act gives the Bank independence to establish specific goals for monetary policy (consistent with the broad objectives of the Reserve Bank Act), as well as the independence to change the instrument, albeit with a government override. This is unlike the situation in New Zealand, where the goal is set by legislation but the central bank has instrument independence (also with a government override) and the United Kingdom, where the Bank of England has neither goal nor instrument independence.

Earlier monetary policy targets

11. The monetary policy framework in Australia has evolved significantly over the past few decades, with each of the objectives in the Reserve Bank Act assuming varying degrees of importance over time. Throughout the 1960s, monetary policy served primarily as a demand management instrument. With the onset of high inflation in the 1970s (Chart III.1), price stabilization emerged as a prominent objective of monetary policy: in 1976, an M3 target was adopted and announced regularly.5 This target was the Treasurer’s target and was announced in the budget speech with major decisions on monetary policy taken by the Monetary Policy Committee of Cabinet. However, the targets were seldom achieved. Following the deregulation of the financial markets, any existing stable relationship between money and nominal income broke down and, by early 1985, the M3 target was abandoned. The M3 target was replaced with a “checklist” of indicators, such as unemployment, that were indicative of the state of the real economy, as well as monetary aggregates, the inflation rate, the exchange rate, interest rates, and the balance of payments. However, high inflation remained a problem during the 1980s with average annual inflation of about 8 percent.



(Annual percent change)

Citation: IMF Staff Country Reports 1997, 023; 10.5089/9781451802016.002.A003

Source: Australian Bureau of Statistics

Evolution of the Reserve Bank’s Effective Independence

The Reserve Bank Act gives the Bank the power to independently determine monetary policy, consistent with the broad objectives of the Act, and take the action necessary action to implement policy changes. However, in the event of a dispute between the Reserve Bank and the Government over monetary policy, the Government may override the Reserve Bank by tabling objections before both Houses of Parliament

From the 1950s until the late 1980s, monetary policy was implemented as though the Reserve Bank had no independence. This arose because the Reserve Bank did not have the instruments of monetary policy at its disposal. Before deregulation of the Australian financial markets in the mid-1980s, the main way of influencing monetary policy was by influencing the way the deficit was financed, that is, by the setting of interest rates on government securities. This was entirely in the hands of the Treasurer. Bank lending and deposit rates were also centrally determined, ostensibly by the Reserve Bank, but changes required prior approval by the Treasurer. The monetary policy instrument that was wholly at the Reserve Bank’s disposal was the Statutory Reserve Deposit ratio. However, this was not an effective instrument as it had little effect on monetary conditions in circumstances where interest rates and the exchange rate were fixed.

It was not until financial deregulation was completed in the mid-1980s that the Reserve Bank gained a significant degree of effective independence to implement monetary policy. The deregulation swept away interest rate controls, freed up the exchange rate and made it possible to finance the budget fully at market-determined interest rates. The last interest rate ceiling on banks was removed in April 1986. This left open market operations, which effectively determined short-term interest rates, as the only monetary policy instrument. Such operations were entirely in the hands of the Reserve Bank, therefore giving the Bank the capacity to act independently in accordance with the Reserve Bank Act by the late 1980s.

The inflation-targeting framework

12. The adoption of inflation targeting in Australia entailed a shift in the Reserve Bank’s policy focus in the early 1990s, rather than a discrete change in the policy regime toward price stability as the key objective. It emerged as a pragmatic response both to a period in the late 1980s of confusing public debate on the role of monetary policy, and, more important, to a longer period in which inflation performance was unsatisfactory. While the approach was effectively in place by 1993, it was not widely publicized until 1994, when the Governor stated in a speech that monetary policy would be conducted to maintain an average underlying rate of “around 2–3 percent…over a run of years” (Fraser, 1994). Subsequently, the Reserve Bank defined the target more precisely as achieving underlying inflation of between 2 and 3 percent, on average, over the cycle.

13. The inflation target is defined in terms of underlying inflation, which is the rate of change of the headline consumers’ price index (CPI) adjusted for special factors that are judged to be either highly volatile or not directly related to excess demand pressures (such as changes in mortgage and consumer interest charges6 and in the prices of publicly provided items).7,8 The underlying measure was defined by the Treasury but is currently calculated and published on a quarterly basis by the Australian Bureau of Statistics. Although it retains a little over SO percent of the headline index, the underlying measure has followed the same trend as the headline index. For instance, over the seven years to September 1996, the underlying measure increased by 23.5 percent while the headline measure rose by 23.3 percent.

14. The inflation target is thought of as a desired “central tendency” for inflation, or “thick point,” rather than a narrow “target band” with upper and lower bounds. A number of considerations led the authorities to the adoption of this formulation. Due to the unpredictable behavior of prices and the difficulties involved in forecasting inflation, the margin of uncertainty surrounding a central inflation forecast over a year is estimated to be well over ±1 percentage point (Debelle and Stephens (1995)). The monetary authorities considered that an inflation target band wide enough to absorb shocks could be too wide to provide a useful anchor for expectations. Moreover, in light of the fact that no country has been able to consistently maintain inflation within a very narrow band (for example, 2 percentage points wide), the authorities considered a narrow band (with hard bounds), unrealistic and potentially damaging to their credibility.

15. In a recent speech, the Governor described the inflation target as essentially requiring that monetary policy should be conducted so that, in the medium term, inflation will average around 2½ percent per annum (Macfarlane, 1996). This new emphasis on the midpoint of the range, rather than the 2–3 percent range itself, was motivated by the wish to avoid the public perception that the operative target for inflation was at the high end of the range (around 3 percent).

16. The time frame over which underlying inflation is to be measured and the duration of deviations from the “central tendency” are not precisely specified in the framework. The authorities’ intention in this regard is to allow monetary policy some latitude in responding to fluctuations in output without prejudicing the medium-term inflation objective. In the authorities’ view, the formulation recognizes that there will still be a business cycle and that, in the fastest growing phases, there will be a tendency for inflation to exceed the medium-term objective, and at some other times to fall below it. It also recognizes that, in the event of a large shock, it is sensible to bring inflation back on track over time without causing undue real costs.

Institutional support for the inflation-targeting framework

17. Initially, the target was unilaterally adopted by the Reserve Bank, which exerted its statutory independence to formulate monetary policy, and was not a joint commitment with the government. The government subsequently endorsed the target on an informal basis. Significantly, the targets were supported by the peak labor union body, the Australian Council of Trade Unions, which agreed in the context of the June 1995 Accord VIII to keep wage claims in line with the Reserve Bank’s inflation objective. However, this support was later withdrawn, on the basis that the Accord agreement was no longer in place.

