Governments and the Economy

Question 1

What is Fiscal Policy?

Answer 1

A macroeconomic policy that can influence resource allocation, redistribute income, and reduce the fluctuations of the business cycle.

• Use of government expenditure and revenue (taxes)
• Through federal budget
• Influence aspects of economy + address market failure

Question 2

How can Market Failure arise?

Answer 2

• Provision of g + s
• Inequality in distribution of income
• Externalities
• Monopoly power

Question 3

What is Economic Activity?

Answer 3

Economic activity is the level of production, income, employment in an economy at a period of time.

Question 4

What are the two types of government policy?

Answer 4

• Macroeconomic policy: monetary policy, fiscal policy
• Microeconomic policy: labour market policy, competition policy, environmental policy

Question 5

What are Discretionary changes in Fiscal Policy?

Answer 5

The deliberate change to fiscal policy to reduce/increase spending or changing tax rates

Question 6

What are Non-Discretionary changes in Fiscal Policy?

Answer 6

Cause changes in level of economic activity by influencing the cyclical component of the budget

Question 7

What are some examples of Non-Discretionary Fiscal Policy and how do they work?

Answer 7

• Unemployment Benefit
○ People without jobs can apply for the unemployment benefit
○ Increases govt expenditure
○ More disposable income
○ Stimulated AD, allowing more jobs to be available due to economic growth

• Progressive Income Taxation System
○ Higher income earners get proportionally taxed more
○ Provides govt revenue

Question 8

What is the purpose of an Expansionary Budgetary Stance?

Answer 8

• Planning to ↑ economic activity
• ↓ in tax revenue and/or ↑ in govt expenditure
• Creating smaller surplus or larger deficit than previous year
• Leads to ↑ in consumption and investment (C + I in AD)

Question 9

What is the purpose of an Contractionary Budgetary Stance?

Answer 9

• Planning to ↓ economic activity
• ↑ in tax revenue and/or ↓ in govt expenditure
• Smaller deficit or larger surplus than previous year
• ↓ in consumption and investment (C + I in AD)

Question 10

What is Monetary policy?

Answer 10

Monetary policy is the change in the Cash Rate Target by the RBA (Reserve Bank of Australia) in order to address levels of inflationary pressure and growing unemployment.

Question 11

What does changing the Cash Rate Target influence in the economy?

Answer 11

• AD
• Economic activity
• Inflation/unemployment
• Transmission Mechanism

Question 12

How does an expansionary stance in monetary policy affect inflationary pressure?

Answer 12

1) The decrease in the Cash Rate Target will prompt banks to pass on these savings to their customers
2) Applies to existing loans, allowing for more disposable income to be spent on consumption/investment in AD
3) New loans will change and encourage more money to be loaned
4) Increase in AD causes an increase in eco activity, unemployment falls

Question 13

What is Economic Activity

Answer 13

The level of production, income, employment in an economy at a period of time

Question 14

What is the Cash Rate Target?

Answer 14

The interest rate banks charge each other when they borrow money from each other in the overnight money market

Question 15

Explain how the Cash Rate Target works and its influence on the economy

Answer 15

1. RBA change CR Target by announcing a change
2. Change in CR Target change cost for banks to borrow money from each other
   • Change in cost passed onto customers through interest rates banks charge (H|H + Firms)
3. Change to interest rate influence C + I in economy
   • Influence AD and economic activity

Question 16

What actions are taken when there is strong aggregate demand and growing inflationary pressure?

Answer 16

An increase in the Cash Rate Target and a Contractionary Monetary Policy stance

Question 17

What actions are taken when there is low aggregate demand with growing unemployment?

