Macro  Tutorial  Test  2  

Explain the concept of potential output and why actual output can differ from potential output? (2 marks)  Potential  output  is  the  amount  of  output  (ie  real  GDP)  that  an  economy  can  produce  when  using  its  resources  at  normal  rates.  Potential  output  usually  grows  over  time,  reflecting  increases  in  the  amount  of  available  capital  and  labour,  and  their  productivity.      The  difference  between  potential  output  and  actual  output  is  called  an  output  gap.      If  the  economy’s  capital  and  labour  resources  are  not  utilised  fully  (less  than  the  normal  rate),  actual  output  will  be  below  the  level  of  potential  output.  The  output  gap  will  thus  be  negative  (contractionary).      If  resources  are  working  much  harder  than  normal  rates,  ie  firms  putting  workers  on  overtime,  actual  output  will  be  larger  than  potential  output,  the  output  gap  will  be  positive  (expansionary).   Identify two factors that might cause a change in the level of potential output. For each factor briefly explain why they can affect potential output. (2 marks) 1. Availability  of  labour  –  an  increase  in  availability  of  labour  force  through  a  surge  in  immigration  would  

increase  potential  output  as  there  would  be  more  labour  available  at  normal  rates  to  produce  goods  and  services  

2. Level  of  capital  investment  –  an  increase  in  level  of  capital  investment  will  increase  potential  output  as  there  would  be  a  greater  amount  of  capital  at  normal  rates  to  produce  goods  and  services  

3. Unfavourable  weather  conditions–  an  occurrence  of  unfavourable  weather  conditions  such  as  severe  droughts  can  lead  to  decrease  in  normal  rates  of  output  as  it  disrupts  with  capital  and  labour  productivity  

4. Developments  of  new  technologies-­‐  lead  to  growth  in  potential  output  as  it  increases  capital  and  labour  productivity  

Identify and briefly explain the main features of the business cycle. (2 marks) The  business  cycle  features  at  time  at  which  real  GDP  reaches  peaks  and  troughs.    A  peak  is  the  beginning  of  a  contraction,  the  highest  point  of  economic  activity  before  a  downturn.  The  contraction  period  ends  at  a  trough,  the  lowest  point  of  economic  activity.  When  the  real  GDP  recovers  and  increases  against,  the  period  between  a  trough  and  a  peak  is  called  an  expansion  period.               Explain the concepts of (a) potential output and (b) the output gap. (3 marks) a) Potential  output,  (y*)  is  the  amount  of  output  as  real  GDP  that  an  economy  can  produce  when  using  its  

resources,  such  as  capital  and  labour,  at  normal  rates.    However,  potential  output  does  not  necessarily  equal  maximum  output  as  capital  and  labour  can  be  utilised  at  greater  than  normal  rates  for  certain  periods  of  time.    Potential  output  is  not  a  fixed  number  but  changes  over  time  tending  to  grow  in  order  to  reflect  increases  in  availability  and  productivity  of  labour,  capital  inputs  and  technology.  

The  potential  output  can  differ  from  actual  output  due  to  either  changes  in  potential  output  (y*)  and  changes  in  utilisation  rate  of  labour  and  capital.  

b) Since  in  reality,  actual  output  does  not  always  equal  to  potential  output  due  to  either  changes  in  potential  output  (y*)  and  changes  in  utilisation  rate  of  labour  and  capital,  we  ultimately  get  a  difference  between  an  economy’s  actual  output  (y)  and  potential  output  (y*)at  a  point  in  time  referred  to  as  output  gap.  

Output  gap  =  Actual  GDP  less  Potential  GDP    When  actual  output  (y)  is  above  potential  output  (y*)  i.e.  y>y*  there  is  a  positive  output  gap  called  an  expansionary  gap.  This  occurs  when  capital  and  labour  are  working  at  greater  than  normal  rates.  For  instance  firms  may  put  workers  on  overtime  so  that  actual  output  expands  significantly  beyond  potential  output  creating  a  boom.    When  actual  output  is  below  potential  output,  y  <  y*,  there  is  a  negative  output  gap  called  a  contractionary  gap.  This  occurs  when  capital  and  labour  are  working  at  less  than  normal  rates  i.e.  below  their  potential.  This  low  level  of  output  would  generally  be  interpreted  as  a  recession.      Contractionary  and  expansionary  gaps  are  viewed  by  policy  makers  as  problem.  For  contractionary  gap,  capital  and  labour  resources  are  not  being  fully  utilised,  and  output  and  employment  are  below  normal  levels.  A  prolonged  expansionary  gap  is  considered  a  problem  as  they  are  associated  with  firms  operating  above  normal  capacity,  leading  them  to  raise  prices  causing  inflation  which  reduces  efficiency  of  economy  in  the  longer  run.   Explain the concept of Okun’s law. Discuss the implications of Okun’s law for policymakers? (5 marks) Okun’s  law  is  the  relationship  between  the  output  gap  and  amount  of  cyclical  unemployment  in  the  economy.  Okun’s  law  simply  provides  a  more  quantitative  definition  of  the  inverse  relationship  between  cyclical  unemployment  and  output  gap.    It  is  mathematically  expressed  as:    

100  !! − ! ∗! ∗ = −!(! − ! ∗)  