18. It was not until August 1996, on the occasion of the appointment of a new Governor (Mr. Macfarlane), that the target was formally endorsed by the (new) government in a joint monetary policy statement by the Governor and the Treasurer. The statement placed considerable emphasis on the price stability objective. It noted that the objectives of the Reserve Bank Act allow the Bank to focus on price stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Further, the statement recognized price stability as a crucial precondition for sustained growth in economic activity and employment. The statement included a formal commitment by the Governor to the target, supported by the government’s endorsement, and emphasized the role that disciplined fiscal policy must play in achieving the target.

19. The need for transparency and accountability to support achievement of the inflation target was highlighted in the joint policy statement. In recent years the Reserve Bank has taken steps to increase the transparency of its monetary policy operations. Most important, it moved to change interest rates in discrete steps and announce and explain these policy changes. In addition, the Reserve Bank increased its public commentary on the economic outlook and issues bearing on monetary policy, through public addresses and its regular quarterly report on the economy. Some further steps to improve transparency and accountability were announced in the joint policy statement of August 1996. First, the Reserve Bank will release regular (roughly six-monthly) statements on monetary policy and progress toward the Reserve Bank’s objectives. These statements will include information on the outlook for inflation. Second, the Governor will report twice a year to a Parliamentary select committee on the conduct of monetary policy (this is a formalization of the previous practice).

Credibility of the inflation target

20. Initially, the inflation-targeting framework did not appear to enhance the credibility of the Reserve Bank as there was no perceptible impact on inflationary expectations in 1993 and 1994. This may have been because the inflation-targeting approach had not been tested in Australia (or other countries) over a full business cycle, and it was not clear how the Reserve Bank would react in the face of demand pressures given its multiple objectives and poor record on the inflation front in the 1970s and 1980s. Further, there may have been concerns about the flexible nature of the targets, particularly the absence of limits on the extent or duration of deviations from the target range.

21. Recent actions by the Reserve Bank have reduced these concerns. In late-1994, the Bank reacted to strong economic growth that threatened achievement of the inflation objective by sharply tightening monetary policy (the official cash rate was raised by 275 basis points). As a result, the Bank was successful in limiting the extent and duration of the deviation of underlying inflation above 3 percent (the upper end of the target range), with year-on-year inflation peaking at 3.3 percent in March 1996 and exceeding 3 percent for only four quarters (September 1995–June 1996). By September 1996, inflation had fallen to 2½ percent, well inside the target range. This was achieved despite real GDP growth in excess of 4 percent on average in 1994/95 and 1995/96. The success in reducing inflation showed that even though the framework does not formally define the extent and duration of deviations permitted from the target range, in practice the authorities tolerated only limited deviations.

22. The joint monetary policy statement in August 1996 also helped strengthen the credibility of the Reserve Bank with the financial markets. The statement was well received as it served to clarify the responsibilities of the Government and the Reserve Bank with regard to monetary policy. The markets perceived that the statement strengthened the independence of the Bank and the credibility of the inflation targeting framework. The success in reducing inflation, combined with the monetary policy statement, and the announcement of the new government’s plan to balance the budget deficit, led to an effective re-rating of the Australian economy by the financial markets. In particular, the spread between Australian and U.S. bonds narrowed to about 100 basis points in late-1996, compared with 250 basis points a year earlier. However, the Reserve Bank has been less successful in building the credibility of the targets with business and consumer groups. Inflationary expectations among these groups are higher than for financial market participants and a “credibility gap” Of about 2½ percentage points persists between consumers’ inflationary expectations and the midpoint of the Bank’s target range (Box 2).

23. While the credibility of the inflation-targeting framework appears to have been enhanced, particularly in the financial markets, the framework has not yet faced a contractionary phase of the cycle. Such a contraction could give rise to a potential conflict between the medium-term price stability and full employment objectives, as pressures to loosen monetary policy for short-term gains come to bear. Further, the framework has not yet been tested by a supply-shock.

Comparison with inflation targeting in other countries

24. In recent years, there has been a growing trend toward the adoption of inflation targeting among industrial countries. Countries that have adopted official inflation targets in the 1990s include: Australia, Canada, Finland, New Zealand, Spain, Sweden, and the United Kingdom (see Table III.1 for details). As in Australia, the adoption of inflation targets in some of these countries (Canada, New Zealand, and Spain) took place after a period of poor performance with other regimes (such as monetary targeting), while in other cases (Finland, Sweden, and the United Kingdom), it was the response to an unexpected unhinging of an earlier managed exchange rate regime. The public announcement of inflation targets, along with measures to improve the transparency and accountability of monetary policy, has been undertaken in an effort to improve the credibility of the authorities’ commitment to price stability, and thereby lower the economic costs of achieving and maintaining low inflation. Those countries that already had an established record of low inflation, such as Germany and Switzerland, have not seen the need to adopt such a framework to enhance the already strong credibility of their commitment to price stability.

Table III.1.

Australia: International Comparison of Inflation Targets

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25. In contrast to some inflation-targeting countries (such as Finland and New Zealand) which announced targets during the disinflation process, the stronger public focus on inflation in Australia came after a significant fall in inflation had been achieved (with underlying inflation falling from almost double digits levels in the late-1980s to 2 percent in 1993). In other countries, the immediate task of inflation targeting was to reduce inflation to the targeted level, whereas in Australia the main task was to lock-in low inflation and condition expectations so that the gains for economic performance from low inflation could be achieved as early as possible.

Inflationary Expectations and Inflation Targeting

Inflationary expectations in Australia have fallen markedly over the past ten years (Chart III.2). Consumers’ inflation expectations1 fell sharply in the early 1990s, from about 10–11 percent in the late 1980s to average about 5 percent over 1991–96. The fall in expectations occurred in line with the fall in actual inflation, and there is no clear evidence that the adoption of inflation targeting in 1993 had a perceptible impact on consumers’ inflationary expectations. Expectations fell to a low of about 4 percent in mid-1994, following two years of annual underlying inflation of about 2 percent, before rising to about 5 percent in 1995, as both headline and underlying inflation rose. By end-1996, consumers’ expectations remained at about 5 percent, well above the Reserve Bank’s target of 2–3 percent, implying a “credibility gap” between the level of expectations and the midpoint of the target range of about 2½ percentage points.

Financial market expectations of inflation are more consistent with the Reserve Bank’s target The differential between the CPI indexed and non-indexed 10-year bonds (a proxy for financial market inflation expectations), fell from about 8 percent in the late 1980s to about 3–5 percent in 1991–95. At end-1996, the differential stood at 3 percent, down from about 4 percent in late-1995. Further, financial market economists surveyed by the Reserve Bank in July 1996 had a median forecast of underlying inflation for the year to June 1998 of 3 percent.