Answer 17

A decrease in the Cash Rate Target and a Expansionary Monetary Policy stance

Question 18

Explain how the Transmission Mechanism works

Answer 18

1. When CR Target change, banks will pass on any extra costs or savings to their customers (consumers/businesses) to
   maintain profits and remain competitive with ↑ or ↓ IR.
2. Change in IR affect existing loans (mortgages and business loans) which ↑ or ↓ disposable Y. This influences C+I, influencing
   AD.
3. New loan payments will also change and encourage or discourage more money being loaned to fund C+I influencing AD.
4. When AD ↑ or ↓ there will be more or less economic activity:
   o AD will encourage or discourage firms to produce, ↑ or ↓ economic growth.
   o Unemployt. ↓ if firms hire more, or inflationary pressure will ↓ as a result.

Question 19

What causes a Market Failure?

Answer 19

Shown by change in business cycle
Because these fluctuations to GDP can cause concerns of high inflation/ high unemployt. the Government Policy is needed to minimise the volatility of these fluctuations.

Question 20

Explain government policy to influence the distribution of income in an economy.

Answer 20

• Government use of tax
o Progressive Income Tax System
The proportion of income paid in tax increase as income grows
o Regressive Tax
The proportion of income paid in tax decrease as income grows
• Transfer Payments - Increase lower income group disposable Y.
o Unemployment benefit
o Aged pension
o subsidies
• Provision of Government services - Govt support Y equality providing services relied on by lower income groups increasing disposable Y.
o Public education
o Public transport
o Medicare

Question 21

Explain the use of market-based policies as a method of quantity intervention to address the issue of externalities.

Answer 21

Quantity intervention as a market-based policy can be used to prevent the sale of goods/services which negatively affect the economy or increase the production of a merit/community good.

• Increase in taxes by intervening in the price mechanism, causing firms to internalise the social costs and increase costs of production and sale, decreasing demand for demerit goods/services.
• Subsidies given to firms to produce merit/community goods which are good for society, decreases social costs.

Question 22

Outline reasons for government intervention in the price mechanism.

Answer 22

• When merit goods are too high in price
• When demerit goods too low in price
• When social costs or social benefits are not considered in the market
• When good is not produced by private sector
• When good is not produced in sufficient quantity

Question 23

Differentiate between a monopoly and monopolistic competition.

Answer 23

• Monopoly is when there is 1 firm in the industry, significant barriers to entry where there are no substitute goods
• Monopolistic competition is when there a large number of relatively small firms in industry with minimal barriers to entry, where there is product differentiation

Question 24

Differentiate between monopolistic competition and monopolistic behaviour.

Answer 24

Monopolistic competition is when there are many small firms that sell different products.

Monopolistic behaviour is the use of unethical or illegal practices in order to gain an advantage over competitors. These include:
1. Monopolisation - abuse of power, weakening competition by excluding rivals
2. Price discrimination - firm changes price based on customer for the same good/service
3. Exclusive dealing - supplying g/s on condition that another g/s can be used
4. Collusion/market sharing - competitors work together to reduce competition

Question 25

Differentiate between a budget deficit and an expansionary fiscal stance.

Answer 25

• Budget deficit if when Government Expenditure > Revenue (comparison from previous year)
• Expansionary Fiscal Stance is when Government decreases taxation and increases Government expenditure

Question 26

Examine how the operation of the free market without government intervention might affect the distribution of income and quality of life for individuals.

Answer 26

A free market with no government intervention will result in a destabilised economy. When the richer get more prosperous, there are no policies to support the unemployed which will result in growing income inequality, leading to a recession in the business cycle. Thus, the quality of life for the majority of the economy will be very low compared to the higher percentile of income earners.

Question 27

Explain the operation of the transmission mechanism after a rise in the Cash Rate Target

Answer 27

1. Cost for banks to borrow money from each other ↑
2. To maintain profit levels, banks pass ↑ borrowing costs onto customers (households + businesses) in form of ↑interest rates
3. ↑ interest rates mean ↑ interest payments on existing loans. ↓ disposable Y available to consumers and businesses (↓C+I and ↓AD)
4. Consumers + Businesses are discouraged to take out new loans (↓C+I and ↓AD)
5. Less AD = less demand for existing G+S ↓ inflation