ECON1102 MACROECONOMICS 1

Session 1, 2011Tutorial Test No. 2 (Held in week 02-06 May)

Instructions 1. Tutorial tests will consist of one of the following six questions (possibly with some minor

twists)2. The question asked in a particular tutorial will be randomly selected 3. You will have 20 minutes to answer the question 4. Answer sheets will be provided 5. Since the following questions will be used in an exam; lecturers, tutors, PASS leaders and

PITSTOP tutors will not provide help in directly answering the questions.

Question 1 (i) Identify and briefly explain the main features of the business cycle.

(2 marks) Business cycle refers to fluctuation in economic activity over several months or years, thus, economy tends to experience periods of expansion and contraction in the level of economic activity. If we focus on GDP as a measure of economic activity, then expansion is a period when GDP is rising, while contraction is a period during which GDP falls. In moving between contraction and expansion the economy will experience peaks and troughs. A peak refers to the beginning of contraction, the high point of GDP prior to downturn, whereas a trough is the end of a contraction, the low point of economic activity before to a recovery. Recessions last 18 months on average and occurs when GDP falls for at least two quarters (“Rule of Thumb”), however, expansions last 60 months on average. Moreover, the pattern of business cycle is irregular, i.e. there are no two business cycles that are quite the same.

(ii) Explain the concepts of (a) potential output and (b) the output gap. (3 marks)

Potential output (y*), also called potential GDP or full-employment output, is the amount of output (real GDP) that an economy can produce when using its resources , such as capital and labour, at normal rates. It’s not the same as maximum output, because the labour and capital are used at NORMAL rates. Potential output is not a fixed number and can grow over time due to increase in both the amount of available capital and labour and their productivity, e.g. an aging workforce, development and use of new technologies. Nation’s actual output can vary, i.e. expand or contract. There are two reasons for that. First, changes in output may reflect changes in country’s potential output. For example, unfavourable weather conditions, such as severe drought, could reduce potential output growth in economy such as Australia’s, or decline in technological innovation might also reduce potential output. Assuming that the country is using its resources at normal rates, i.e. potential output equals to actual output, a significant fall in potential output growth would tend to result in recession. Similarly, new technologies, increased capital investment, or a surge immigration that increases the labour force could produce unusually brisk growth in potential output, i.e. an economic expansion or even boom will occur. As a result, changes in potential output are part of explanation for expansions and contractions. Second, actual output (y) does not always equal potential output(y*). For example, potential output may be growing normally, but for some reason the economy’s capital and labour resources may not be utilised fully, thus, actual output significantly below potential. Alternatively capital and

labour may be work much harder than normal, so that actual output greater than potential. The difference between the economy’s potential output and its actual output called output gap. Which can be expansionary – positive output gap (y>y*), and contractionary - negative output gap(y<y*). Contractionary gap is a problem because the resources are not been fully utilised, and output and employment below normal levels. Expansionary gap is a problem as well, because when demand for the products is higher than their normal capacity, firms tend to increase prices, which results, typically, in inflation, reducing efficiency of economy in long run.

(iii) Explain the concept of Okun’s law. Discuss the implications of Okun’s law for policymakers? (5 marks)

Before discussing concept of Okun’s law, lets define key terms. Cyclical unemployment refers to the extra unemployment that occurs during periods of economic contractions, especially recessions. Natural rate of unemployment (u*) – is the rate of unemployment, that occurs when cyclical unemployment is zero. The unemployment rate (u) includes all three types of unemployment: frictional, structural and cyclical.

By definition, cyclical unemployment is positive when the economy has a contractionary gap, negative when there is an expansionary gap and zero, when there is no output gap. Moreover, it is equal to (u-u*). A more quantitative relationship between cyclical unemployment and the output gap is given by Okun’s law, which says that each extra percentage of cyclical unemployment is associated with about 1.6 percentage point (for Australia) increase in absolute value of output gap, measured in relation to potential output. Formula (y-y*)/y*= -β(u-u*). Β – elasticity of unemployment rate with respect to output; it can differ across different countries, e.g. β=2 for US. There are different versions of Okun’s law. The one described above is the gap version.