Therefore  each  extra  %  point  of  cyclical  unemployment  is  linked  to  a  1.6%  point  decline  in  the  output  gap  (!=1.6%  in  Australia).  Where  y  =  Actual  output,  y*  =  potential  output,  u  =  actual  total  unemployment  rate,  u*=  natural  rate  of  unemployment,  β  =  (1.6  in  Australia).    Furthermore,  Okun’s  law  gives  policymakers  the  ability  to  assess  the  state  of  the  economy  through  cyclical  unemployment  rates  since  Okun’s  law  relates  percentage  of  cyclical  unemployment  to  a  percentage  change  in  the  output  gap.  This  indicates  for  policy  makers  that  it  is  possible  to  monitor  and  reduce  cyclical  unemployment  rates  towards  zero  or  slightly  negative  in  order  to  control  and  rectify  presence  of  any  contractionary  and  expansionary  output  gaps  in  economy  both  of  which  are  problematic  in  policymaker’s  view.  In  cases  where  cyclical  unemployment  is  not  close  to  zero,  it  can  be  used  as  a  signal  for  policy  makers  to  attempt  to  close  output  gaps  towards  zero  through  use  of  government  fiscal  and  monetary  policies.  For  instance,  the  presence  of  positive  cyclical  unemployment  would  indicate  that  a  contractionary  gap  exists  and  recession  is  likely  which  is  problematic  in  view  of  policymakers  as  economy  is  not  utilising  its  capital  and  labour  resources  to  its  full  potential  and  would  signal  for  policy  makers  to  use  government  fiscal  policy  such  as  budgeting  for  a  surplus  in  order  to  reduce  the  gap  towards  zero,  thus  achieve  a  desired  target  output  gap  close  to  zero.    In  cases  where  cyclical  unemployment  where  is  highly  negative,  this  would  indicate  presence  of  expansionary  gap  which  is  also  problematic  in  view  of  policy  makers  in  long  run  due  to  inflationary  effects  in  reducing  efficiency  of  economy.  This  would  signal  for  central  bank  policy  makers  to  tighten  its  monetary  policy  by  raising  interest  rates  in  order  to  slow  economic  growth  and  close  the  expansionary  gap.    

Through  these  fiscal  and  monetary  actions,  policy  makers  are  able  to  minimise  the  effects  of  fluctuations  in  the  business  cycle  and  reduce  problems  that  arise  from  both  expansionary  and  contractionary  output  gaps. Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Planned  Aggregate  Expenditure  or  PAE  is  the  total  planned  spending  on  domestically  produced  final  goods  and  services.    This  can  be  mathematically  expressed  as:  

PAE  =  C+Ip+G+NX    

In  national  accounts,  actual  expenditure  must  add  up  to  value  of  total  output.  Actual  expenditure  differs  from  PAE  as  in  reality,  firms  that  are  meeting  the  demand  for  their  product  or  service  at  preset  prices  cannot  control  how  much  they  sell  and  produce  depending  on  demand  and  thus  may  not  actually  always  sell  all  their  planned  goods  or  services,  either  selling  more  or  less  than  expected  and  hence  there  may  usually  be  an  inventory  of  unsold  goods  when  they  produce  more  and  sell  less  than  what  was  expected.  Under  aggregate  expenditure,  any  amount  of  unsold  inventory  is  assumed  by  statisticians  to  be  “purchased”  by  the  firm  itself  as  its  own  inventory  investment  expenditure  (I).  Thus,  the  difference  between  actual  and  planned  aggregate  expenditure  is  that  whilst  actual  expenditure  includes  unplanned  changes  in  inventory,  this  is  excluded  in  planned  aggregate  expenditure.  Thus,  aggregate  expenditure  can  be  expressed  as  follows:  

                                                               AE  =  C  +  I  +  G  +  NX  =  PAE  +  Δ  Inventory                            Where  I  =  Ip  +  Unplanned  ΔInventory  

Explain why the following two conditions are equivalent ways of describing equilibrium in the Keynesian aggregate expenditure model. (3 marks)

• Y = PAE • WDINJ P =

The  basic  assumption  of  the  Keynesian  model  is  than  in  the  short  run,  producers  leave  prices  at  preset  levels  and  simply  meet  the  demand  that  is  forthcoming  at  those  prices,  meaning  that  firms  produce  an  amount  that  is  equal  to  planned  aggregate  expenditure.  Therefore,  short  run  equilibrium  output  is  the  level  of  output  at  which  output  Y  equals  planned  aggregate  expenditure  PAE.    

Y  =  PAE  Injections  are  all  sources  of  exogenous  expenditure  and  comprises  firms’  investment  expenditure  (Ip),  government  expenditure  (G)  and  expenditure  by  foreign  residents  on  domestic  exports  (X).  The  notation  INJ^p  represents  total  planned  injections,  meaning  that  INJ^p  =  Ip  +  G  +  X.    Withdrawals  are  that  part  of  households’  income  that  is  not  spend  on  goods  and  services  produced  domestically,  which  includes  saving  (S),  tax  payments  (T)  and  imports  (M).  The  notation  WD  represents  withdrawals,  meaning  that  WD=  S+T+M.  Equilibrium  is  a  situation  where  planned  injections  of  expenditure  exactly  offset  any  withdrawals  i.e.    