Business-sector inflationary expectations have been somewhat lower than consumers’ expectations but nonetheless higher than financial market expectations. According to the National Australia Bank September 1996 survey, almost 9 out of 10 respondents expect inflation to average less than 4 percent over the remainder of the decade. This proportion is slightly higher than that prevailing over 1993 and 1994, a time when actual underlying inflation was higher than in 1996, which is a tentative sign of growing credibility in the Reserve Bank’s target. However, only about one in four respondents expect inflation to average less than 3 percent.

1 Consumers’ inflationary expectations are measured by the Melbourne Institute/Westpac survey median expected inflation rate for the year ahead.


Citation: IMF Staff Country Reports 1997, 023; 10.5089/9781451802016.002.A003

Sources: Australian Bureau of Statistics; and Reserve Bank of Australia.1/ Calculated as the 10-year bond yield less indexed bonds.

26. The differences between Australia and other countries in the key areas of (1) legislative support for inflation targeting; (2) multiple versus sole objectives for monetary policy, (3) transparency and accountability; (4) the level of the inflation target; and (5) the target band and policy horizon are discussed below before drawing a comparison with the New Zealand approach.

Legislative support for inflation targeting

27. The extent of legislative and institutional support for inflation targeting has varied widely. Australia did not make any changes to the central bank legislation in support of the inflation targets, given the authorities’ view that the Reserve Bank Act provides support for inflation-targeting and gives the Bank sufficient independence. Similarly, Canada and the United Kingdom did not make legislative changes. This contrasts with New Zealand where the inflation targets were established as part of a thorough legislative reform. This included moving away from multiple objectives for monetary policy and legislating the goal of price stability as the prime function of the Reserve Bank of New Zealand as well as putting in place an independent and accountable central bank. In Spain, the adoption of targets was also accompanied by a greater degree of independence for the central bank, and Finland is considering greater central bank independence.

Multiple versus sole objectives for monetary policy

28. The multiple objectives of monetary policy in Australia’s Reserve Bank Act (currency stability, employment, and welfare) contrast most sharply with the focus on price stability in New Zealand’s 1989 legislation. In Australia, the concern about a strict inflation target is that in the event of an unfavorable supply shock there might be unacceptable adverse consequences for the real economy.9 In a recent speech, the Governor of the Reserve Bank reconciled the focus on inflation targeting in Australia with the other objectives by noting that “another way of expressing the inflation target is to say that monetary policy is set in a way which lets the economy grow as fast as possible without breaking the inflation objective, but no faster” (Macfarlane, 1996). He also added that “the most useful thing that monetary policy can do in the long run is to encourage sustainable low inflation expansions” (Macfarlane, 1996). In a similar vein, New Zealand recently revised the monetary policy targets’ agreement between the Governor and the Minister of Finance, as part of the December 1996 coalition agreement, without revising the Reserve Bank Act. The new agreement requires monetary policy to maintain price stability and thereby make its maximum contribution to sustainable economic growth, employment and development opportunities within New Zealand.

29. The Australian approach is in line with the argument presented by Green (1996) that the credibility of inflation targets may be enhanced by targeting output at a level consistent with nonaccelerating inflation. In this way, the framework addresses the underlying cause of the “inflation bias” in monetary policy by eliminating the monetary authorities’ incentive to engineer surprise inflation. Thus, in contrast to the “conventional wisdom” that a sole objective of price stability for monetary policy is required to strengthen the credibility of the inflation targets, a dual monetary policy objective may enhance the prospects for low inflation. Importantly, this approach is likely to be strengthened by the publication of the inflation projections along with projections of potential output. Such projections are not published by the Reserve Bank at present (as discussed below).

Transparency and accountability

30. While Australia has taken several steps to improve the transparency and accountability of the monetary policy framework (as discussed above), some countries have gone further than Australia. In particular, New Zealand and the United Kingdom have published regular reports on monetary policy which include official forecasts of quarterly inflation over a 2–3 year horizon (based on the current policy setting and a technical exchange rate assumption). In both cases, the forecasts have helped to signal the path of projected inflation consistent with achieving the objective. The Reserve Bank of Australia does not publish detailed forecasts of inflation or output as the authorities are concerned that the lack of precision in the forecasts and the unpredictable nature of prices could lead to large forecasting errors and thereby undermine the credibility of the Reserve Bank.10 Instead, the current practice of the Reserve Bank is to make statements about the outlook for inflation in broad terms without providing details of the quarterly track.

The level of the inflation target

31. The level of the inflation target in Australia is somewhat higher than in other inflation targeting countries. The midpoint of the target range for Australia (2½ percent) is one percentage point above the midpoint of the target range for New Zealand (revised upward recently from 1 to 1½ percent), and half a percentage point above the midpoint for Canada, Finland and Sweden. The targets for Spain (less than 3 percent by 1997 and below 2 percent from 1988 onwards) and the United Kingdom (below 2½ percent from spring 1997 onwards) are more comparable with Australia, but given that these are upper bounds with no lower bounds specified, these specifications imply a lower level of targeted inflation than in Australia. The Australian authorities consider that the target of 2–3 percent could be revised downwards in the future, if other industrialized countries achieved inflation outcomes more consistent with a lower inflation target.

32. The authorities consider that the optimal target for inflation in Australia is likely to be above zero given the downward inflexibility of nominal wages and upward bias in the CPI. Downward rigidity in nominal wages arises from the existence of the system of awards in Australia that provides a floor for the terms and conditions of employment (see Chapter Π for a discussion of the labor market in Australia). However, it is possible that wages would become more flexible as a result of the recent reforms to industrial relations. Furthermore, a longer period of price stability would likely alter inflation expectations and wage contracting habits.

33. The upward price index measurement bias creates a wedge between the optimal inflation target in theory and in practice. However, the bias in the CPI is estimated to be as low as 0.3 percent per annum in Australia due to the regular rebasing of the index. This contrasts with estimates of about 1 percent in New Zealand (Reserve Bank of New Zealand, 1996) and ½ to 1 percent for Canada (Wynne and Sigalla, 1996).

The target band and policy horizon

34. The inflation-targeting framework in Australia is more flexible and less hard edged than in many countries. Most other inflation-targeting countries specify upper bounds (and sometimes lower bounds) for the inflation target—the exception is Finland which has no explicit target band but simply has a point target. Further, most other countries specify the time frame for achieving the target more definitively than in Australia. For instance, in New Zealand the target is specified as achieving annual inflation of 0–3 percent, while in Sweden the target is annual inflation of 2 percent with a tolerance of ± 1 percent.

