Question

Question 5

1. 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
2. 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?
3. 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.
4. Discuss whether this fiscal policy initiative aligns with the RBA’s decision to reduce interest rates.

Answer 1

(a) To understand the effect of reduced interest rate by the RBA and the budget deifit ny the australian government we need to understand the components of aggregate demand AD,

AD = C (Y-T) + G(T) + I(r) + NX

C = Private consumption which depends on the disposable income, income after taxes T

G = Government expenditure which is a function of taxes T

I = Investment spending which is a function of real interest rate r

NX = Net exports.

So when the RBA of australia reduces the interest rate the real interest rate r goes down as aresult investment speinding increases from I to I' and when the australian government runs a budget deficit they are spending more than what they previously uswd to do as a result the G goes up from G to G'. In the figure you can see that original AD curve and original AS curve and the initial equilibrium was at point A where the initial equilibrium output was Y* and the initial equilibrium price level was p*.

But the AD curves shifts to the right due to the reasons mentioned above, the new AD curve is shown by the AD' where the G increases to G' and I increases to I'. And the new equilibrium is at point B. Now the equilibrium output is at Y' and the equilibrium price level is at P'.

So the equilibrium output increases as well as the equilibrium price level.

(b) The formula for multiplier is given as,

Multiplier = 1/(1-MPC)

Here MPC = Marginal propensity to consume

As you can see that the marginal propensity to consume is positively related with multiplier. So If the MPC is low the multiplier will be low and of the MPC is high then the multiplier will be high. So a hihg MPC will increase the the impact of fiscal intervention but if MPC is low then the impact of fiscal intervention will be lower.

(c) If the consumers starts to increase their savings due to increased uncertainty which means their marginal propensity to consume falls and as discussed earlier that a low MPC will reduce the impact of fiscal intervention. So a higher saviings would mean that the impact of fiscal intervention will be reduced.

(d) As discussed in part a due to reduced interest rate by RBA the investment spending I increases to I' from I. And due to budget deficit by the australian government the government expenditure increases to G from G. So we can say that the fiscal intervention aligns with the monetary intervention which is reduced interest rate, since both the interventions increases the aggregate demand.

I hope I was able to help you, thank you.