INJ^p  =  WD  INJ^p  =  WD  can  be  derived  from  Y=PAE,  meaning  that  they  are  equivalent  ways  of  describing  equilibrium.    Y=  PAE,  however  we  know  that  PAE=  C  +  Ip  +  G  +  X  –  M  .  Therefore,    Y  =  C  +  Ip  +  G  +  X  –  M,  Subtract  T  and  C  from  both  sides    Y  –  T  -­‐  C=  Ip  +  G  +  X  –  M  –T,  but  S=  Y-­‐  T-­‐C    S=  Ip  +  G  +  X  –  M  –T    S  +  T  +  M  =  I^p  +  G  +  X  Therefore,  equilibrium  condition  defined  by  Y=PAE  is  exactly  the  same  as  equilibrium  defined  by  INJp=  WD.    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)

Fixed(  or  sticky)  prices  is  a  Key  assumption  of  the  basic  Keynesian  model  of  income  determination.  The  fixed  prices  in  the  model  states  the  firms  respond  to  the  changes  in  demand  only  by  changing  the  amount  of  production  and  employment  but  not  by  changing  the  prices  in  the  short  run.      If  prices  were  fully  flexible  in  the  short  run:      -­‐  There  will  never  be  excess  in  production  because  firms  will  cut  their  prices  to  sell  it    -­‐  There  will  never  be  persistent  unemployment  because  workers  will  be  willing  to  cut  down  their  wages  to  keep  their  job.    -­‐  Fluctuations  in  demand  will  then  be  accommodated  by  flexible  prices  and  wages  without  changing  the  level  of  output  and  employment  -­‐  incur  significant  menu  costs  in  the  short  run  of  continually  changing  prices  that  are  avoided  through  sticky  price  assumption  in  Keynesian  model   Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following:

• The paradox of thrift • The effect on equilibrium GDP of an exogenous increase in exports.

(4 marks) The  paradox  of  thrift  is  the  implication  of  Keynesian  model  that  in  the  short  run,  if  there  is  an  attempt  to  increase  community  agent’s  exogenous  savings,  it  will  fail  with  aggregate  savings  remaining  unchanged  and  the  level  of  GDP  will  fall,  and  thus  as  a  result  the  overall  economy  will  be  worse  off  as  a  result  of  this  attempt.    In  a  Keynesian  aggregate  expenditure  model,  savings  represent  withdrawals,  the  part  of  income  not  consumed.  Thus,  if  withdrawals  in  form  of  savings  are  increased  by  the  community  at  every  level  of  income  but  there  is  no  equivalent  increase  in  injections,  then  INJ  <WD  and  thus  PAE<Y,  resulting  in  disequilibrium.  In  terms  of  consumption  and  savings  function,  the  attempt  to  increase  exogenous  savings  would  result  an  upwards  shift  in  savings  function  from  SS  to  SnewSnew  and  downwards  shift  in  consumption  function  from  CC  to  CnewCnew  which  in  turn  lowers  PAE  from  PAE  to  PAEnew  as  shown  in  figure  1.    As  a  result  of  attempt  to  increase  exogenous  savings,  there  will  be  a  decrease  in  planned  expenditure  leading  to  firms  experiencing  an  unplanned  increase  in  inventories.  In  order  reduce  stockpiling,  firms  will  revise  their  production  plans  downwards,  thus  causing  the  level  of  GDP  to  fall  from  original  equilibrium  output  Ye  towards  new  equilibrium  ouput  Yenew  where  equilibrium  can  be  achieved  once  again  i.e.  INJp  =  WD.  Not  only  is  overall  economy  worse  off  as  the  result  of  the  attempt  to  increase  savings,  but  the  aggregate  amount  of  saving  in  economy  remains  unchanged  since  firms  spending  plans  have  not  changed  in  short  run  and  since  at  equilibrium  savings  match  planned  investment  spending  by  firms  which  have  remained  unchanged.  

 The  effect  on  equilibrium  GDP  of  an  exogenous  increase  in  exports:    If  there  is  an  exogenous  increase  in  exports  (X)  which  is  an  injection  in  the  4  sector  Keynesian  model,  the  level  of  injections  in  the  economy  would  increase  upwards  from  INJ0  to  INJ1,    creating  a  disequilibrium  situation  where  INJ1  >  WD0  and  PAE1  >  Ye  at  original  equilibrium  output  Ye  as  shown  in  the  diagram.  As  a  result,  firm  will  experience  an  unplanned  decline  in  inventories  and  in  order  to  rebuild  their  inventories  will  increase  their  level  of  production  to  meet  demand  of  exogenous  increase  in  exports.  Thus,  since  exports  are  a  component  of  PAE,  an  increase  in  export  production  will  lead  to  an  upward  shift  in  PAE  function  from  PAE0  to  PAE1  where  Y  =  

PAE  once  again  closing  the  expansionary  gap  as  shown  in  diagram  which  would  establish  a  new  equilibrium  GDP  at  higher  level  of  output    and  GDP  Ye1.  

