AD/AS model and Fiscal Policy Flashcards
What is the AD/AS model?
a macroeconomic model which illustrates the relationship between the aggregate levels of expenditure and output(which equals income)
- identifies the point of equilibrium
where AO = AE which determines the
current level of econ activity
What is aggregate demand?
illustrates the total amount of spending by all sectors in the economy at difference price levels AD
= AE
- AD is negatively sloped -> as the general level of prices in the economy increases, total spending in the economy falls
What are the 3 reasons why AD is negatively sloped?
income effect
- open economy effect
- interest rate differential
What are the factors affecting shifts in AD?
C+I+G+(X-M)
2 Factors affecting AD: Consumption
- Income
- interest rates
2 Factors affecting AD: Investment
- interesst rates
- investment sentiment
2 Factors affecting AD: govt
- changes in govt spending
- level of economic activity
2 Factors affecting AD: net exports
-exchange rates
- terms of trade
What is aggregate supply?
illustrates the total amount of output produced by producers at each general price level
- AS curve not infinitely positively sloped
- the economy has a finite amount of resources, therefore cannot increase
“output indefinently”
What is short run aggregate supply curve?
illustrates the ability of producers to increase output in the short term
- output can be increased and will put pressure on prices to rise
8 What are factors affecting SRAS
- price of imports eg capital
- ER (price of imported capital)
- price of oil, wages
- ToT (price of imported capitals)
- supply shocks eg natural disaster
- sales tax
- technology
- productivity
What is long run AS curve
represents the productive capacity of the economy where resources are fully employed -> productive capacity of the economy
- it demonstrates the full employment Ivl of output (NAIRU-non accelerating inflation rate of UE)
- full employment Ivl of output without high inflation
5 Factors affecting LRAS
- investment
- technology
- productivity
- education/efficiency
- changes to workforce
Contraction graph of LRAS/SRAS
- vertical line of LRAS, is where AD and SRAS intersects.
- equilibrium OE/O(FE), PE
- sustainable growth
- stable prices
- full employment at the NAIRU
5 characteristics of Peak graph of LRAS, SRAS
vertical line of LRAS, is left side of equilibrium OE,PE
- high growth, demand pull inflation
- equilibrium O(FE), PE
- creating expansion gap
- operating at a level of output higher than OE (increase inflation)
6 characteristics of Trough graph of LRAS/SRAS
- LRAS right side of OE,PE
- equilibrium PE, O(FE)
-creating contraction gap - trough has lower employment, OE (where we are at) is lower than O(FE)
(where we want to be) - high cyclical UE, low growth
- operating at a level of output lower than OE
3 Notes about lras/sras
- AD = SRAS -> where the economy is
at (macroeconomic equilibrium OE) - LRAS-> where we want to be →>
O(FE) - O(FE) - tells us where we want to be
(full employment level of output)
What are the 3 EPO’s(economic policy objectives), target rate, types.
Full employment (target UE 4%)
- cyclical: follows business cycle
Stable prices (target 2-3% infl rate)
- Demand pull excess demand
- cost push not enough supply
Sustainable growth (target 3.5-4%)
- sources:
- demand factors
-supply factors
- increase efficiency (allocative, dynamic, technical(productive))
AE model to show cyclical UE (full employment) 3 characteristics
- at y(fe) the economy is operating at a full employment level of Y, output where cyclical UE is zero
- fall in AE from AE(fe) to AE(def) creates a stock buildup which results in a decrease in production which reduces demand for resources including creating cyclical (or demand efficient UE)
- economy contracts to Y(def) and economy is now operating at a level of income, output below full employment - creating deflationary gap
AD/AS model to show cyclical UE(full employment) 3 characteristics
- at O(fe)LRAS the economy is operating at a full employment level of output where cyclical UE is zero
- fall in AD from AD to AD1 creates a stock buildup which results in a decrease in production which reduces demand for resources including creating cyclical UE (or demand efficient UE)
- economy contracts to OE1 and economy is now operating at a level of output below full employment - creating deflationary gap
AE model to show demand pull inflation 3 characteristics
- at y(fe) the economy is operating at a full employment level of Y, output where prices are stanle
- rise in AE from AE(fe) to AE(inf) creates a stock rundown which results in a increase in production which increases demand for resources, including labour
- economy expands to Y(inf) and economy is now operating at a level of income, output aove full employment - creating inflationary gap
AD/AS model to show demand pull inflation 3characteristics
- at O(fe)LRAS the economy is operating at a full employment level of output where prices are stable
- rise in AD from AD to AD1 creates a stock rundown which results in a increase in production which increases demand for resources including labour
- economy expands to OE1 and economy is now operating at a level of output above full employment - creating inflationary gap
AD/AS model to show cost push inflation 3characteristics
- at O(fe) LRAS the economy is operating at a full employment level of output where prices are stable
- decrease in AS from SRAS to SRAS1 due to increase in costs of proud, decreasing supply/prod, results in rise from PE to PE1
- economy contracts to OE1 and economy is now operating at a level of output below full employment
AD/AS model to show sustainable growth: demand source 3characteristics
- at O(fe)LRAS the economy is operating at a full employment level of output where growth is sustainable
- rise in AD from AD to AD1 creates a stock rundown which results in a increase in production which increase demand for resources including labour
- economy expands to OE1 and economy is now operating at a level of output above full employment - creating inflationary gap
AE model to show sustainable growth: demand source 3characteristics
- at y(fe) the economy is operating at a full employment level of Y, output where growth is sustainable
- rise in AE from AE(fe) to AE(inf) creates a stock rundown which results in a increase in production which increases demand for resources, including labour
- economy expands to Y(inf) and economy is now operating at a level of income, output above full employment - creating inflationary gap
AD/AS model for sustainable growth: supply/ increase efficiency source
-
What is fiscal policy?