Basically, Okun’s law is used by policymakers to predict the changes in unemployment rate, based on changes in output gap and vice versa. As a result, dynamics/fluctuations of recession or expansion can be predicted as well. There are few steps that are used to estimate Okun’s law.

Firstly, for country a dynamic version of the Okun’s law equation is estimated using data on unemployment and output for the 20 years prior to the start of each recession. The more recession the country had the more “episodes” for estimation would be, resulting in the set of beta’s, which will vary over time due to factors, such as employment protection legislation (makes more difficult to fire workers, leading to lower elasticity), unemployment benefits and temporary employment contracts (unemployment more responsive to changes in output).

Secondly, compute forecast errors. Based on the estimated Okun’s law relationships for each country, predictions about unemployment are made (1) during recessions and (2) during recoveries, using the observed changes in output for both. Actual unemployment rates in current period of recession/expansion are compared to the predicted rates in order to compute the error that occurs due to other factors that can influence the output. For example, consider the recession in the United Kingdom in the early 1990s. The level of output peaked in the second quarter of 1990 and reached a trough in the third quarter of 1991. The window over which Okun’s law is estimated for this episode ranged from the third quarter of 1970 to the second quarter of1990. Based on the estimated coefficients, forecasts for the unemployment rate are generated for the recession period; that is, from the third quarter of1990 to the third quarter of 1991. The forecast errors during the recession are then computed as the difference between the actual outturn of the unemployment rate and these forecast values. The forecast errors for the recovery period, which spanned the fourth quarter of 1991 to the third quarter of 1993, are computed based on the same Okun’s law coefficients that were estimated up to the peak in output before the start of the next recession.

Okun’s law is just an empirical measure of relationship between changes in unemployment rate and growth, which predicts that growth slowdowns typically coincide with rising

unemployment. Thus, it can be used by policymakers in order to implement necessary policies for preventing unemployment rate from rising. However, there are might be exceptions where the growth slowdown doesn’t correspond with rising unemployment when looking at both short and long periods of time, reminding that the “law” is just the “rule of thumb”. Moreover, the relationships are changing overtime because there are other factors that might influence unemployment rate other than changes in output. Furthermore, both measures – unemployment rate and output gap are not direct observations. Nevertheless, the gap version of Okun’s law reminds policymakers of a great reward such as increase in production associated with reduction in unemployment.

Question 2 (i) Discuss the role played by fixed (or sticky) prices in the Keynesian model of income determination. Briefly explain what would happen if prices were fully flexible in the short-run.

(2 marks) The key assumption of Keynesian model of income determination is that firms don’t respond to every change in demand for their production by changing their prices, instead of it, the typically set a price for some period, then meet the demand at that price , i.e. produce just enough to satisfy their customers at the prices that have been set. Therefore, with increase in demand firms will increase output and employment, while keeping fixed (sticky) prices; with decrease in demand firms will decrease the output along with employment. Thus, since demand is affected by people’s spending, changes in economy-wide spending are the primary cause of output gaps, to eliminate which the government policies are used. According to Keynes, firms do not change their prices in short run because it would be costly, generating the menu cost, which in turn will lead to short-term fluctuations in a business cycle. Moreover, firms do not adjust their prices quickly due to externalities that occur with price change, such as price reduction of one firm will lead to economic benefit for another firm. When a firm lowers the price it charges, it lowers the average price level slightly and thereby raises real income. The stimulus from higher income, in turn, raises the demand for the products of all firms. This macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ products is called an “aggregate-demand externality”. However, if prices were fully flexible in short run, the mechanism of self-adjustment would work, i.e. if customers demand will fall, the surplus will occur, then in order so sale the stock firm would lower the price. If there is an excess demand, leading to shortage, the firm would simply increase the price due to scarce of products. Therefore, there are no output gaps in market with fully flexible prices.

(ii) Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) In Keynesian theory, output at each point of time in economy is determined by Planned Aggregate Expenditure – total planned spending on final goods and services, which consists of four main components.

Consumer expenditure or Consumption (C) - spending by household on final goods and services.

Investment (I) – spending by firms on new capital goods, such as office buildings, factories and equipment. Spending on new houses and apartment buildings and changes in inventories are also included.