  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? (4 marks) The  income-­‐expenditure  multiplier  or  multiplier  is  the  effect  of  a  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.      The  reason  that  a  one  dollar  change  in  exogenous  expenditure  produces  a  larger  change  in  short  run  output  is  because  a  given  initial  change  in  spending  changes  the  income  of  producers,  which  leads  them  to  adjust  their  spending,  changing  the  incomes  and  spending  of  other  producers  and  so  on.  A  fall  in  consumer  spending  not  only  reduces  the  sales  of  consumer  goods  directly;  it  also  reduces  the  incomes  of  workers  and  owners  in  the  industries  that  produce  consumer  goods.  As  their  incomes  fall,  these  workers  and  capital  owners  reduce  their  spending,  which  reduces  the  output  and  incomes  of  other  producers  in  the  economy.      Ultimately,  successive  rounds  of  declines  in  exogenous  spending  and  income  leads  to  a  decrease  in  PAE  and  output  that  is  significantly  greater  than  the  change  in  spending  that  started  the  process  due  to  the  compounding  multiplying  effect  of  the  multiplier.    For  example  if  there  is  a  fall  in  consumer  spending  by  10  units  and  MPC  is  0.85  and  the  tax  rate  is  0.06,  then  producers  of  consumer  goods  will  reduce  their  consumption  spending  by  eight  units  or  0.8  times  their  income  loss  of  10.  This  reduction  in  spending  cuts  the  incomes  of  other  producers  by  eight  units,  leading  these  other  producers  to  reduce  their  spending  by  6.4,  or  0.8  times  their  income  loss  of  eight  units.  This  process  continues  indefinitely.    10  +  8  +  6.4  +  5.12  +  …    10  [1  +  0.8  +  (0.8)^2  +  (0.8)^3  +  …]    1  +  x  +  x^2  +  x^3  +  …  =  1/(1  –  x)    10  .  1/(1  –  0.8)  =  10  .  5  =  50    Therefore  short-­‐run  equilibrium  output  falls  by  50  units.   Explain the role played by the marginal tax rate in determining the size of the multiplier. Other things equal, how does a cut in the marginal tax rate affect the size of the multiplier? (2 marks) In  the  4  sector  Keynesian  model,  the  multiplier  can  be  expressed  algebraically  as    1/(1-­‐k)  where  the  economy’s  overall  marginal  propensity  of  expenditure  on  domestically  produced  goods  and  services    denoted  by  k=  (c  –  m)(1  –  t)      c  =  marginal  propensity  to  consume,  m  =  marginal  propensity  to  import,  t  =  marginal  tax  rate    Thus,  the  marginal  tax  rate  (t)  directly  influences  the  value  of  k  and  respectively  the  size  of  the  multiplier.  

 A  cut  in  marginal  tax  rate  will  increase  the  flow  of  domestic  income  for  expenditure  on  domestically  produced  G&S,  leading  to  a  higher  MPC  and  a  higher  multiplier.  Hence,  assuming  all  other  things  being  equal,  a  cut  in  marginal  tax  rate  will  increase  the  marginal  propensity  to  consume  on  domestically  produced  goods  and  services,  and  thus  increasing  the  size  of  the  multiplier.   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)  [INSERT  DIAGRAM!]  As  illustrated  in  above  diagram,  short  run  equilibrium  in  Keynesian  aggregate  expenditure  model,  is  graphically  represented  by  the  45  degree  line  which  is  a  line  that  traces  out  all  possible  points  where  the  economy’s  equilibrium  condition,  Y=  PAE.  It  is  represented  by  the  point  E,  where  total  planned  injections  equals  withdrawals  and  planned  aggregate  expenditure  equals  output.    If  the  economy  is  out  of  equilibrium  whereby  output  is  in  excess  or  less  than  planned  aggregate  output,  firm  will  adjust  to  a  new  equilibrium  by  changing  production  levels  and  thus  changing  level  of  economy’s  GDP/output.      In  the  case  where  planned  aggregate  expenditure  exceeds  output  in  economy  as  represented  by  point  Y0  on  diagram  where  PAE  >Y0  i.e.  INJ  >  WD  causing  an  expansionary  gap  equal  to  Ye  -­‐  Yo,  firms  will  experience  an  unplanned  decline  in  their  inventories  and  therefore  in  order  to  restore  their  inventories  firm  will  increase  their  level  of  production.  This  will  cause  an  increase  in  overall  level  of  output  and  GDP  from  initial  output  Y0  towards  the  higher  equilibrium  output  Ye  where  Y  =  PAE    and  PAE  intersects  45  degree  line  as  shown  in  diagram,  closing  the  expansionary  gap.    In  the  case  where  output  exceeds  planned  aggregate  expenditure  in  the  economy  as  shown  by  Y1  in  diagram  i.e.  PAE  <Y  or  INJ<  WD  causing  a  contractionary  gap,  firms  will  experience  an  unplanned  increase  in  their  inventories.  In  order  to  reduce  this  unplanned  increase  in  unsold  inventories  firms  will  revise  downward  their  production  plans.  This  will  cause  a  decrease  in  overall  level  of  output  and  GDP  from  initial  output  Y1  to  the  lower  equilibrium  output  Ye  where  Y  =  PAE  and  INJ  p  =  WD,  closing  the  contractionary  gap.     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? (2 marks) In  the  4  sector  Keynesian  model,  the  multiplier  can  be  expressed  algebraically  as    1/(1-­‐k)  where  the  economy’s  overall  marginal  propensity  of  expenditure  is  denoted  by  k=  (c  –  m)(1  –  t)      c  =  marginal  propensity  to  consume,  m  =  marginal  propensity  to  import,  t  =  marginal  tax  rate    Thus,  the  marginal  propensity  to  import  (m)  directly  influences  the  value  of  k  and  thus  the  size  of  the  multiplier.    For  a  given  value  of  marginal  propensity  to  consume  and  tax  rate,  the  higher  or  increase  in  value  of  the  marginal  propensity  to  import  (m)  would  decrease  the  size  of  the  multiplier.  This  makes  sense  as  if  an  increase  in  marginal  propensity  to  import  (m)  will  indicate  a  significantly  large  proportion  of  income  is  spent  on  imports,  then  any  change  in  income  earned  domestically  will  have  a  smaller  effect  on  domestic  expenditure  relative  to  situation  where  marginal  propensity  to  import  is  small  as  consumers  have  reduced  their  propensity  to  consume  domestically,  decreasing  the  size  of  the  multiplier.    Hence,  holding  all  other  factors  equal,  an  increase  in  the  marginal  propensity  to  import  would  thus  decrease  the  size  of  the  multiplier.  