35. The authorities consider that they have learned from the experience of other countries with inflation targeting and that this is reflected in their framework. In particular, the Australian authorities noted that their concerns about the threat to credibility when upper bounds are breached have been reinforced by the experience in New Zealand when the upper bound of 2 percent inflation was exceeded by a small amount in 1995 and 1996 (and was subsequently increased to 3 percent). Further, the Australian view that the price stability should be achieved on average over the cycle rather than over a shorter time frame has also been reinforced by the New Zealand experience, given that the breach of the inflation target in New Zealand was largely a result of price pressures during an expansionary phase of the business cycle.

Comparison with the New Zealand approach

36. The relative merits of the Australian and New Zealand approaches are difficult to assess. In principle, New Zealand’s stronger commitment to price stability, supported by greater transparency and accountability could give its monetary policy greater credibility. Against this, the approach involves reversing deviations relatively quickly, which could theoretically prove damaging for growth in the short term at least, and possibly undermine credibility.

37. The differences between the Australian and New Zealand approaches are not as significant in practice as implied by the formulation of the targets. In New Zealand, temporary and limited deviations from the target band are tolerated. The target band is seen as the objective which monetary policy aims at achieving, but which will, at times, be missed due to the “inevitable uncertainties in forecasting and lags in the effectiveness of monetary policy” (Reserve Bank of New Zealand, 1996). In Australia, the authorities only tolerated relatively limited deviations from the target in 1995 and early 1996, during a period of strong economic growth, even though the extent and duration of deviations are not precisely defined in the framework. This suggests that, in practice, the target is more hard edged than formally defined in the framework.

38. The empirical evidence in assessing the two approaches is not conclusive. Australia’s underlying inflation rate has averaged 2.4 percent over the past four years, in line with the mid point of the target range, and was only about 0.6 percentage points higher than in New Zealand, where the midpoint of the target range (1 percent during this period) was exceeded by about 0.8 percentage points (Chart III.3). While monetary conditions were tightened more sharply in New Zealand than Australia during 1993/94 and 1994/95 (with a sharper rise in the real exchange rate and higher short-term interest rates in New Zealand) it is not clear that this involved sizable real costs. Real output grew at similar rates on average over the past four years (albeit with lower growth in New Zealand in 19%) and unemployment fell further in New Zealand. On the credibility front, somewhat lower long-term real interest rates in 1994/95 in New Zealand suggest a greater degree of credibility in macroeconomic policy at that time, but this turned around in 1995/96 as Australia’s real long-term rates fell more sharply than in New Zealand (Chart III.4). In the main this reflected the growing confidence in Australian policy rather than any concerns about New Zealand policy. Further, the “credibility gap” between consumers’ inflation expectations and the midpoint of the targets was about 2½ percent for both countries.



Citation: IMF Staff Country Reports 1997, 023; 10.5089/9781451802016.002.A003

Sources: Australian Bureau of Statistics; and New Zealand Department of Statistics.1/ Excludes Brazil.


(In percent)

Citation: IMF Staff Country Reports 1997, 023; 10.5089/9781451802016.002.A003

Sources: Australian Bureau of Statistics; and New Zealand Department of Statistics.1/ 10-year government bond rate less underlying Inflation.

39. In the final analysis, the various approaches to inflation targeting, as well as the overall approach itself, should be assessed on the basis of the success in achieving and maintaining low inflation without undue economic cost. Even though Australia’s inflation targeting framework is somewhat more flexible than in many other inflation-targeting countries and does not have the same extent of legislative and institutional support as in some cases, Australia’s success in achieving relatively low inflation in recent years is comparable with that for other inflation-targeting countries. In the past four years, Australia’s headline inflation rate averaged 2.8 percent compared with 2.6 percent for the five other industrial countries11 that adopted inflation targeting and about 2 percent for a control group of five other OECD countries12 that did not adopt inflation targeting (all on a headline basis, Chart III.5).13 Further, a recent study suggests that the inflation-targeting countries were successful in achieving or maintaining a regime shift toward low inflation and that the costs of such a shift were not obviously higher than in non inflation-targeting countries (Box 3).



(In percent)

Citation: IMF Staff Country Reports 1997, 023; 10.5089/9781451802016.002.A003

Sources: Australian Bureau of Statistics; and IMF, WEO database.1/ Includes Finland, New Zealand, Spain, Sweden, and United Kingdom.2/ Includes France, Germany, Japan, Switzerland, and United States.

Have Inflation Targets Made a Difference?

While it is clear that inflation has fallen in the inflation-targeting countries, it is less clear whether this can be credited to the targeting approach or would have been achieved in the absence of inflation targets, in line with the fall in inflation in other major economies. Furthermore, the approach has raised concerns about whether the inflation targets have been achieved at the expense of excessive costs to the economy in terms of lower output or greater volatility of output.

In a recent study, Haldane (1996) presents some evidence of a regime shift in the inflation performance of inflation-targeting countries as a result of the adoption of the targets. This is based on the observations that (1) mean inflation fell significantly in the inflation targeting countries between the periods before and after the adoption of the targets; and (2) the significant differences in mean inflation between the inflation targeting countries and a control group of non inflation-targeting countries (France, Germany, Japan, Switzerland, and the United States) before the introduction of the targeting framework disappeared in the period following the introduction of the targets (see table below). Even though inflation had fallen in some countries before the adoption of the targets, the approach helped maintain low inflation.

Haldane also observes that there is little evidence of the mean or variability of output having been adversely affected by the disinflation in the inflation-targeting countries. For both sets of countries (see table below), there is evidence that output variability increased more recently, with no evidence that the inflation-targeting countries have fared worse.

Further, the study presents measures of the sacrifice ratio, defined as the ratio of the cumulative loss in output over the period 1990–1995 to the difference in average inflation between the periods 1980–89 and 1990–95 for each country (assuming trend growth of 2.5 percent per annum for all countries). The sacrifice ratios vary greatly, with estimates as low as 0.12 percent for Australia and as high as 4.6 percent for Japan.1 While there is no obvious pattern, it is clear that the disinflation in inflation-targeting countries has been no more costly than in the non-inflation-targeting countries.

While the evidence tends to suggest that the inflation-targeting approach has made a difference, without involving excessive real costs, the experience with the approach has been relatively short None of the inflation-targeting countries have experienced a full business cycle or a range of shocks, and the true test of the approach will come over time. Further, there may be a sample-selection bias in the analysis, as only those countries with relatively poor track records of inflation adopted the inflation-targeting approach and the success in reducing inflation may have been more to do with a growing consensus for firmer monetary policy rather than the inflation-targeting approach itself.