Government purchases (G) – spending by governments on goods and services. For example, purchase of new schools and hospitals, military hardware; service of gvt employees: soldiers, police and office workers. Transfer payments (social security payments and unemployment benefits and interest on gvt debt) are NOT included in government purchases.

Net exports (NX) – exports minus imports.

Planned spending can differ from actual spending, if a firm sells either less or more of its products than expected. Government statisticians assume that the firm buys its unsold output form itself, and then they count those purchases as part of the firm’s investment spending.Suppose, firm’s actual sales are less than expected, so the part of what it had planned to sell remains in the warehouse. So the firm adds more to its inventory than planned. And since firm has to purchase the inventory from itself, the actual investment would be more than planned investment. However, if the firm’s sales are higher than expected, so the firm has less inventory

left to repurchase, therefore, actual investment would be less than planned. As a result, the main difference between planned expenditure and actual expenditure is firm’s investment, because at preset prices firms cannot control how much they sell. PE – sum of planned spending by household, firms, government and foreigners, while AE – sum of actual spending, assuming that planed household, government and foreigners spending is the same as their actual spending.

(iii) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following:

The paradox of thrift (2 sectors model – households and firms) The effect on equilibrium GDP of an exogenous increase in exports (4 sectors model)

(6 marks)

The paradox of thrift states that an attempt by individuals to increase savings will lead to fewer savings for community and economy, overall, will be worse off. Assumptions of Keynesian model are constant price and constant interest rates, and apply to short run economy. Diagram 1.

The diagram 1 above shows the Keynesian aggregate expenditure model. Parameters with index “0” indicate initial consumption, savings and planned aggregate expenditure. However, if people would start saving, in order to do that they need to cut their consumption, therefore it will shift downward to C1 while saving function will shift upward to S1. Moreover, it can be seen that those movements reduce the level of planned aggregate expenditure at every level of GDP. Thus, new short run equilibrium output Ye

1 occurs, which is significantly smaller than equilibrium before an increase in savings Ye

0. As a result an attempt to save more actually leaded to lower equilibrium level of GDP. Moreover, an attempt to save in fact failed because reduction in consumption leads to decrease in employment, thus lower income, which in turn leads to further decrease in

Ip

S0

Y

PAEY

PAE0 C0

Ye 0

S1

C1

PAE1

Ye1

0

consumption, meaning decrease in employment and so one… Therefore, it will result in actual decrease in savings.

The effect on equilibrium GDP of an exogenous increase in exports. Lets refer to four sector model – a model of economy where there are households, firms, the government and the foreign sector. There are injections that equal to investment, government spending and export (INJ p = I p + G + X). Withdrawals are equal to savings, tax payments and imports (WD = S + T + M). In order to reach equilibrium in the short run injections have to be equal to withdrawals.

Diagram 2.

On the diagram 2 INJ0 and PAE0 show the initial positions, indication an equilibrium output Ye0,

where 45 degree line (income) equals to PAE0 or where withdrawals equal to injections (INJ0) for the short run economy. After there has been an exogenous increase in export, since it is one of injections components, the injections level will increase, causing an upward shift in injections function to INJ1. Moreover, since planned aggregate expenditure affected by net export, which has increased due to export increase, PAE function will also shift upwards to PAE1, resulting in equilibrium output increase from Ye

0 to Ye1. The economic explanation for that is this: an increase

in export expenditure means that more good have been sold and demanded by other countries. Therefore, more goods have to be produced, resulting in higher output/GDP.

INJp0=Ip+G+X0

W=S+T+M

Y

PAEY

Ye 0

C

Ye1

0

PAE1=C+Ip+G+NX1

INJp1=Ip+G+X1

PAE0=C+Ip+G+NX0

Question 3 (i) Explain what is meant by the multiplier? Why, in general, does a one dollar change in exogenous expenditure produce a larger change in short-run output?

