Question

In: Economics

Consider the Australian economy if a health pandemic is experienced unexpectedly and a need for isolating...

Consider the Australian economy if a health pandemic is experienced unexpectedly and a need for isolating people causes aggregate output and consumption to fall. Explain the main actions you would take in the Federal Budget, if you were both the Federal Treasurer and the Chair of the Reserve Bank, when the situation is that Aggregate Demand has declined markedly, economic activity and production in the economy is in sharp decline, unemployment has increased rapidly from 5% to 10%, real interest rates are extremely low, inflation is extremely low, and expected annual economic growth in gross domestic product is expected to fall from the 3% annual growth that was anticipated before the pandemic to a 10% decline in the next 3 months and at least 3% negative growth in the GDP for the coming whole year.

  • Draw and label the diagram of the macroeconomy in Australia
  • Define Monetary and Fiscal policy and who is responsible for each
  • Discuss the options for Monetary policy, what they are and what the likely effects could be
  • Discuss the options for Fiscal policy, what they are and what the likely effects could be
  • Explain how the different Monetary and Fiscal policies could be implemented to address the problems of declining aggregate demand, rising unemployment, low inflation and negative growth in GDP
  • Explain some of the downsides of these policies in terms of being blunt instruments and lags in impacts

Solutions

Expert Solution

Figure-1 illustrates the impact of the health pandemic on the goods market in Australia. The price level of goods and services and the real output or income in the Australian goods market are denoted as P and Y in y and the x-axis respectively. The aggregate demand, short-run aggregate supply, and long-run aggregate supply in the goods market are represented as AD, SRAS, and LRAS and the initial or original AD, SRAS, and LRAS curves prior to the spread of the health pandemic in the country are labeled AD1, SRAS1, and LRAS1 respectively. The initial equilibrium price level of goods and services and the real income or output in the goods market and the domestic economy before th health panemic in the country are indicated as P*1 and Y*1 corresponding to the intersection of the AD1, SRAS1, and LRAS1. Now, as the aggregate consumption expenditure on goods and services by the individuals and households in the country declined the AD also decreased following the health pandemic as indicated by a leftward or downward shift of the AD curve from its original position at AD1 to AD2 in figure-1. As a consequence, the equilibrium real output or income level in the Australian goods market and the economy decreases from Y*1 to Y*2 and the equilibrium price level of goods and services also declines from P*1 to P*2 as shown in the figure causing a deflationary effect in the domestic economy, holding everything else as constant.

With particular attention to a decrease in the aggregate output and consumption expenditure in the country mainly due to the widespread economic inactivity following the health pandemic, the government of Australia can possibly implement an expansionary fiscal and/or monetary policy to stimulate the economy essentially by revitalizing the aggregate demand or AD. In this regard, fiscal policy basically involves manipulation of government expenditures and/or various government taxes to positively influence the national or domestic economy. Now, part of the expansionary fiscal policy, the government can increase the government expenditure on infrastructural development and various public sector facilities and projects and/or reduce or cut various taxes to primarily stimulate the AD and subsequently the domestic economy as a whole. On the other hand, the central bank or financial authority in any country is responsible for implementing the monetary policy in the country which includes the effective manipulation of the overall money supply level and/or the interest rate to stimulate the domestic economy by indirectly stabilizing the AD. An expansionary monetary policy commonly involves an increase the overall level of money supply and/or reduction in the interest rate in the money or loanable funds by the central bank in any country.  

In this particular instance, the Australian government can possibly implement an expansionary fiscal policy implying either an increase in government expenditure or reduce taxes in the economy. However, considering a decline in the overall consumption expenditure on goods and services by individuals and households and a significant fall in the aggregate output, the government can perhaps implement a reduction in both the income taxes of the individuals and households thereby raising their disposable income and the profit/corporate business income taxes as well which would impel higher business and capital investments by the domestic firms or companies in the country thereby boosting potential production of goods and service as well. Hence, a reduction in both personal income and the business taxes would expectedly lead to an increase in consumption expenditure on goods and services and the aggregate investment expenditure thereby enhancing the AD and the real output or income in the potential future.

In this regard, the Reserve Bank of Australia or RBA can also possibly reduce the interest rate in the domestic money or loanable funds thereby reducing the cost of financial borrowings thereby encouraging both the individuals and households and the domestic firms or companies to increase financial borrowings or undertaking financial loans to liquidate large-scale consumption expenditures and various business or commercial projects and undertakings. Hence, the aggregate consumption expenditure on goods and services and the aggregate investment expenditure by the firms or companies would increase leading to an increase in AD and the real output or income in the long-run.

Thereby, an expansionary fiscal policy mainly characterized by a reduction in the personal income tax would increase the disposable or tax-deducted income of the individuals and households in the domestic economy thereby encouraging them to increase the consumption spending on the goods and services thereby enhancing the aggregate consumption expenditure on goods and services by individual consumers and households. This would initially boost the AD in the goods market and the domestic economy in Australia thereby causing an increase in the price level of goods and services in the goods market or a higher inflationary impact and the aggregate real income or output as well. Furthermore, a reduction in the business or profit taxes along with higher overall consumption expenditure on goods and services would motivate or incentivize the domestic firms or companies to increase business or capital investment on various business and commercial projects and undertakings which would potentially lead to higher mobilization or utilization of productive resources and factors or inputs of production in the economy leading to higher employment in the labor market in Australia and overall production level of goods and services. This would also eventually lead to higher real output or income level and a relatively higher inflation level in the country.

On the other hand, an expansionary monetary policy implied executed through a reduction in the interest rate by RBA in the domestic money or loanable funds market would reduce the cost of financial borrowings in the market and the economy thereby encouraging both the individuals and households and the domestic firms or companies to undertake more financial loans to liquidate or finance their large-scale consumption spending or expenditures and business or commercial investments. Therefore, the lower interest rates would expectedly lead to higher aggregate consumption expenditure on goods and services by individuals and households and aggregate investment expenditure by domestic private firms and business organizations as well. All of this would ideally lead to an increase in the AD consequently impelling a rise in real output or income and the price level of goods and services causing an inflationary effect in the domestic economy. Now, as the private firms or companies in the economy undertake more business and capital loans to finance various business projects and investments, it would again lead to higher resource and the factor/input ,mobilization or utilization in the factor markets consequently causing higher employment level in the domestic labor market in Australia.

Now, one of the downsides of expansionary fiscal policy mainly characterized by tax reduction or cuts is that it could possibly lead to a higher budget deficit for the federal government considering the current situation of the government budget. Consistent tax cuts could reduce the tax revenue obtained or collected by the federal government leading to an expansion in the budget deficit and an increase in the government spending or expenditure which is also a part of the expansionary fiscal policy would practically aggravate the problem. Similarly, a consistent or sustainable expansionary monetary through increase in interest rate could lead to inflationary concerns in the domestic economy as reduction in interest rate would lead to a higher price level of goods and services thereby reducing the real purchasing power or affordability of the consumers or buyer, holding everything else constant.


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