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1 The sacrifice ratio estimates for inflation-targeting countries are: Australia 0.12; Canada 1.69; Finland 3.95; New Zealand 0.6; Sweden 4.41; Spain 0.89; and United Kingdom 3.29. The estimates for non-inflation-targeting countries are: France 1.21; Germany 4.29; Japan 4.63; and the United States 0.67.

C. Fiscal Policy Reform

40. While Australia has relatively low public debt and deficits by OECD standards, reforms to the fiscal policy framework in Australia were motivated by the steady increase in net Commonwealth government debt in the early 1990s as a result of sizable fiscal deficits and growing concerns about the continued low level of public and national saving. Further, there has been increasing focus on the fiscal implications of an aging population in recent years.

41. The public sector in Australia consists of the Commonwealth, state and territory, and local government sectors. A key characteristic of Australian fiscal federalism is the imbalance between the revenue-raising capabilities and expenditure responsibilities at each of the three levels of government.14 The Commonwealth has been able to exercise an important degree of control over the consolidated public sector though its role in determining the overall level and allocation of grants to the states and its traditional influence on the magnitude and allocation of borrowings by state and local governments. Nevertheless, the fiscal policies of the state and local governments continue to be an important determinant of the budgetary position of the Australian public sector. A deterioration of the fiscal situation at the state level in the early 1990s prompted a considerable degree of institutional reform (Box 4).

Earlier fiscal reforms at the Commonwealth level

42. Australia has traditionally had a budget process that functions well and is relatively transparent. Many of the current features are a result of earlier efforts to improve the transparency of fiscal reporting. The most significant of these reforms was the introduction of rolling multi-year forward estimates in the mid-1980s. The forward estimates present the expected path of the budget under the assumption of no new policies over a three-year horizon and thereby increase the awareness of the medium-term implications of fiscal policy action. Furthermore, the starting point for budgeted expenditure is the level included in the previous forward estimates for that year and a reconciliation of the budget with the forward estimates is required. The distinction made in this reconciliation between policy and parameter variations transparently presents the extent of the two influences on the fiscal position.

43. A further reform introduced in the mid-1980s was the adoption of a “trilogy” of targets for Commonwealth government outlays, revenue and the deficit relative to GDP. The “trilogy” established the macroeconomic framework for the budget. When the forward estimates for that year (updated for changes in economic parameters, but assuming no policy changes) were compared with the “trilogy” of targets, this helped the Cabinet determine the extent of policy action in the budget necessary to achieve the “trilogy.” Improvements in public administration were also introduced in the 1980s through the Financial Management Improvement Program which helped devolve departmental responsibility, established management incentives, and granted some management flexibility.

44. Other reform measures that were taken to improve transparency include the publication of: (1) the National Fiscal Outlook which presents a consolidated picture of Commonwealth and states’15 fiscal position, along with their fiscal strategies; (2) information on unfunded employee entitlements for the Commonwealth and the states; (3) details of annual tax expenditures (including significant tax concessions for superannuation savings and research and development); and (4) the underlying deficit measure,16 so as to exclude the impact of large one-off transactions.

The Charter of Budget Honesty

45. In a major step to reform the institutional framework for fiscal policy, the new government recently introduced the Charter of Budget Honesty Bill to Parliament.17 The Charter proposes greater discipline, transparency, and accountability in government fiscal policy, along the lines of New Zealand’s Financial Responsibility Act (FRA) which was introduced in 1994 (see below). Like the FRA, the Charter does not prescribe quantified fiscal targets, as the international experience with such targets was disappointing (Box 5), but it does require that the government’s fiscal strategy be based on broad principles for sound management of fiscal policy.18 These principles require the government to:

Institutional Reform of Fiscal Policy at the State Level

In the early 1990s, the budgetary position of the Australian states deteriorated sharply, largely due to the recession in 1990/91, the collapse of the commercial real estate sector, and the financial difficulties experienced by some state-owned financial institutions. In response, most states implemented fiscal consolidation strategies based on public enterprise reforms, asset sales, and significant reductions in public sector employment which were successful in improving their fiscal positions.1 A key aspect of the reforms was the adoption of fiscal strategies that had a medium-term focus. These strategies have been published annually for the past four years in the National Fiscal Outlook (a report prepared for the annual Commonwealth heads of government meetings). The National Fiscal Outlook also presents medium-term projections of the Commonwealth and state government sector finances.

In New South Wales (NSW), the fiscal strategy has been built into the state’s legislation through the adoption of the General Government Debt Elimination Act in 1995 which sets out mandatory fiscal reporting requirements and non mandatory short, medium and long-term fiscal targets. The long-term target is to eliminate net debt for the general government sector by 2020. The Act also establishes fiscal principles, including: adherence to fiscal targets; maintaining or increasing government net worth; funding employer superannuation liabilities; properly maintaining physical assets; constraining growth in net costs of services and outlays; prudently managing risks, and restraining tax levels. The government is able to depart from the principles but only on a temporary basis. The Act also requires that government reporting be on an accrual basis, in line with generally accepted accounting standards (this has been the practice for several years).

Although other states have not legislated their fiscal strategies, they have adopted strategies that focus on a range of fiscal indicators. For instance, Victoria aims to reduce state debt to levels consistent with an AAA rating (it currently has an AA rating), while reducing the tax burden closer to the average of the Australian states, delivering high quality government services at least cost, and investing in sufficient infrastructure. The fiscal strategies for Western Australia and Tasmania include reducing debt to more prudent levels, while Queensland’s includes retaining the lowest tax burden among the states.

Until the mid-1980s, all public sector borrowing was conducted by the Commonwealth government, which transferred funds to the states through the Loan Council (a body formed by the Commonwealth and states in the 1920s), giving the Commonwealth a degree of control over the potential size of states’ deficits. In 1984, the states were given greater freedom to borrow on their own behalf, with the Loan Council placing “global limits” on overall public sector borrowing. However, deregulation of Australian financial markets in the 1980s and state budgetary stress in the early 1990s resulted in the states circumventing these limits. The global limits were abolished in 1992/93 and in its place the Loan Council adopted procedures that seek to introduce broader-based macrocconomic controls on the operations of the public sector. Under the new arrangements, the Commonwealth and each state government are required to present their net financing requirements to the Loan Council. If an adjustment is necessary to meet national macrocconomic objectives, there would be a negotiation within the Loan Council. The greater market discipline on borrowing resulting from the new arrangements has led to an increase in reporting requirements for the states.