(3 marks) Income-expenditure multiplier – the effect of one unit increase in exogenous expenditure on short run equilibrium output; for example, a multiplier of 5 means that a 10-unit decrease in exogenous expenditure reduces short-run equilibrium output by 50 units. To calculate multiplier formula is used: one divided by one minus marginal propensity to consume, i.e. 1/(1-MPC) or 1/MPS. MPC - amount by which consumption rises when disposable income rises by one dollar and lies between zero and one (0<c<1). The one dollar change in expenditure leads to a greater change in short run equilibrium output, because the changes in expenditure not only change sales of consumer goods, it indirectly affects income of workers and owners that produce consumer goods, which in turn, has influence on their consumption of goods, leading to changer in output of OTHER producers in the economy and so on. It’s continuous chain. For example, if there is a decrease in spending, it reduces firstly sales, i.e. demand on goods and services. Secondly, the owners and workers of those industries in which demand has fallen would produce less by cutting down the output, reducing planned aggregate expenditure. Thirdly, their revenue will fall, followed by decrease in income, i.e. in their purchasing power, i.e. decrease in consumption of g/s, resulting in further reduction in other industries’ output due to fall in demand. Therefore, the result on changes in expenditure is multiplied.

(ii) Explain the role played by the marginal propensity to import in determining the size of the multiplier. Other things equal, how does an increase in the marginal propensity to import affect the size of the multiplier?

(3 marks)Generally, marginal propensity to import indicates the extent (degree) to which imports are affected by changes in income or production. For example, if MPM is 0.1, then each dollar of extra income in the economy induces 10 cents of imports. MPM can be worked out by dividing changes in import on changes in disposable income (∆M/∆(Y-T)). Moreover, MPM determines the slope of import function. It also shows up as the negative of the slope of the net exports line. Because imports are proportional to after-tax income, we can write it as M=m(1-t), where m is MPM and t is tax rate. From this, we can define MPM as proportion of each after-tax dollar that is spent on import. Since income affected by consumption (increase in consumption will lead to increase in income), thus, if there is a change in consumption it will cause change in income, i.e. change in import expenditure. The higher MPM, the higher expenditure on imports, and therefore, the higher consumption expenditure.While the marginal propensity to consume is the most important marginal affecting the multiplier process, the marginal propensity to import also enters the picture. Because imports reduce net exports, the increase in consumption expenditures on production are partially offset by the decrease in net exports. Basically, if we have more imports it will increase consumption expenditure; however, it will reduce net export, nevertheless it would still affect total planned aggregate expenditure, thus, would slightly affect multiplier effect. There is a formula connecting multiplier, MPC and MPM:

expendituremultiplier

=1

(1 - (MPC - MPM))

Therefore, an increase in the marginal propensity to import increases the value of the denominator on the right-hand side of the equation, which then decreases the overall value of the fraction and thus the size of the multiplier. Because, if a significantly large proportion of income is

spend on imports, (when value of m is relatively high), then any changes in income earned domestically will have smaller effect on domestic expenditure.

(iii) Use a diagram to illustrate the concept of short-run equilibrium in the Keynesian aggregate expenditure model. Suppose the economy is initially not in equilibrium, explain the process by which the economy adjusts to equilibrium.

(4 marks) In the Keynesian aggregate expenditure model short run equilibrium can be defined by two conditions. The first is where planned aggregate expenditure equals income (45 degree line), indicated by point A in the diagrams 1 and 2. The second is when planned injections equal withdrawals shown by point B in both diagrams (in the two sector model, where savings equal investments). Diagram 1. Two sector model.

