Question

This question is based on the following commentary:

“Amid the challenges brought about by the COVID-19 pandemic and the stringent measures taken to contain it, inflation concerns are surfacing. This is understandable, given potential disruptions to the supply of a range of goods and given the trillions of government dollars being employed to stabilize global economies. For now, though, the greater likelihood is disinflation—a slowing in the rate of inflation. The data underlying a 0.4% decline in April in the U.S. core consumer price index, the largest monthly drop on record, hinted at what we could see in the months ahead. Vanguard expects that, in the near term, the effects of diminished demand will outweigh upward pressures on inflation given increased unemployment and consumers’ general reluctance to spend. But eventually, any lingering impact on supply chains, a sizable government debt overhang, and a U.S. Federal Reserve willing to tolerate somewhat higher inflation could win out and push prices higher. … The global policy efforts of the last few months have been unprecedented, appropriately so given the unprecedented nature of the challenges that the global economy and health officials face. When the immediate challenge is over, getting central bank balance sheets and fiscal budgets back toward normal will take some doing and may involve somewhat higher-than-target inflation. With more information about the trajectory of recovery, we’ll shape our longer-term view. But as the experience of the global financial crisis shows, 1970s-style runaway inflation need not be part of it.” (Andrew Patterson, Vanguard senior economist, June 2020)

(a) Using a basic (static) aggregate demand/aggregate supply diagram, explain and illustrate what is meant by the combined short run effect of having “potential disruptions to the supply of a range of goods” and “the effects of diminished demand will outweigh upward pressures on inflation.”

(b) “But eventually, any lingering impact on supply chains, a sizable government debt overhang, and a U.S. Federal Reserve willing to tolerate somewhat higher inflation could win out and push prices higher.” Using the basic (static) aggregate demand/aggregate supply diagram, explain how eventually a combination of monetary policy and fiscal policy measures (mention examples of these monetary and fiscal policies) adopted by the Australian government could lead to higher prices during the current pandemic.

(c) “When the immediate challenge is over, getting central bank balance sheets and fiscal budgets back toward normal will take some doing and may involve somewhat higher-than-target inflation.” One way the government can get balance sheets back to normal and finance government debt is to print money. For example, the Reserve Bank of Australia can print money to purchase the bonds sold by the government's treasury department. Explain using the quantity theory of money how inflation might eventually arise over time.

(d) “…given the trillions of government dollars being employed to stabilize global economies.” Apart from printing money, an alternative way to finance government debt is by borrowing. The government’s treasury department can sell government bonds to finance its deficit. Using an Aggregate Expenditure450 line diagram and assuming that there is no inflation, explain how this borrowing will affect private investment, and its subsequent effect on the aggregate level of expenditure and output. What happens in the long run?

Answer 1

A.

B. Fiscal policies such as increase in government spending and reduction in tax rates can help in increasing the demand, income, employment and output by shifting IS curve rightwards. Similarly, expansionary monetary policy like printing money to increase money supply can shift LM curve rightwards and can help in increasing demand in the economy. Both expansionary monetary and fiscal policy will affect aggregate demand in the economy and will shift AD curve rightwards leading to a push in the prices.

C.

According to Quantity theory of money, general price level of goods and services is directly proportional to the amount of money in circulation.

• is the price level
• T is an index of the real value of aggregate transactions.
• M is the money supply
• V is the velocity

so, When there is a rise in the supply of money by printing money , there is a proportional change in the price and price will eventually rise.

D.

Aggregate Expenditure = C + I + G + (X – M).

Increase in borrowing will increase the government spending and will shift aggregate expenditure line upwards. In the long run, economy will return back to it's potential GDP.