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 sizeable government debt overhang, and a U.S. Federal Reserve willing to tolerate somewhat higher inflation could win out and push prices higher.”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 Expenditure- 450 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.

The above mentioned changes will lead to leftward shift of the aggregate supply of the economy and decline in demand will shift the aggregate demand curve of the economy leftwards to AD' and the equilibrium will shift from point E1 to point E2 where price level has decreased to OP₂ and the level of real GDP has decreased to OY₂.

b.

Combination of various expansionary fiscal and monetary policies will increase the level of government expenditure in the economy, reduce taxes and also increase the level of money supply in the economy which will shift the AD' curve back to AD and this leads to increase in price level in the economy as new equilibrium is established at higher prices where SRAS' and AD curve intersects.

c. According to Quantity theory of money, Money Supply * Velocity = price level * Output.

In this case increase in the level of money supply will lead to increase in the level of prices in the economy considering the fact that velocity and output are constant in the economy.

d. The borrowing will increase the demand for loanable funds which will increase the rate of interest in the economy. As the rate of interest increases, the level of private investment will fall in the economy. Since government expenditure has multiplier impact on the economy, thus national output will increase but not by the full multiplier impact because of decrease in private investment.