Diagram 2. Four sector model

Ip

Y

PAE

YPAE C

Ye 0

0

A

B

INJp=Ip+G+X

W=S+T+M

Y

PAE

Y

Ye 0

C

Ye1

0

PAE=C+Ip+G+NX

A

B

S

Ye1

Ye2

Ye2

However, if economy is not at equilibrium, it’s called disequilibrium. Suppose economy was at level of GDP given by Y e 1, which is above the equilibrium level. It can be interpreted in two ways. First thing to notice is that economy’s aggregate output is greater than planned aggregate expenditure because point on PAE corresponding to Y e 1 lies below 45 degree line. Thus, when planned expenditure falls short of actual level of production in the economy, i.e. firm sells less output than it produces, we know that the firm is experiencing an unintended increase in their inventory investment. The magnitude of unplanned increase in inventories is the vertical distance between points on savings and planed investment functions for two sector economy and vertical distance between points on withdrawals and injections functions, corresponding to the level of GDP Y e 1. Thus, when savings are greater than planned investment or withdrawals are greater than planned injections, build-up inventories motivate firms to revise their production downward to avoid the cost of carrying unplanned inventories, which cause GDP to fall back from Y e 1 to Y e 0. In the process of this cut back in aggregate production, the income will fall and pulls withdrawals back to the point where savings are equal planned injections. However, suppose that economy was at level Y e 2, which is below equilibrium level. Thus, aggregate expenditure lies above 45 degree line, i.e. above production. The difference between aggregate expenditures and aggregate production means that economy-wide production shortages exist. Economy-wide shortages result in unplanned decreases in inventories because the business sector sells more output than current production. The magnitude of unplanned decrease in inventories is the vertical distance between points on savings and planed investment functions for two sector economy and vertical distance between points on withdrawals and injections functions for four sector economy, corresponding to the level of GDP Y e 2. The reduction of inventories motivates the business sector to increase aggregate production. The increase in aggregate production then moves the economy to the equilibrium level Y e 0.

Question 4 (i) What are the main instruments of fiscal policy? Explain how each might be used to close an expansionary output gap.

(4 marks)

Decision of about government purchases – government purchase of current g/s, investment and infrastructure – represents one of the two main components of fiscal policy, the other being decision about taxes and transfer payments. Fiscal policy is one of the government stabilisation policies which balances government budget in a way to eliminate contractionary or expansionary gaps. In order to eliminate expansionary gap, contractionary fiscal policy has to be used by decrease in government spending, an increase in taxes or decrease in transfer payments.According to Keynes, government purchases of g/s, being a component of planned aggregate expenditure, directly affect total spending. If output gaps are cause by too much or too little total spending, then the government can help to guide the economy toward full employment by changing its level of spending. In order to eliminate expansionary gap, the government should decrease its spending on current g/s, investment and infrastructures. An inflationary gap exists if the existing level of aggregate production is greater than what would be produced with the full employment of resources. This gap arises during a business-cycle expansion and typically gives rise to higher rates of inflation. Thus, if the government will spend less on purchases and investment, i.e. will inject less money to the economy, it will reduce aggregate demand on current g/s, resulting in its downward shift (to the left) towards the level of full employment, eliminating inflationary/expansionary gap, furthermore, government expenditure has direct effect on PAE, thus, by reducing government purchases we reduce PAE by the amount of decrease times multiplier.Besides making decisions about government purchases of g/s, fiscal policy-makers also determine the level and the types of taxes to be collected and transfer payments such as unemployment benefits, welfare benefits and so on. The basic Keynesian model implies that changes in level of taxes or transfers can be used to affect planned aggregate expenditure, however, the do not affect PAE in direct way. They work indirectly by changing disposable income in the private sector. In order to eliminate expansionary gap, either taxes have to be increased or government transfers have to be decreased. Doing so will reduce disposable income, leading to a lower consumption, i.e. reduction in PAE. It won’t cause a shift in PAE, it will decrease its slope, restoring the economy to the full employment level where actual output equals to potential.

(ii) Explain what is meant by the government budget constraint. Indicate how it provides a link between fiscal policy and public debt.

(3 marks) Government budget constraint – the term given to the concept that government spending in any period has to be financed either by raising taxes or by government borrowing, there is another approach of financing - printing money, however, it leads to hyperinflation and has a bad reputation. One consequence of fiscal policy has been extraordinary change in the amount of debt owed by government. Spending activity of the government includes government expenditure and transfer payments. Therefore, government have to finance its activities. One of the financial options is borrowing, i.e. issuing securities – financial asset which obliges the government to repay the loan and interest over specified period. Another option is to raise taxes which would be spent by government in a period t. Thus, there is an equation which represents all government spending that has been undertaken by the government in period t on the left-hand side, and all the sources of funding available to the government to finance this expenditure on the right-hand side:

Gt + Qt + rBt-1=Tt + (Bt - Bt-1)