1 For a fuller discussion of the states’ recent budgetary performance, refer to Chapter IV of Australia: Recent Economic Developments, 1997.
  • manage risks faced by the Commonwealth prudently,19 having regard for economic circumstances, including by maintaining Commonwealth general government debt at prudent levels;

  • ensure that fiscal policy contributes to achieving adequate national saving and to moderating cyclical fluctuations (taking account of the economic risks facing the nation and the impact of those risks on the government’s fiscal position);

  • pursue spending and taxing policies that are consistent with a reasonable degree of stability and predictability in the level of the tax burden;

  • maintain the integrity of the tax system; and

  • ensure that its policy decisions have regard to their financial effects on future generations.

46. The authorities noted that the principles take account of the need to address short-term issues, such as moderating cyclical fluctuations, while recognizing the importance of medium-term issues such as the sustainability of government debt and national saving.

47. While no specific targets are included in the Charter, the government has separately adopted a fiscal program that targets achievement of an underlying budget balance “over the cycle,” which is consistent with the principles of the Charter. At the heart of the program is an improvement in the underlying budget position from a deficit of 2 percent of GDP in 1995/96 to near balance in 1997/98 and a surplus of 1 percent of GDP in 1999/2000. The “balance over the cycle” rule should reverse the trend rise in the Commonwealth net debt ratio, which has increased from 4 percent in 1989/90 to 21 percent in 1995/96. No quantified target for a “prudent” level of debt has been set by the government, either in the Charter or its fiscal program. Nevertheless, the government’s program implies a fall in net debt to about 13 percent of GDP by the turn of the decade.

International Comparison of Charter of Budget Honesty

Largely to correct the deficit bias experienced almost worldwide over the past decades, a number of countries have adopted, or are planning to adopt, rules that impose a permanent constraint on fiscal variables. Specifically, the rationale for fiscal rules rests primarily on the need for macrocconomic stability, support for other financial policies, long-term sustainability, reduction of negative spillovers under a common currency and policy credibility. A variety of rules have been adopted or proposed, including reduction of, or limits on, the public debt-GDP ratio, limits on the fiscal deficit, prohibition on domestic borrowing by the government, and prohibition or limit on government access to central bank credit. Institutional arrangements implementing fiscal rules vary over a wide spectrum, including constitutional provisions, legal statutes, administrative guidelines and custom, without a clear pattern regarding effectiveness of the rule.

Federal approaches to deficit reduction in the United States were initiated with the Balanced Budget and Emergency Deficit Control Act of 1985 (commonly referred to as the Gramm-Rudman-Hollings Act). This Act set specific targets for each fiscal year from 1986 through 1991, aiming at eliminating the deficit by that date. Those targets, however, were not achieved because the Act: did not include effective provisions for enforcing automatic cuts to meet targets; protected most important programs from cuts; and did not contain a mechanism to take account of the impact of forecast revisions on the deficit. The Act subsequently was ruled unconstitutional and amended in 1987. The successive Budget Enforcement Act of 1990 shifted the focus from deficit targets to controls on receipts and expenditures on a multi-year basis. A more far-reaching balanced budget amendment to the constitution, which has been proposed on several occasions in the past (for example, in 1982 and 1995) but so far been rejected, would require the government to balance the federal budget each year.

In Japan, fiscal policy controls relate to legislative restrictions on issuing bonds. Bond issues are limited under the Public Finance Law to financing public infrastructure. Deficit-financing bonds can also be issued, but special legislation is required by the Diet. In Germany, the 1949 Constitutional Law (Grundgesetz) requires a current balanced budget, and limits borrowing to investment expenditure. The 1967 Growth and Stabilization Law requires a five-year rolling financial plan. In the United Kingdom, since 1993 the government has operated a Medium-Term Financial Strategy, within which the government’s current fiscal objective is to bring the deficit back to balance over the medium term.

In New Zealand, the Fiscal Responsibility Act (FRA) was passed in 1994. This legislation (which is discussed further in the text) is one of the most far-reaching efforts to impose transparency and discipline on fiscal policy at the national level. Australia’s Charter is modeled on the FRA.

The Maastricht Treaty on European Union is the only example of a “supra-national” control of fiscal policies. The criteria against which a country demonstrates a sustainable financial position are that its budget deficit should be no more than 3 percent of GDP and that its debt not more than 60 percent of GDP, to be measured by the European Commission. Penalties, such as fines and non-interest bearing deposits with the Community, are set for those countries which will adopt a common currency if they breach the criteria.

48. A crucial premise of the Charter is that increased transparency will promote prudent fiscal policy and better fiscal outcomes. To this end, the Charter requires a high degree of transparency in fiscal reporting. A fiscal strategy is to be published with each budget explaining the long-term fiscal objectives within which shorter-term fiscal policy would be framed and laying out the broad strategic priorities for the budget. It would also specify, for the budget year and the following three financial years, the government’s fiscal objectives and targets, and explain how the objectives and strategic priorities relate to the principles of sound fiscal management. Further, the fiscal strategy would need to specify policy actions taken (or to be taken) by the government that are temporary in nature and are adopted for the purpose of moderating cyclical fluctuations in economic activity. The government is also required to indicate the process for the reversal of such countercyclical policy actions.

49. A midyear economic and fiscal outlook report and a final budget outcome report are to be prepared. These reports would provide updated information to allow an assessment of the government’s fiscal performance relative to that laid out in its fiscal strategy.

50. The Charter requires the Treasury and Department of Finance to prepare a preelection report providing an updated assessment of the fiscal and economic outlook within 10 days of an election being called. Further, the Charter provides for more equal access to Treasury and Department of Finance costings of election commitments by the government and Opposition in the run-up to an election.

51. In addition, an intergenerational report will be produced every five years to report on the long-term sustainability of current fiscal policies over 40 years. This reflects the concerns about the increasing fiscal pressures from the projected increase in dependency ratios in the future. The first report is likely to be available by end-1997.

Comparison with New Zealand’s institutional reforms

52. The Charter is modeled on New Zealand’s Financial Responsibility Act (FRA) 1994, which was the culmination of over a decade of public sector reforms (see Cangiano, 1996 and Scott, 1996) Neither the Charter nor the FRA prescribe quantified fiscal targets. However, both impose fiscal discipline by setting out broadly similar principles for responsible fiscal management as legislative benchmarks (see Table III.2). The Charter goes beyond the FRA in certain areas. In particular, it requires fiscal policy to contribute to adequate national saving, moderate cyclical fluctuations, and take account of the financial impact on future generations—such principles were not included in the FRA.20 These extensions to the FRA were motivated by concerns in Australia about the sustainability of national savings (and the current account deficit), particularly given the aging of the population, while recognizing that the medium-term focus of fiscal policy cannot ignore the business cycle.

