Question

1. Imagine a scenario where not only has the Australian government managed to pull Australia out of recession but has actually managed to get the economy moving so well that current output (real GDP) is above potential GDP.

i. What type of fiscal policy has the government used to try and get Australia to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation). Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changings (if any), and in which direction.  

ii. Can the existence of a fiscal multiplier help the government in terms of its commitments to reach potential GDP level of output? Provide a brief example.

Answer 1

i) If Ausralia is operating below potential level of output, there exist a recessionary gap in the economy. As per the diagram below, economy is operating at point E where there is recessionary gap in the economy of (Y1 - Y0). Australian government should adopt expansionary fiscal policy through which they raise government spending and reduce taxes which will raise disposable income after payong taxes with consumers and raise aggregate demand in the economy. It will shift demand curve rightward from demand to new demand vanishing all the recessionary gap in the economy where price level rises from P0 to P1 and output level rises from Y0 to Y1.

Aggregate demand = Consumption + Investment + Government Spending + Exports - Imports

Rise in government spending and consumption raises aggregate demand in the economy.

ii) Yes, fiscal multiplier helps government taking its economy to its potential level. Spending multiplier is calculated as = [1 / (1 - MPC)] where MPC is the marginal propensity to consume.

Change in Government Spending * Spending Multiplier = Recessionary Gap

Government with help of consumer behavior or knowing the MPC can reduce the recessionary gap.