Where rBt-1 is an interest payment on debt, Gt government expenditure, Qt government transfer payments; Tt taxes, (Bt-Bt-1) new borrowing during time t.If we rearrange the equation, we’ll get

Gt + Qt - Tt + rBt-1= (Bt - Bt-1)

When the government runs budget deficit (expansionary policy), Gt + Qt - Tt will be a positive number, meaning that (Bt - Bt-1) is also positive, i.e. budget deficit lead to increase in the stock of public debt over time. When the government runs budget surplus (contractionary policy), Gt + Qt - Tt will be negative, therefore, as long as the surplus can cover interest payment, it will mean that the stock of debt will fall over time; i.e. Bt will be less than Bt-1.

(iii) Explain the difference between discretionary fiscal policy and automatic stabilisers. (3 marks)

Discretionary fiscal policy refers to deliberate changes in the level of government spending, transfer payments or in tax rates in order to stabilise economy, while automatic stabilisers refers to tendency for a system of taxes and transfers which are related to the level of income automatically reduce the size of GDP fluctuation. Simply speaking, discretionary policy is a manual regulation, while automatic stabilisers act through preset tax rate and transfer payments that depend on the level of income. For example, if output is falling, i.e. income is falling as well, thus since the tax rate is progressive, less amount of tax will be charged, increasing proportion of purchasing power, i.e. more income can be spend on consumption, which leads to increase in planned aggregate expenditure and, thus, shift output to equilibrium level. When output is falling, more people will be unemployed, elderly more likely to retire and people are more likely enter the ranks of the poor in need of assistance, thus, more transfer payments would be made, which means increase in disposable income would to increase in consumption, i.e. increase in PAE.

The main difference between discretionary fiscal policy and automatic stabilisers is that discretionary fiscal policy requires discretionary action and experience potentially lengthy policy lags that make fiscal policy pro-cyclical rather than counter-cyclical. Pro-cyclical means that it brings more fluctuations, rather than cooling them down like counter-cyclical policy. It can be due to biased government decisions towards its voters trying to spend money in the way to get a good reputation for upcoming votes. For example when there is a boom voters would demand more public goods or fewer taxes, which induces a pro-cyclical bias in fiscal policy. Moreover, fiscal policy is not always flexible enough to be useful for stabilisation due to annual basis of changes in government budget and because in reality changes in taxes or government spending must usually go through a lengthy legislative process, which reduces the ability to timely respond to economic conditions, resulting in time lag, unlike automatic stabilisers that respond almost immediately to changing economic conditions, with little or no policy lags. Moreover, the government budget plan is handed down in May of every year and may lapses for few months before it comes to effect. That’s why discretionary policy to increase government spending and cut taxes may come to effect after contraction is over and economy is moving towards expansion, however, since at the time of making decisions about changes in budget, taxes and transfers the economy was in contraction, the policy won’t be relative and effective and would increase fluctuations in economy.

As a conclusion, it can be said that the stronger automatic stabilisers are, the less need for discretionary fiscal policy, however, fiscal policy may still be useful in dealing with prolong episodes of recession.

Questions 5 A government is considering its fiscal policy response to a decline in exogenous desired expenditure by households and firms which has produced a large contractionary output gap.

(i) Two alternative policies are under consideration: -An increase in government spending of $20 billion, or -A one-time cash payment to all households, which also has a total value of $20 billion

Use the 4-sector Keynesian aggregate expenditure model to explain which of these policies will have the largest effect on planned aggregate expenditure and on the level of output.

(4 marks)

Since changes in government spending has a direct effect on PAE, in the first case PAE will increase by $20 billion because government expenditure is an autonomous component of PAE. However, output will increase by $20 billion times multiplier. The diagram is illustrated below.

Diagram 1. Effect of Government expenditure increase.

Transfer payment of $20 billion to household can be thought of as a negative exogenous tax, since T=T + tY. Thus, the transfer can be regarded as exogenous tax cut. Since consumption depends on after-tax income level of changes in PAE depend on cT (PAE=C - cT +Ip+G+X+(c-m)(1-t)Y), resulting in MPC times $20 billion increase in PAE, which is less than $20 billion because MPC is always between zero and one. However, transfer payment might be financed by $20 billion cut in other government spending program, resulting in $20 billion decrease in PAE. Thus, we have an increase in PAE by $20 billion times MPC and a decrease in PAE by $20 billion resulting in net decrease in PAE by ($20 billion x (1-MPC)). Thus, the output will fall by even greater amount due to multiplier.

