Question

a) At the same time as the RBA is reducing interest rates the Australian Government will be running a budget deficit in 2020. How this will affect aggregate demand? A diagram would assist your answer here and attract further marks b) How will the size of the marginal propensity to consume affect the size of the multiplier and how will this impact on this fiscal policy initiative? c) If consumers decide to increase their rate of savings due to increasing uncertainty about the future, explain how this will affect the fiscal policy initiative. d) Discuss whether this fiscal policy initiative aligns with the RBA’s decision to reduce interest rates.

Answer 1

A.

RBA is reducing the rates and it is the part of expansionary monetary policy. At the same time, Australian Government has increased the spending, leading to budget deficit in 2020. It is the part of expansionary fiscal policy. As a result, of these two policies, the aggregate demand (AD) will increase and shifts to the right. So, real output will also increase. It is shown in the following diagram.

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B.

A bigger value of MPC leads to the bigger value of spending multiplier in the economy. Further, a bigger value of multiplier, leads to bigger impact of the policy stimulus. So, it is important to have a bigger MPC so that impact of fiscal policy is more strong and bigger.

For example, if MPC = .75

Then, spending multiplier = 1/(1-MPC) = 1/(1-.75) = 4

So, $1 B increase in spending, will increase in AD by $4 B.

But, if MPC = .8

Then, spending multiplier = 1/(1-MPC) = 1/(1-.8) = 5

So, $1 B increase in spending, will increase in AD by $5 B.

So, it can be seen that with increase in MPC, AD increases by a bigger margin.

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C.

If saving rate increases, then it means that consumers are saving more and spending less. So, MPC will decrease. It will diminish the impact of fiscal initiatives in the economy.

Here, AD curve shifts from AD1 to AD2, increasing real output from Q' to Q''.

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D.

Yes, both the policies are aligning with each other. Reduced rate of interest, reduces the cost of borrowing. It causes consumption and investment spending to increase. So, AD increases. Now, with increase in government spending, AD also increases. It leads to the economic recovery and economy expands. So, both policies are complementing each other.