Week 9

Question 1

How fiscal policy influences aggregate demand

Answer 1

Changes in government purchases

Changes in taxes

Supply side economics

Question 2

Changes in government purchases

Answer 2

When the government changes the level of its purchases it influences aggregate demand directly. A decrease in government purchases shifts the aggregate demand curve to the left. An increase in government purchases shifts the aggregate demand curve to the right.

The multiplier effect and the crowding out effect

Question 3

The multiplier effect

Answer 3

The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Question 4

Expansionary fiscal policy

Answer 4

A planned decrease in the budget surplus (e.g. tax cut) to increase household’s income and consumption.

Question 5

Contractionary fiscal policy

Answer 5

A planned increase in the budget surplus (e.g. reduced government spending without any reduction in taxes.)

Question 6

The crowding out effect

Answer 6

The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

Question 7

The multiplier and crowding out effect

Answer 7

If the multiplier effect e.g. 3 billion is greater than the crowding out effect e.g. 2 billion, aggregate demand will rise by more than 1 billion and vice versa

Question 8

Changes in taxes

Answer 8

Changes in taxes affect affect a households take-home pay. If the government reduces taxes, households income will increase which results in higher saving and consumption. The aggregate-demand curve will shift to the right and vice versa. The size of the shift in the aggregate demand curve will also depend on the sizes of the multiplier and crowding-out effect.

Question 9

Supply side economics

Answer 9

Tax policy and work incentives

Fiscal policy and AS curve

Question 10

Tax policy and work incentives

Answer 10

A decrease in tax rates may cause individuals to work more because they get to keep more of what they earn. The aggregate supply curve would increase (shift to the right). However most economists believe that a cut in tax rates only has a small effect on the AS curve

Question 11

Fiscal policy and AS curve

Answer 11

If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right.

Question 12

Using policy to stabilise the economy

Answer 12

Active stabilisation economy

Automatic

Against active stabilisation policy

Question 13

Active stabilisation policy

Answer 13

The level of aggregate demand can be influenced by a change in government spending or taxation (fiscal policy) or a change in the interest rate (monetary policy). Keynesians believe that it is necessary for the central government to use its tax, government purchase ad interest rate (open market operation) policies aggressively to stimulate the economy during recession and slow the economy down during inflationary times.

Question 14

Automatic

Answer 14

Fiscal policy

Government spending

Tax system

Question 15

Fiscal policy

Answer 15

Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

Question 16

Government spending

Answer 16

Government spending is also an automatic stabiliser. More individuals become eligible for transfer payments during a recession. E.g. unemployment payments to the unemployed.

Question 17

Tax system

Answer 17

The most important automatic stabiliser is the tax system. The government’s revenue falls during a recession. Tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn.

Question 18

Against active stabilisation policy

Answer 18

Fiscal and monetary policy tools should only be used to help the economy achieve long run goals such as low inflation and economic growth. Policy tools may affect the economy with a large time lag.

Question 19

Policy tools may affect the economy with a large time lag.

Answer 19

With monetary policy, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly.

With fiscal policy the lag is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate.

Question 20

How monetary policy influences aggregate demand

Answer 20

The aggregate demand curve is downward sloping.

The theory of liquidity preference

Question 21

The aggregate demand curve is downward sloping

3 reasons

Answer 21

Pigou’s wealth effect

Keyne’s interest rate effect

Mundell-flemings exchange rate effect

Question 22

Pigou’s wealth effect

Keyne’s interest rate effect

Mundell-flemings exchange rate effect

Answer 22

All three effects occur simultaneously but are not of equal importance. Household’s money holdings are a small part of the total wealth (small wealth effect). Imports and exports are a small fraction of Australian GDP, the exchange rate effect is also fairly small for Australia. The most important reason for the downward sloping aggregate demand curve is the interest rate effect.

Question 23

The most important reason for the downward sloping aggregate demand curve is the interest rate effect.

Answer 23

A higher inflation rate induces the RBA to reduce interest rate. A higher interest rate reduces the quantity of goods and services demanded.

Question 24

The theory of liquidity preference

Answer 24

An explanation of the supply and demand for money and how they relate to the interest rate. 29/9

The money supply is assumed to be controlled by the central bank. Since the money supply does not depend on other economic variables, it’s a vertical line.

Interest rate is the opportunity cost of holding money. As the interest rate rises the quantity of money demanded will fall. Therefore, the demand for money will be downward sloping.

Question 25

5. Which of the following policies would Keynes have supported when the economy is experiencing unemployment?
   a. An open-market purchase
   b. A reduction in tax rates
   c. An increase in government purchases
   d. All of the above

Answer 25

Keynes would have supported a policy that directly increases spending within the economy. An open market purchase by the RBA would lower interest rates, encouraging increased consumption and investment spending. A reduction in tax rates would encourage greater consumption spending. An increase in government purchases would directly contribute to an increase in national expenditure. Thus, Keynes would have supported all the possible options presented here.

Question 26

9. Why do people still hold cash in their wallets, despite the fact that they receive no returns compared to storing cash in their bank accounts?

Answer 26

According to the liquidity preference theory, people hold cash because it is by far the most liquid asset for completing transactions. In other words, people derive the benefit from holding cash not by receiving interest payments; the benefit flows through in the form of convenience.

Question 27

10. What are the key determinants of the interest rate in the short run? What are the key determinants of the interest rate in the long run?

Answer 27

In the short run, we can think of the interest rate as being determined in the money market, so its key determinants are the supply of and demand for money. In the long run, we can think of the interest rate as being determined in the loanable funds market, so its key determinants are the supply of and demand for loanable funds.

Question 28

11. What are the impacts of an expansionary fiscal policy on output and the inflation rate in the short run? How about in the long run?

Answer 28

An expansionary fiscal policy will raise both output and the inflation rate in the short run. However, without corresponding changes to long-run aggregate supply, such a policy will only lead to a permanent increase in the inflation rate.

Question 29

12. Define expansionary and contractionary fiscal policy, giving examples of each.

Answer 29

expansionary = a planned decrease in the budget surplus (T-G); e.g. a tax cut

contractionary (or tight) = a planned increase in the budget surplus (T-G); e.g. reduced government spending without any reduction in taxes