INJp0=Ip+G0+X

W=S+T+M

Y

PAEY

Ye 0

C

Ye1

0

PAE1=C+Ip+G1+NX

INJp1=Ip+G1+X

PAE0=C+Ip+G0+NX

$20 billion ∙ multiplier

$20 billion

____

Diagram 2. Simplified model of 4 sector economy.Transfer payment effect.

As a result, even if we don’t take into account that government transfer payment has been financed by cutting government expenditure, an increase in government expenditure will have larger effect on changes in PAE and output than increase in government transfer payment, that have indirect effect on PAE.

Y

PAEY

Ye 1Ye

0

0

PAE0=C0+Ip+G0+NX

PAE1=C1+Ip+G0+NX

$20 billion x (1-MPC) x multiplier

$20 billion x MPC PAE2=C1+Ip+G1+NX

Red: Net decrease in PAE

Ye2

Decrease by $20 billion in G

(ii) Suppose the government is concerned about the size of the budget deficit. It decides to increase government spending by $20 billion, but at the same time to increase exogenous taxes by $20 billion. Will this policy have any effect on the level of output? Explain your answer.

(3 marks) Budget deficit means government expenditure exceeds government tax revenue. Since government expenditure has a direct effect on PAE, PAE will increase by $20 billion, while output will increase by $20 billion times multiplier. However, taxes are indirectly related to changes in PAE, thus, a $20 billion increase in EXOGENOUS tax will result in consumption decrease by $20 billion times MPC because consumption depends on the after-tax income, which is less than $20 billion decrease in PAE because MPC is between zero and one and, therefore, $20 billion times MPC times multiplier decrease in output. As a result, since multiplier is the same the policy will have expansionary effect on output, i.e. output will increase.

(iii) Briefly indicate any complications or issues with fiscal policy that are not accounted for by the Keynesian aggregate expenditure model.

(3 marks)

One of the complications of fiscal policy is that it may have effect for the supply side of the economy that might have undesirable long-run consequences. The supply-siders view is that when the government increases taxes it may reduce willingness of people to save more for future since they don’t get to save very large proportion of their income, while new tax break on new investment may encourage firms to increase their rate of capital formation, which would certainly affect output. Thus, the government have to take into account not only stabilisation of PAE, but the effects of changes in government spending, taxes and transfers on economy’s productive capacity.

Secondly, expansionary fiscal policies may lead to large budget deficits that reduce national savings, which in turn reduces investment in new capital goods – an important source of long-run economic growth. E.g. Japan has substantially increase government spending over the past decade in its attempt to stimulate lagging economy, however, the deficit became so large that Japanese prime minister ruled out any additional fiscal stimulus until the deficit could be brought under better control.

Finally, fiscal policy is relatively inflexible as government expenditure and taxes are not able to be changed quickly. In reality changes in taxes or government spending must usually go through a lengthy legislative process, which reduces the ability to timely respond to economic conditions, resulting in time lag. Moreover, the government budget plan is handed down in May of every year and may lapses for few months before it comes to effect. That’s why discretionary policy to increase government spending and cut taxes may come to effect after contraction is over and economy is moving towards expansion, however, since at the time of making decisions about changes in budget, taxes and transfers the economy was in contraction, the policy won’t be relative and effective and would increase fluctuations in economy.

Question 6 (i) Money can be defined by its functions. In the following cases explain whether or not something is money, and which of the functions of money that it satisfies.

- Credit-card account with a $5,000 limit - A BHP-Billiton share - A Transaction Account with the Commonwealth Bank with a $2000 balance

(3 marks) (ii) Explain the assumptions and implications of the quantity theory of money.

(3 marks) (iii) Explain what is meant by open-market-operations. Briefly explain how the RBA uses open-market-operations to influence the cash rate.

(4 marks)