Table III.2.

Australia: Comparison of Principles in Charter of Budget Honesty with New Zealand’s Fiscal Responsibility Act 1994

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53. The FRA is more specific on how prudent levels of debt should be achieved and maintained than is the Charter. The FRA requires the Government to reduce crown debt to prudent levels by ensuring fiscal surpluses until this is achieved. Thereafter, debt is to be maintained at this level by balancing operating expenses and revenues, on average, over a reasonable period of time. In Australia, the Charter simply requires the maintenance of Commonwealth general government debt at prudent levels and there is no intention to specify how this is to be achieved. In part, this reflects the higher net public debt in New Zealand than Australia at the time the FRA was introduced.21 Rather, in Australia, the specification of the fiscal strategy will be the responsibility of the government of the day, but must be consistent with the principles of the Charter. The new government has set the target of achieving underlying budget balance over the cycle, which is similar to the principle in New Zealand’s FRA of a balance on average over a reasonable period of time (once debt is lowered to a prudent level in New Zealand by running operating surpluses until this is achieved).22


54. The Charter and the FRA take the same general approach to fiscal reporting. Both require a high degree of transparency in fiscal reports in order to facilitate accountability. In New Zealand, the broad fiscal strategy is outlined in the Budget Policy Statement which is comparable to Australia’s Fiscal Strategy Document and regular updating of the fiscal outturn and outlook is required in both countries. However, there are several differences in the approach taken on fiscal reporting (which are summarized in Table III.3). In part, the differences reflect the fact that the FRA was the culmination of many years of public sector reforms (see Box 6), whereas earlier reforms in Australia were not as far-reaching. For instance, in New Zealand, the Public Finance Act of 1989 introduced generally accepted accounting practice (GAAP), including accrual accounting, for financial reporting of all government departments and agencies. This allowed the FRA to make GAAP mandatory for all government reporting and projections, with only a small additional investment. In Australia, the current system is based on cash-reporting, but the Charter is formulated to accommodate a shift to accrual-based fiscal reporting and a study of the costs and benefits of moving to such a system is under way at present.23

Table III.3.

Australia: Comparison of Fiscal Reporting in the Charter of Budget Honesty with New Zealand’s Fiscal Responsibility Act 1994

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55. A key difference between the Charter and the FRA is the broader coverage of government activities in New Zealand. Reporting under the FRA covers the whole of government (including the core central government, the Reserve Bank, state-owned enterprises, and crown agents) whereas the Charter covers the Commonwealth general government only. In New Zealand, the relatively small size of the government and the absence of any state governments facilitated a comprehensive approach. In Australia, this would be a more complicated task, particularly given the substantial and independent role of the state governments. Nonetheless, the lack of comprehensive coverage of the Charter leaves open the possibility that the Commonwealth could achieve its fiscal objectives by cutting support to the states. However, the greater transparency in Commonwealth fiscal reporting that will result from adoption of the Charter, and the continued publication of the National Fiscal Outlook (which presents fiscal projections for the Commonwealth and states combined), provide a check on such behavior.

Further reforms under consideration

56. Consistent with the Charter the government is considering the introduction of further reforms to improve the quality, transparency and public accountability of government activities. A number of proposals were laid out in a recent discussion paper (Reith, 1996), in line with the recommendations of the National Commission of Audit Report (1996). The proposals include the introduction of:

  • a Charter of Government Performance, which would require the definition of outcomes sought by the government for each portfolio. Performance plans would also be required for each portfolio, and performance and output benchmarks established.

  • public performance agreements for heads of government agencies would be established to hold agency heads accountable for performance relative to benchmarks;

  • a Government Service Charter would set out the nature and level of service clients can expect to receive and establish service quality, alongside efficiency and effectiveness, as key evaluative criteria for performance; and

  • reforms to work practices in the public service. This would include simplifying the public sector award (which lays out the terms and conditions of employment) and replacing the hierarchical control structure with more team-based arrangements.

New Zealand: Public Finance Reform Leading up to the Fiscal Responsibility Act, 1994

During the decade 1984–94, New Zealand implemented one of the most comprehensive reorganizations of the public sector in the postwar period. The reforms emphasized transparency and accountability at all levels of government and attempted to put the relationship between ministers and government departments on a more commercial footing. The Public Finance Act of 1989 introduced a number of new concepts, such as a distinction between outcomes and outputs; the separation between government as a whole (the Crown), who purchases outputs, and individual departments, who provide outputs; performance agreements; and generally accepted accounting practice (GAAP).

Outcomes are defined as “impacts on, or consequences for, the community of the … activities of the Government.” Ministers individually and the cabinet collectively are responsible for defining the outcomes for which they will be held accountable to parliament and, ultimately, the electorate. Outputs are defined as “goods and services that are produced by a department… or other person, or body.” This distinction is the basis for the accountability relationships between ministers and chief executives of departments.

Performance agreements with heads of individual departments were introduced to hold the department head responsible for producing key outputs. The ministers remained responsible for the key outcomes. This distinction gave the minister an interest both as a purchaser of outputs from the department and in the ownership of the department.

New Zealand was the first, and so far the only, country where the government produces its accounts completely on an accrual basis (consistent with the GAAP, and including a balance sheet with a measure of net worth). This approach makes the assessment of the financial performance and position of the government more transparent. In particular, it clearly indicates whether movements in the government’s net worth are caused by a shift in the balance between capital consumption and new investment or whether the government is depleting its net worth to sustain current consumption.

New Zealand based the costing of outputs on a profit-center approach, which attempts to measure the full costs of producing outputs (including capital charges), on an accrual basis. This approach enabled the budgetary process to be improved with the introduction of a Cabinet Expenditure Review Committee which aimed at control of government expenditure. The emphasis on outputs and transparent reporting meant that ministers had meaningful information on services provided by their departments and were in a much stronger position to make an informed tradeoff between competing priorities.

57. As noted by the National Commission of Audit Report (1996), these reforms have considerable potential for efficiency gains. Further, the thrust of the reforms is similar to those introduced in New Zealand heading up to the FRA, which have proved effective in enabling ministers to make better informed decisions.

D. Conclusion

58. The recent institutional reforms of monetary and fiscal policy in Australia have aimed at establishing credible medium-term targets while retaining the flexibility to take short-term countercyclical policy action. The focus on achieving inflation of 2–3 percent, on average, over the cycle, is more flexible and less hard edged than in many other countries that pursue inflation targeting. The Charter of Budget Honesty is similarly more flexible than the specific fiscal rules adopted elsewhere. However, the Charter does not define specific objectives in the way that the inflation target is defined. This reflects the fact that the medium-term objective of price stability for monetary policy is widely accepted and relatively easy to define, whereas the medium-term objectives for fiscal policy are more difficult to define, requiring judgements about the appropriate level of public indebtedness. Consequently, the Charter includes broad principles for sound fiscal policy management rather than specific targets. The specific targets are left to the government of the day to define. Consistent with the Charter, the new government has committed itself to achieving an underlying budget balance, on average, over the cycle, which parallels the approach taken in defining the policy horizon for the inflation target.