- refers to the chnages in the levels of taxation and government expenditure to stabilise economic activity
- a macroeconomic policy: focuses on stimulating economy
- demand management policy
What the 3 budget outcomes of fiscal policy
Budget surplus (T>G)
Budget Deficit (G>T)
Balanced Budget (G=T)
What are the two types of fiscal policy?
Expansionary and contractionary
- has the ability to expand and contract to minimise economic flunctuations
What is expansionary fiscal policy? what budget outcome?
- Budget deficit
- refers to a situation where govt exp exceeds tax revenue - the govt injecting more money than leaking therefore the flow of income rises resulting in a expansion in economic activity
- occurs when budget changes from a surplus to a deficit
- high UE, BD
What is contractionary fiscal policy? what budget out come?
- Budget surplus
- refers to a situation where taxation exceeds govt exp - the govt leaking more money than injecting therefore the flow of income falls resulting in a contraction in economic activity
- high inflation BS
What is Discretionary FP?
refers to deliberate changes to the levels of taxation revenue and government expenditure in order to stabilise economic activity - known as structural budget outcome
What is non discretionary FP?
refers to automatic changes to the levels of taxation revenue and govt expenditure in order to stabilise economy activity - known as cyclical budget outcome
- is an example of automatic stabilisers other than T and G. other automatic stabilisers is savings and imports
- automatically change during certain economic conditions so that flunctatuions in the business cycle is reduced
What are 4 automatic stabilisers
- savings
- imports
- taxation
- government expenditure
The automatic stabilisers in a TROUGH(low AE,AY,AO) : Savings
- falls during an economic contraction and trough phase due to low AY
- savings is a leakage therefore less income is leaking from flow of income
- expansionary effect on the economy, reducing flunctuations (stabilising effects)
The automatic stabilisers in a TROUGH(low AE,AY,AO) : taxation
- falls due to less tax revenue, income, spending
- a leakage therefore less income is leaking from flow of income
- expansionary effect on the economy, reducing flunctuations (stabilising effects)
The automatic stabilisers in a TROUGH(low AE,AY,AO) : govt expenditure
- rises due to switch to public g/s - increase in demand
- cyclical UE high so high demand for govt welfare
- a injection therefore more income is being injected into flow of income
- contractionary effect
The automatic stabilisers in a TROUGH(low AE,AY,AO) : Imports
- falls due to less spending, income
- a leakage therefore less income is leaking from flow of income
- expansionary effect on the economy, reducing flunctuations (stabilising effects)
What are the three function of a government budget
- allocative
- distributive
- stabilising (fiscal policy)
Budget deficit - expansionary fiscal policy effects 6 characteristics
- to expand the economy during low periods of economic activity, the government will implement a budget deficit
- spending exceeds tax revenue
- financed by selling government bonds to private sector or overseas
- attract investors to the public sector (govt) by increasing interest rates on govt bonds
- this causes investors to shift away from private sector towards government
- the private sector becomes crowded out
3 Ways to finance a budget deficit
- selling new govt bonds to domestic and/or overseas residents
-> downside: causes crowding out - borrowing from the central bank RBA
-> downside: increases supply which created inflationary effects - borrowing from overseas
-> downside: appreciation of aud
What is the paradox of a budget deficit
- increase in interest ratest attract investors to the government has contractionary effect on economy
- govt borrow more to und deficit = increase govt debt
- means the budget deficit will not be as expansionary as intended
Fiscal policy during a contraction AE model 5characteristic
- an implementation of a budget deficit is demonstrated by a increase in G, from G to change in G, due to an increase in IR on govt bonds
- this causes AE to increase from AE(Def) to AE(fe) as investors attracts to high IR
- creates stock rundown which results in an increase in production, which increases demand for resources including labour, decrease in cyclical ue
- increases AY(Y(DEF) TO Y(FE), demonstrates multiplier effect as rise in AE results in a greater increase in AY.
