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 economys 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 economys actual output (y) and potential output (y*)at a point in time referred to as output gap. 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 Okuns law. Discuss the implications of Okuns law for policymakers? (5 marks) Okuns law is the relationship between the output gap and amount of cyclical unemployment in the economy. Okuns 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, = (1.6 in Australia). Furthermore, Okuns law gives policymakers the ability to assess the state of the economy through cyclical unemployment rates since Okuns 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 policymakers 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. Output gap = Actual GDP less Potential GDP

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 + Inventory Where I = Ip + Unplanned Inventory Explain why the following two conditions are equivalent ways of describing equilibrium in the Keynesian aggregate expenditure model. (3 marks) Y = PAE

INJ P = WD

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 agents 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 economys 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 economys 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 economys 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 economys 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) Australias 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 Ye = [C (c m)T + I P + G + X ] (3)
(1 [(c m)(1 t )])

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 economys 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 economys 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 G = T . 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:

Ye =

1 [C (c m)T + I P + G + X ] (1 [(c m)(1 t )]) (1) 1 Y e = [(c m)T + G] (1 [(c m)(1 t )])

1 (c m) G (1 [(c m)(1 t )]) 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 economys equilibrium level of GDP; however it will be less than $20 billion. Diagram: Y e =

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 economys 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 isnt 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-marketoperations 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 RBAs 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 RBAs 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 banks 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.