Explain what is meant by the government budget constraint. Indicate how it can provide a link between fiscal policy and public debt. (3 marks) Government  spending  is  made  up  of  government  purchases  Gt  and  transfer  payments  Qt.    The  Government  budget  constraint  is  the  concept  that  any  government  spending  has  to  be  financed  by  either  by  raising  taxes  Tt  (gross  taxes)  or  by  borrowing  money  (ie  issuing  securities).  The  number  of  bonds  still  owing  at  the  end  of  the  last  period  is  Bt-­‐1,  so  new  borrowing  this  period  is  number  of  Bt  –  Bt-­‐1,  also  known  as  public  debt.  This  also  means  more  expenditure  for  the  government,  the  interest  it  needs  to  pay  on  its  stock  of  debt,  ie  rBt-­‐1  where  r  is  the  real  rate  of  interest.      

Gt+  Qt  +  rBt-­‐1  =  Tt  +  (Bt  –  Bt-­‐1)  Government  Spending  =  Funding  for  the  Spending  

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

If  the  government  runs  a  government  deficit,  Gt+  Qt  –  Tt  will  be  positive  and  lead  to  a  positive  RHS,  ie  budget  deficits  lead  to  an  increase  in  the  stock  of  public  debt.  If  the  government  runs  a  budget  surplus,  Gt+  Qt  –  Tt  will  be  a  negative  number,  and  as  long  as  the  surplus  can  cover  interest  payments  (ie  Gt+  Qt  –  Tt  +  rBt-­‐1  <  0)  then  the  surplus  will  cause  the  stock  of  debt  to  fall  over  time,  so  RHS  decreases.    Therefore,  the  maths  equation  of  budget  constraint  provides  means  by  which  we  can  determine  whether  a  specific  fiscal  policy  will  increase  or  decrease  debt,  depending  on  govt  spending  and  taxation  revenue.       Briefly explain the main implications of demographic changes (over the next 50 years) for fiscal policy. (3 marks) Australia’s  population  is  expected  to  increase  from  20.5  million  in  2006  to  24.5  million  in  2048  meaning  that  overall  government  expenditure  in  fiscal  policy  on  all  public  goods  and  services  such  as  education  and  healthcare  must  increase.  More  specifically,  due  to  declining  fertility  rates  and  increased  longevity,  a  large  portion  of  the  current  workforce  known  as  baby  boomer  generation  will  be  65  and  over  and  will  retire  over  next  50  years,  rising  from  13%  to  approximately  22%  in  that  time,  creating  an  aging  population.  This  implies  that  there  must  be  increased  government  expenditure  in  fiscal  policy  in  areas  of  health  care  services,  aged  care  and  aged  pensions.  Due  to  declining  fertility  rates,  there  is  also  projected  to  be  a  slight  decrease  in  working  age  demographic  aged  between  15  –  64  years,  from  68%  in  2006  to  60%  in  2051.  This  implies  that  there  will  be  less  government  taxation  revenue  base  as  there  will  be  a  relatively  smaller  pool  of  taxpaying  working  age  population  compared  to  increasing  proportion  of  aging  retired  individuals  who  require  welfare  payments  such  as  pension,  inducing  greater  strain  on  limited  government  funds,  projected  to  cause  large  budget  deficits  from  2025  onwards  assuming  government  revenue  as  proportion  of  GDP  remains  at  about  22%.  However,  this  will  depend  on  future  taxation  rates,  size  of  labour  force  and  growth  of  GDP.      Therefore,  due  to  the  forecasted  larger  proportion  of  elderly  people  in  Australian  demographic  and  decreased  proportion  of  people  in  workforce  age  group  over  next  50  years,  this  implies  a  projected  increase  in  government  expenditure  and  possible  decrease  in  government  taxation  revenue,  which  will  in  turn  likely  to  lead  to  large  government  budget  deficits  starting  from  around  2025.  The  government  should  increase  size  of  budget  surplus  now  in  anticipation  of  having  to  run  budget  deficits  in  future  and  increase  taxation  rates  in  future  to  minimise  deficits  and  possibly  change  legislation  regarding  retirement  ages.   What are the main instruments of fiscal policy? Explain how each might be used to close an expansionary output gap. (4 marks) The  main  instruments  of  fiscal  policies  are:  Government  Expenditure:    current  goods  and  services,  investment  and  infrastructure  Taxes  ((direct,  indirect),  income  taxes,  consumption  taxes)  Transfer  payments-­‐benefits,  pensions.  (not  part  of  G)    

