Question

The Australian economy is expected to record a contraction in GDP of around 10 per cent over the first half of 2020; total hours worked are expected to decline by around 20 per cent and the unemployment rate is forecast to rise to around 10 per cent in the June quarter. Inflation is expected to be negative in the June quarter largely as a result of lower fuel prices and free child care. (Source RBA)

Fiscal Policy Responses

Over the past month, the Federal Government has announced an unprecedented fiscal injection of $194 billion (almost 10 per cent of GDP) consisting of $39 billion directly to business, $25 billion to households and the $130 billion Job-Keeper payment to support business and households through the COVID-19 shutdown.

Monetary Policy responses

The Reserve Bank of Australia has reduced the cash rate to 0.25%

Possible Outcome

A plausible baseline scenario is that the various restrictions are progressively relaxed in coming months and are mostly removed by the end of September, except for some restrictions such as international travel. If this occurs, and the spread of the virus in Australia remains limited, GDP growth is likely to turn around in the September quarter and the recovery would strengthen from there.

Questions:

1.Use the ADAS model to describe the monetary responses of the RBA to the pandemic. Is this an expansionary or contractionary monetary policy? What is the main objective of this monetary policy? What are the possible risks you see in this monetary policy?

2.Use the ADAS model to describe the fiscal policy responses of the Australian government. Is this fiscal response a demand side policy or a supply side policy? What are the intended effects?

Answer 1

Answer 1:

The pandemic has caused recesionary gap in the economy because actual level of GDP in the economy is below the potential level of GDP in the economy and the economy is currently at point E₁ where price level is P₁ and actual level of GDP in the economy is Y_1.The RBA has reduced cash rate in the economy which leads to decrease in reserve requirements of banks and thus increases the level of money supply in the economy. This is known as Expansionary Monetary policy of the government. The main objective of this monetary policy is to increase the level of aggregate demand in the economy which will help in eliminating recessionary gap in the economy and move actual level of GDP closer to the potential level of GDP in the economy.

This will shift the AD curve of the economy rightwards to AD' and at new equilibrium point E2 prices will increase to OP2 and output will be at the full employment level. Some of the possible risks of the monetary policy are:

1. Increase in inflation rate

2. Lack of Monetary Transmission from Commercial banks to the general public because interest sensitivity of investment decreases during the time of recession.

Answer 2:

The measures taken by the government are demand side measures aimed at increasing the level of aggregate demand in the economy. Because it involves direct payment to businesses and households which will increase the level of consumption and investment expenditure in the economy and shift the AD curve of the economy rightwards to AD' where at new equilibrium point E2, there has been increase in price level and increase in the level of Real GDp in the economy.