- expansionary effects to Y(FE), removing deflarionary gap
What are 3 uses of a surplus
- increasing personala nd company tax rates
- reducing or postponing spending on major projects
- increasing excise taxes such as those applied on sales of cars, tobacco, alc
What is financial requirement
amount of funds an entity (indiviudal, group, organisation) requires to borrow
What is net financial requirement
- difference between the amount of funds the govt requires minus the amount the ogvt has to lend, when implementing fiscal policy
-> POSITIVE: required borrowed funds (budget deficit)
-> negative: funds available to lend (budget surplus)
Budget surplus - contractionary fp effects 4 characteristics
- to contract the economy during high period of econ activity
- no financial requirement
- deter investors to shift away from public sector (Govt) by decreasing the IR on govt bonds.
- causes investors to shift away from public sector and towards private sector, and private secotr becomes crowded in
Fiscal policy during a expansion AE model 6 characteristics
- an implementation of a budget surplus is demonstrated by a decrease in G, from G to change in G, due to a decrease in IR on govt bonds
- this causes AE to decrease from AE(inf) to AE(fe) as investors attracts to high IR
- creates stock buildup which results in an decrease in production, which decreases demand for resources including labour
- decreases AY(Y(inf) TO Y(FE), demonstrates multiplier effect as fall in AE results in a greater decrease in AY.
- conftractionary effects to natural Y(FE), NAIRU removing inflationary gap
-decreases demand pull inflation
Fiscal policy during a contraction AD/AS model 4 characteristics
- economy is operating at a level below full employment (OE1, PE1)
- increase in IR on govt bonds, increases AD1 to AD2.
- economy expands to o(fe)
- economy now operating at full employment, removing deflationary gap
Fiscal policy during a expansion AD/AS model 4 characteristics
- economy is operating at a level above full employment (OE1, PE1)
- decrease in IR on govt bonds, decreases AD1 to AD2.
- economy contracts to o(fe)
- economy now operating at full employment, removing inflationary
What is Commonwealth Govt Securities(CGS)
most important method of govt borrowing is by selling govt bonds, known as CGS
What is gross debt?
total amount of borrowing by the govt
- no. of CGS isued
What is net debt
gross debt minus the total govt lendings
3 Trends in gross debt and net debt over the decade
over the past decade, gross debt has increased at a faster rate than net debt indicating higher growth in govt borrowing than lending,
- indication of the large number of consecutive budget deficits over the time period
- actual budget surplus of 22.1b in 2022-23 - contractionary
- first surplus since gfc 2007-08
- a deficit of 28.3b in 2024-25 - expasnionary
predicted a deficit of 42.8b in 2025-26 - relatively expansionary as budfet deficit increase
- current planned budget out come 2024-25: deficit of 28.3 billion
Planned vc Actual budget outcomes
- budget delivered in may of each year and is a statement of the govt’s estimated exp(G) and revenue (T) for the next fiscal year
- economicc conditions can change and alter budget estimates
- revision of budget estimated occur in December or January, govt issues as assessment of economic conditions
Why the planned budget differs from actual budget 5
- prevailing economic conditions since last budget
-> palans don’t always equal reality - changes in economic activity domestically
-> downturns can result in a pallned surplus evaporating
-> downturns may be less severe than predicted so smaller deficit could accur - global economic events like GFC, recessions
-> changes in global demand - exogenous factors
- Er movements, ToT, non economic events
Automatic and discretionary changes that happened in 2020
- increasig G spending included:
-> jobseeker, jobkeeper(discretionary
-> spending on infrastrucutre
-> suport for covid hit industries
-> support for retraining and apprenticeships
-falling T included:
-> falling company profits(Decrease in tax revenue)
-> falling h/h income (fall in income revenue)
- discretionary tax cuts
How can fiscal policy enforce full employment?
- expansionary stancr on fiscal policy -> implement a budget deficit
- budget defifct will increase AD(AE) creating stockrundown, increase output, demand for resources including labour-> decrease in cyclical UE
How can fiscal policy enforce price stability?
- contractionary stance on FP -> implement budget surplus
- will decrease AD(AE) - reduces inflationary pressure caused by overheated economy
- AD falls causing dmenad pull inflation
How can fiscal policy enforce sustainable growth?
- expasnionary FP when the economy is experiencing a trouth/contraction
- increase in AD by reducing income tax rate + corporate tax
-> increase AD by increase spending in infrastructure +welfare+public g/s - increase ad -> stocm rundown
- increase output (demand source of growth)
4 types of time lags
- recognition lag
- decision lag- inside lag(govt)
- implementation lag - inside lag (govt)
- effect lag- outside lag (outside govT)
What are 6 strengths of fiscal policy
- outside lag is shorter than MP
- controls the spending tap ->injection/withdrawal of funds in the economy
- direct policy (G is a component of AE)
- more effective in a trough than MP
- influences by automatic stabilisers
- selective - as govt can target specific industries/sectors
What are 6 weaknesses of fiscal policy?
- recognition lag
-inside lags is longer than mp - crowing in/out means fiscal policy Is not as contractionary/expansionary as intended
- political constraints
- federal budget conflicts with state budget
- inflexible -> difficult to change the budget->mid year budget adjustment