Both  taxes  and  transfers  only  have  an  indirect  effect  on  PAE.    An  expansionary  gap  is  when  there  is  a  positive  output  gap,  when  actual  output  is  above  potential  and  resources  are  being  utilised  at  above-­‐normal  rates.    To  close  an  expansionary  output  gap  represented  by  Y0  –  Ye  in  the  diagram,  the  government  would  reduce  its  government  expenditure.  As  government  expenditure  is  an  exogenous  component  of  planned  aggregate  expenditure,  a  decrease  in  government  expenditure  would  result  would  shift  the  PAE  curve  down  from  PAE0  towards  PAEnew  decreasing  the  equilibrium  level  output  and  GDP  from  Y0  towards  the  lower  potential  output  and  GDP    of  Ye,  shown  in  the  diagram  thus  closing  the  expansionary  gap  Y0  –  Ye.  In  terms  of  induced  component  of  taxes,  in  order  to  close  the  expansionary  gap  a  government  would  have  to  increase  its  tax  rate  (t)  to  lower  point  where  the  output  would  be  desired  (Ye)  as  this  would  lower  household  disposable  income,  leading  to    lower  planned  aggregate  expenditure.  Since  (c  –m)(1-­‐t)  is  the  gradient  of  PAE  curve,  graphically,  a  greater  t  will  give  a  flatter  PAE,  eliminating  an  expansionary  output  gap  as  indicated  by  diagram  above  where  slope  of  PAE  curve  is  shifted  downwards  towards  point  where  the  PAE  intersects  with  45  degree  equilibrium  at  the  desired  lower  potential  equilibrium  output  Ye  in  diagram  2,  thereby  closing  the  expansionary  gap.    As  exogenous  taxes  and  transfer  payments  affect  level  of  (Y  –  T)  received  by  private  sector,  indirectly  affecting  PAE,  on  order  to  close  an  expansionary  gap,  the  government  could  also  decrease  transfer  payments  or  increase  exogenous  component  of  tax,  both  of  which  would  decrease  exogenous  component  of  taxes  (T_Bar)  at  each  level  of  output,  shifting  the  entire  PAE  curve  downwards  by  an  amount  equal  to  marginal  propensity  to  consume  minus  marginal  propensity  to  import  times  decrease  in  transfers  or  increase  in  exogenous  taxes.  This  is  because  a  decrease  in  transfer  payments  or  increase  in  exogenous  taxes  would  decrease  disposable  income  (Y-­‐  T)  and  thus  in  turn  decreasing  PAE  by  households  at  each  level  of  output,  and  thereby  closing  the  expansionary  gap.   Explain the difference between discretionary fiscal policy and automatic stabilisers. Which one of these will be the main influence on the size of the structural budget deficit? Explain. (3 marks) Discretionary  Fiscal  Policy  –  Refers  to  the  deliberate  changes  in  the  level  of  government  spending,  transfer  payments  or  in  tax  rates  e.g.  one-­‐off  payments  of  $900.  They  can  be  relatively  inflexible  compared  to  automatic  stabilisers  which  are  immediate  and  must  be  implemented  in  a  timely  and  appropriate  manner  in  order  to  be  useful  as  a  stabilisation  tool  e.g.  no  point  increasing  government  spending  when  recession  is  over  and  in  expansion    Automatic  Stabilisers  –  tendency  of  system  of  taxes  and  transfers  which  are  related  to  the  level  of  income  to  automatically  reduce  the  extremity  of  size  of  GDP  fluctuations  (expansions  and  contractions)  than  would  have  been  otherwise  without  government  action.  For  instance,  as  GDP  declines,  level  of  taxes  paid  falls  and  level  of  transfer  payments  increases  automatically  due  to  effect  of  stabilisers.    The  discretionary  policy  will  be  the  main  influence  on  the  size  of  structural  budget  deficit  as  structural  changes  are  more  longer  term  and  chronic  in  nature,  existing  even  if  economy  is  at  its  potential  and  thus  can  only  be  rectified  through  direct  discretionary  fiscal  policy  such  as  increasing  taxation  or  reducing  government  expenditure  since  government  has  a  certain  time  period  to  determine  how  much  expenditure  and  how  much  taxation  revenue  to  collect.  Automatic  stabilisers  on  the  other  hand  are  immediate  in  implementation  and  are  focused  on  driving  and  responding  to  cyclical  changes  and  fluctuations  in  the  business  cycle.     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) In  the  4  sector  Keynesian  aggregate  expenditure  model,  at  equilibrium:  Y  =  PAE  PAE  =  C  +  Ip  +  G  +  NX.  (1)  PAE  =[C_bar  –  (c  –  m)  T_bar  +  Ip  +  G  +  X]  +  (c  –  m)(1  –  t)Y  (2)  Since  at  equilibrium,  Y  =  PAE  we  can  get:  

])([)])1)([(1(

1 XGITmcCtmc

Y Pe +++−−−−−

=  (3)  

 With  the  first  policy,  from  equation  (2)  it  can  be  seen  that  an  increase  in  government  expenditure  (G)  by  20  billion  will  directly  raise  autonomous/exogenous  component  PAE  without  any  modifications  and  thus  raise  overall  PAE  20  billion  at  each  income  level,  resulting  in  a  shift  upwards  in  PAE  curve  by  20  billion  towards  its  original  equilibrium  point  and  closing  the  contractionary  gap  caused  by  the  decline  in  exogenous  expenditure.    In  contrast,  with  the  second  policy,  where  government  pays  an  equivalent  $20  billion  amount  but  to  households  as  a  onetime  payment  which  acts  as  a  transfer  payment,  it  can  be  treated  as  a  negative  exogenous  tax  effect.  From  equation  (2),  it  can  be  seen  that  this  will  reduce  the  level  of  exogenous  component  of  taxation  T_Bar  and  thus  increasing  the  overall  level  of  PAE.  However,  it  will  not  increase  PAE  by  full  $20  billion  due  to  modification  effect  of  the  coefficient  (c  –  m)  comprised  of  marginal  propensity  to  consume  and  import,  leading  to  a  smaller/lower  increase  in  PAE  of  [$20billion  (c  –m)]  compared  to  the  direct  $20  billion  increase  of  PAE  as  result  of  direct  government  increase  in  expenditure.    In  terms  of  output  levels,  for  the  first  policy,  from  equation  (3),  it  can  be  seen  that  an  increase  in  government  expenditure  (G)  by  $20  billion  would  increase  the  numerator  of  RHS  by  exactly  $20  billion  directly  and  would  increase  in  the  economy’s  equilibrium  level  of  output/GDP  (Ye)  by  greater  than  $20  million  due  to  the  presence  of  the  multiplier  1/[1  –  k],  which  is  always  >1.    In  contrast,  with  the  second  policy  again,  although  the  onetime  payment  has  a  negative  exogenous  tax  effect,  increase  value  of  numerator  of  RHS  of  equation  due  to  the  modification  effects  of  (c  –  m)  will  result  in  a  lower  increase  in  the  numerator  figure  for  the  RHS  of  equation  (3)  than  the  first  policy.  Given  that  in  both  cases  the  multiplier  is  the  same,  this  would  mean  there  would  be  a  lower  increase  in  the  economy’s  equilibrium  level  of  output  Ye,  but  it  will  still  be  greater  than  $20  billion  due  to  effect  of  multiplier.    Thus,  the  first  policy  to  increase  government  expenditure  by  $20  billion  would  have  largest  effect  on  PAE  and  output  since  it  is  not  modified  by  any  coefficient  whereas  the  second  policy  is  affected  by  a  coefficient  (c  –m)  which  reduces  the  effect  of  onetime  payment  on  PAE  and  output  level.   Suppose a 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) • In  this  policy,  the  amount  of  increase  government  spending  and  the  increase  in  exogenous  taxes  are  both  