59. The adoption of a strong medium-term focus on price stability and prudent fiscal management, combined with the early success of the inflation-targeting framework in bringing inflation quickly back within the target range in the past year, has enhanced the credibility of monetary and fiscal policy. As a result, the financial markets have effectively re-rated Australian assets in the past year. Further, there are signs that inflation expectations have fallen among financial market participants, although expectations remain above the Reserve Bank’s target among consumers and business groups.

60. While the institutional reforms to monetary and fiscal policy strengthen the credibility of macroeconomic policy, the reforms themselves will not guarantee achievement and maintenance of low inflation and prudent public debt levels over time. The strength of the authorities’ commitment to firm policies will be a more important factor in this regard. In particular, the authorities will need to make careful use of the flexibility to take countercyclical monetary and fiscal action built into the framework, to ensure that the focus on the medium-term objectives is not lost and that the credibility of the framework is not undermined. Moreover, even though the inflation-targeting framework has performed relatively well during the recent period of strong demand pressures, it is not yet clear whether the Australian approach to inflation-targeting is preferable to that adopted in other countries. Further, the framework has not yet faced a supply-side shock or the contractionary phase of the cycle which could give rise to a potential conflict between the Reserve Bank’s price stability and full employment objectives.


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This chapter was prepared by Ray Brooks. The discussion of fiscal policy reform draws on an unpublished paper by Gloria O. Pasadilla, who was a summer intern in the Fund during 1996. The paper also builds on earlier work in this area that was presented in the background paper on Selected Issues for the 1995 Article IV consultation with Australia (SM/96/62, 3/14/96).


The essentials of this Act were already in the Commonwealth Bank Act of 1951.


It should be noted that all three studies of independence are somewhat dated and do not take account of the changes in New Zealand in 1989 and France and Spain in 1994.


This distinction was first introduced by Debelle and Fischer, 1994.


M3 in Australia is defined to include currency plus all bank deposits of the private nonbank sector. Broad money is M3 plus borrowing from the private sector by nonbank financial institutions less the latter’s holdings of currency and bank deposits.


The Australian Bureau of Statistics includes mortgage rates directly in the headline CPI, with a weight of about 6 percent. Mortgage rates are closely related to short-term interest rates, as most mortgages in Australia are of the floating rate type. As a result, changes in monetary policy tend to have a pronounced effect on the CPI.


The Treasury underlying CPI is derived by excluding the following items from the CPI basket: meat and seafood, fresh fruit and vegetables, clothing, government-owned dwelling rents, mortgage interest charges, consumer credit charges, local government rates and charges, household fuel and light, automotive fuel, postal and telephone services, urban transportation fares, tobacco and alcohol, health services, Pharmaceuticals, holiday travel and accommodation, and education and child care.


Tax effects are not excluded from the measure of underlying inflation, but are deducted by the Reserve Bank from time to time as one-off changes in the price level to obtain a “true” underlying measure (“ongoing inflation”) which reflects the balance between supply and demand conditions in the economy.


In the case of a demand shock, for example, an unanticipated increase in aggregate demand, the monetary policy response—raising interest rates—would serve the dual purposes of slowing activity and lowering inflation. However, in the case of a supply shock, for example, an unanticipated fall in aggregate supply, monetary policy aimed at dampening inflation would tend to exacerbate the shortfall in output.


In part, the United Kingdom has attempted to address concerns about forecasting errors by publishing the forecasts complete with confidence ranges. The latest Inflation Report (Bank of England, November 1996), presents a central projection for inflation of 2½ percent by end-1997, and estimates a 70–80 percent chance that inflation will be in the range of about 1½–3½ percent by end-1997.


Canada, Finland, New Zealand, Sweden, and the United Kingdom.


France, Germany, Japan, Switzerland, and the United States.


Headline inflation rate are used in the comparison, even though this is not the variable targeted in Australia or several other countries, as underlying inflation rates are not available for all the countries included.


The Federal fiscal structure is discussed in more detail in the background paper on Selected Issues for the 1995 Article IV consultation (SM/96/62, 3/14/96).


The terms “states” is used in this chapter to denote the six states and two territories of Australia: New South Wales, Queensland, South Australia, Tasmania, Victoria and Western Australia, and the Northern Territory and Australian Capital Territory.


The underlying budget balance is defined as the headline balance less equity transactions (particularly privatization receipts) and net policy lending.


The bill may be enacted by mid-1997.


This contrasts with the legislation introduced in NSW in 1995, which targets zero net public debt by 2020. However, the NSW legislation also includes principles for sound fiscal policy similar in many respects to the Charter (Box 4).


The financial risks referred to include: risks arising from excessive net debt; commercial risks arising from ownership of public trading enterprises and public financial enterprises; risks arising from erosion of the tax base; and risks arising from the management of assets and liabilities.


In New Zealand, while there is no principle outlining a counter cyclical role for fiscal policy, the FRA permits the government to depart from the principles in the FRA, provided it explains its reasons and indicates how, and within what time frame, it plans to return to them. The requirement for an explicit explanation of temporary departures from the medium-term objectives of fiscal policy is also a feature of Australia’s Charter, as is the need for an explanation of how these temporary departures would be reversed.


Net public debt in New Zealand was 43½ percent of GDP at end-June 1994, the year the FRA was introduced. It has since fallen to 32½ percent of GDP at end-June 1996. This compares with net Commonwealth government debt in Australia of 21 percent of GDP in 1995/96, up from 4 percent in 1989/90 (including unfunded employees entitlements would raise the ratio to 35 percent of GDP at end-June 1996).


In New Zealand, the balance is defined as the difference between operating expenses and revenues, based on accrual accounting, whereas in Australia cash accounting concepts are used.


The National Commission of Audit (1996) recommended that the Commonwealth government formally adopt accrual accounting as the basis for financial reporting. It recommended that the 1998/99 Budget be presented on an accrual basis, following a move to full accrual accounting by December 1997. The Commission also prepared a trial “whole of Commonwealth government” financial report for 1994/95, based on entities that report to Parliament on an accrual basis. This included a trial “balance sheet” for end-June 1995.

Australia: Selected Issues
Author: International Monetary Fund
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