Question

During the spread of CPOVID19 pandemic in 2020 and the onset of the global financial crisis in 2007/08, the government of Australia decided to temporarily increase spending to avoid recession in both events. Given that Australia is a small open economy with a floating exchange rate, discuss the impacts of such policy shocks on the economy (trade balance, aggregate demand and aggregate supply) if residents perceive the effect of the shocks as:
      i.        Temporary
    ii.        Permanent

Answer 1

Permanent and Temporary Increase in government spending

In both cases of a permanent and a temporary increase of government spending we will take hypothetical example.

PERMANENT increase in Government Spending

Refer to the below figure (Panel a): X-axis shows the real GDP in Australia and Y-axis shows the price level. Initially, the economy is at equilibrium point A, where aggregate demand curve AD1 and aggregate supply curve AS1 intersect. At this point, equilibrium level of income is Y1 and equilibrium price level is P1.

Suppose the government spending is temporarily increased by 100 units. In order to finance the increase in government spending, the lump sum taxes (not the tax rate) are also increased by 100 units. If the residents of Australia, perceives the increase in spending as permanent than the increase in tax amount is also assumed to be permanent. This reduces the disposable income (Y-T) of the households permanently by 100 units which induces them to reduce their consumption accordingly. Assuming marginal propensity equal to one, a fall in 100 units of disposable income would lead to a fall in consumption entirely by 100 units. Initially, a rise on government spending (G) is completely off-set by an equivalent fall in consumption expenditure ( C), making the aggregate demand unchanged. This just leads to reallocation of expenditure away from private sector towards public sector.

Lower disposable income makes households less wealthy (wealth effect), which induces them to work extra hours in order to make up some of their lost spending power. How much they try to put in extra working hours, in reality it is not possible for them to replace the entire 100 units lost in consumption. Instead, only a part of the disposable income could be replaced and let's say that mounts to 40 units. Thus an increase in work effort leads to an increased production and shifts the aggregate supply rightwards from AS1 to AS2 by 40 units. Along with this the consumption component too increases by 40 units. Thus, with a net change (60 units fall in consumption and 40 units rise in consumption) – the aggregate demand too shifts rightwards by the amount of 40 units.

As a result, the economy moves to a new equilibrium level at point B, where equilibrium income rises from Y1 to Y2, but the price level remains unchanged to P1. With an unchanged price levels, interest rates and exchange rates remain stable and leads to no change in the trade balance of the economy.

TEMPORARY increase in Government Spending

Refer to the below figure (Panel b): X-axis shows the real GDP in Australia and Y-axis shows the price level. Initially, the economy is at equilibrium point A, where aggregate demand curve AD1 and aggregate supply curve AS1 intersect. At this point, equilibrium level of income is Y1 and equilibrium price level is P1.

Suppose the government spending is temporarily increased by 100 units. In order to finance the increase in government spending, the lump sum taxes (not the tax rate) are also increased by 100 units. If the residents of Australia, continue to perceive the increase in spending as temporary only then the increase in tax does not lead to a fall in consumption initially – no wealth effect initially. As government spending (G) increases by 100 units with no initial change in any other component of aggregate expenditure, aggregate demand curve shifts upwards from AD1 to AD2 by 100 units. This increases the output and the price level (to P2), in response to the excess demand. This in turn drives up the interest rates in the economy.

Thus, a temporary increase in government spending drives up the interest rates. With higher interest rates, there is an increased capital inflows in the domestic country (here Australia) leading to appreciation of Australian dollars. Along with this, higher price levels make Australian exports less competitive in the foreign exchange market and thus the economy experiences a fall in its Exports. The overall impact is a fall in trade balance/net exports.

Higher interest rates induces the domestic private sector to reduce investment spending leading to Indirect crowding out. The fall investment spending is not one for one i.e. it does not fall by an exact amount of 100 units. It actually falls by a lesser amount say by 70 units – making output to rise actually by 30 units from Y1 to Y2.