$20  billion,  thus  we  can  assume   TG Δ=Δ .    • Hence  this  is  an  example  of  the  balanced  budget  multiplier  (BBM);  the  short  run  effect  of  equilibrium  GDP  

of  an  equal  change  in  government  expenditure  and  net  tax.    • Using  the  BBM  formula:  

])([)])1)([(1(

1 XGITmcCtmc

Y Pe +++−−−−−

= (1)

])([)])1)([(1(

1 GTmctmc

Y e Δ+Δ−−−−−

=Δ

Gtmc

mcY e Δ×−−−

−−=Δ

)])1)([(1()(1

• c,m,  and  t,  all  have  to  be  between  0  and  1.    • In  the  4-­‐sector  model,  BBM  is  positive  but  less  than  one  in  value.      • the  effect  of  an  increase  in  both  exogenous  taxes  and  government  expenditure  on  overall  output  levels  

will  depend  on  magnitude  of  (c-­‐m)  coefficient  of  T_Bar  relative  to  1,  coefficient  of  G  • Can  assume  that  -­‐1  <  (c-­‐m)  <1  • Since  (c-­‐m)  can  never  equal  1  or  -­‐1,  we  can  deduce  that  the  decrease  in  output  caused  by  increased  in  

exogenous  taxes  (T_Bar)  can  never  fully  offset  the  increase  in  government  spending  (G)  in  the  numerator  of  RHS  of  equation  (1)  and  thus  since  -­‐1<(c  –  m)  <1,  there  will  always  be  an  effect  of  level  of  output-­‐  an  OVERALL  INCREASE  IN  OUTPUT.  The  effect  on  level  of  output  will  be  equal  to  multiplier  x  [$20  billion  –  (c  –m)  $20  million].  

• Thus  the  result  is  an  increase  in  the  economy’s  equilibrium  level  of  GDP;  however  it  will  be  less  than  $20  billion.    

• Diagram:    

Briefly discuss any complications or issues with fiscal policy that are not accounted for by the Keynesian aggregate expenditure model. (3 marks) Fiscal  policy  has  3  complications  which  needs  to  be  examined,  supply-­‐siders,  deficit  and  inflexibility:    Fiscal  policy  and  supply  side  –  Fiscal  policy  may  also  affect  potential  output  in  addition  to  planned  aggregate  expenditure  that  is  focused  on  in  Keynesian  model.  On  spending  side,  government  investments  in  public  capital  and  infrastructure  such  as  roads,  airports  and  schools  can  play  a  major  role  in  the  growth  of  potential  output  and  GDP.  On  the  expenditure  side,  tax  and  transfer  programs  may  well  affect  the  incentives,  and  the  thus  economic  behaviour  of  households  and  firms.      E.g.  a  high  tax  rate  on  interest  income  may  reduce  the  willingness  of  people  to  save  for  the  future,  while  a  tax  break  on  new  investment  may  encourage  firms  to  increase  their  capital  formation.  Such  changes  in  savings  or  investment  will  in  turn  affect  potential  output.  Some  supply  siders  critical  of  Keynesian  theory  have  argued  the  only  effects  of  fiscal  policy  that  matter  are  on  potential  output.  However,  a  more  balanced  view  is  that  fiscal  policy  affects  both  planned  spending  and  potential  output.  Thus  in  making  fiscal  policy,  government  officials  should  take  into  account  not  only  the  need  to  stabilise  planned  

aggregate  expenditure  but  also  the  likely  effects  of  government  spending,  taxes,  and  transfers  on  the  economy’s  productive  capacity.    Problem  of  deficits  –  Need  to  avoid  large  and  persistent  budget  deficits.  Sustained    government  deficits  can  be  harmful  as  it  reduces  national  saving,  which  in  turn  reduces  investment  in  new  capital  goods  –  an  important  source  of  long-­‐run  economic  growth.  This  would  make  spending  or  tax-­‐cutting  less  attractive,  both  economically  and  politically,  in  order  to  keep  deficits  under  control.    The  relative  inflexibility  of  Fiscal  Policy  –fiscal  policy  is  not  always  flexible  enough  to  be  useful  for  stabilisation.  In  practice  changing  government  spending  or  taxes  typically  involves  a  lengthy  legislative  process,  which  reduces  the  ability  of  fiscal  policy  to  respond  in  a  timely  way  to  economic  conditions.  There  are  also  many  other  objectives  besides  stabilising  aggregate  spending  e.g.  defence  and  income  support.  This  lack  of  flexibility  means  that  fiscal  policy  is  less  useful  for  stabilising  spending  than  the  basic  Keynesian  model  suggests.  However  2  reasons  why  fiscal  policy  is  an  important  stabilising  force  is:  

• Presence  of  Automatic  stabilisers  which  use  taxes  and  transfer  payments  to  respond  automatically  to  output  gaps.  

• Fiscal  policy  is  an  important  stabilising  force  although  it  may  be  difficult  to  change  quickly,  it  may  still  be  useful  for  dealing  with  prolonged  episodes  of  recession.  

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) Money  is  any  asset  that  can  be  used  in  making  purchases  and  for  something  to  be  classified  as  money,  it  must  satisfy  all  3  following  criterias:    

• a  medium  of  exchange  –  An  asset  primarily  used  in  purchasing  other  goods  and  services,  • a  unit  of  account  –  A  basic  measure  of  economic  value  • store  of  value    -­‐  An  asset  that  serves  as  a  means  of  holding  or  transferring  wealth  over  time  

A  credit-­‐card  account  with  a  $5000  limit  –  is  not  money  as  it  is  only  a  medium  of  exchange  used  to  purchase  goods  and  services  but  does  not  satisfy  the  other  2  criteria  for  money.  A  BHP-­‐Billiton  share  –  is  not  money  as  it  is  only  a  store  of  value  providing  a  means  of  holding,  transferring  wealth  over  time  but  is  not  a  unit  of  account  as  it  isn’t  a  basic  measure  of  economic  value  and  not  a    medium  of  exchange  as  it  cannot  be  used  to  purchase  other  goods  and  services  A  transaction  account  with  the  commonwealth  bank  with  a  $2000  balance-­‐  It  is  money  as  its  primary  objective  is  a  store  of  value  ,  it  is  unit  of  account  and  medium  of  exchange  which  can  be  used  to  purchase  other  goods  and  services.   Explain the assumptions and implications of the quantity theory of money. (3 marks)  Quantity  theory  of  money  is  that  the  nominal  value  of  expenditure  =  stock  of  money  x  velocity  of  circulation    The  assumptions  are  that:    

o  Velocity  is  constant  o  Output  is  constant  

 Quantity  equation=  money  stock  x  velocity=  price  level  x  output=  nominal  GDP    

M  x  Vbar=  P  x  Ybar  

Price  level  is  proportional  to  the  money  stock.  Change  in  M  causes  proportional  change  in  P  and  V  and  Y  are  constant    

P=kM  Quantity  theory  of  money  implies  that  percentage  increase  in  money  stock  (increase  in  money  supply)  should  be  in  proportion  to  the  price  of  money  (lead  people  to  bid  up  price  of  G&S)  and  hence  increasing  the  rate  of  inflation.  This  explains  why  printing  of    new  money  by  govt  to  cover  large  budget  deficits  should  be  avoided  as  it  increases  money  supply  and  hence  money  growth  leading  to  higher  than  normal  rates  of  inflation  in  the  country.                     Explain what is meant by open-market-operations. Briefly explain how the RBA uses open-market-operations to influence the cash rate. (4 marks) Open  market  operations  is  the  action  of  buying  and  selling  government  bonds  by  RBA  used  by  RBA  as  the  main  tool  by  which  it  affects  the  overall  level  of  cash  reserve  supply  in  bank  exchange  settlement  accounts  (ESAs)  in  order  to  influence  and  ensure  that  overnight  cash  rate  in  the  overnight  cash  market  is  equal  to  the  RBA  target  rate  predetermined  by  the  Board  at  the  beginning  of  each  month  to  reflect  the  stance  of  monetary  policy.  It  is  employed  on  a  daily  regular  basis  and  is  a  combination  of:  

• Open  market  sale:  the  sale  by  the  RBA  of  government  bonds  and  securities  to  the  banks  using  repurchase  agreements  for  the  purpose  of  reducing  the  balances  in  banks’  exchange  settlement  accounts.  

• Open  market  purchases:  The  purchase  of  government  bonds  from  the  banks  by  the  Reserve  Bank  using  repurchase  agreements  for  the  purpose  of  increasing  the  balances  in  banks’  exchange  settlement  accounts.    

If  the  overnight  cash  rate  was  below  the  RBA’s  predetermined  target  rate  due  to  excess  cash  in  the  overnight  cash  market  system  RBA  will  engage  in  open  market  sale  of  government  bonds  to  stimulate  banks  to  buy  the  bonds.  To  purchase  these  bonds,  banks  use  funds  from  the  cash  reserves  in  their  ESA  with  their  accounts  being  debited  by  RBA,  which  would  reduce  supply  of  cash  in  ESAs  and  thus  in  the  overnight  cash  market,  creating  a  shortage/deficit  of  funds.  This  reduction  in  supply  cash  in  overnight  cash  market  would  lead  to  increase  demand  for  funds  by  banks  to  prevent  funds  in  ESAs  from  becoming  too  low,  putting  upward  pressure  on  overnight  cash  rate  and  raising  the  cash  rate  towards  desired  cash  rate.      Alternately,  if  the  overnight  cash  rate  was  above  the  RBA’s  predetermined  target  rate  due  to  shortage  of  cash  in  system,  RBA  will  engage  in  open  market  purchase  of  government  bonds  from  banks.  It  will  deposit  payment  by  crediting  bank’s  ESA,  thus  increasing  supply  of  cash  funds  in  ESAs  and  overnight  cash  market,  creating  a  surplus  of  funds.  This  increase  in  supply  of  cash  in  overnight  cash  market  would  in  turn  decrease  cash  rate  towards  desired  cash  rate.