Question

Use the following news clip to work on the following questions:

Debt Reduction at Center of State Election Campaign
Queensland business leaders are demanding that the election campaign focuses on reducing a
growing debt level and putting the state’s finances back on track. The state’s financial position
has been under fire because of a debt blowout caused by the domestic and international market
volatility and the natural disasters last year.

a. If reducing debt means spending cuts, will aggregate expenditure fall by more than, less
than or exactly the same as the spending cuts? Explain.
b. Explain and draw a graph to illustrate the effects of the events described in the news clip
on aggregate expenditure and aggregate demand in both the short run and the long run.

Answer 1

a) Let us first define debt. Debt is the summation of Government's past deficits.

Aggregate Expenditure= Consumption (C) + Investment (I) + Government Spending (G) + Net Exports [Exports-Imports] (X-M)

Consider an equilibrium position in the goods and money market. In an attempt to reduce debt by curtailing spending by the government, ie. a fall in the government spending (G), would shift the IS curve to the left exactly by the amount of the change in the government spending (G). Symbolically, = . This shift in IS would lower the real interest rates from to and output level from to at a new and lower equilibrium level of to .

There will be two impacts of the fall in interest rates-

1. If the investment spending is a function of interest rates (negative relationship), then a fall in interest rate would raise investment spending and will thus lead to shift in the IS curve.

2. Lower interest rates will cause a fall in demand for the foreign exchange, thus lowering the exchange rate or depreciation of the currency and boosting net exports. This will further cause the shift in the IS curve.

This will happen till the IS curve moves back to its original position with as the equilibrium. The fiscal contraction completely crowds in the private investment. The net long-run effect on aggregate demand will be zero.

b) (i) An increase in domestic and international market volatility may lead to a demand shock implying a fall in aggregate expenditure. This fall in expenditure could be in the form of a decline in investment spending or a fall in net exports. As a result, in the short-run, the Aggregate demand curve will shift to the left from to , lowering the prices from to and output from to . The supply cannot be adjusted in the short-run, hence, the final equilibrium is achieved at from .

However, in the long-run, supply will adjust to the lower prices and the suppliers will raise supply, shifting the aggregate supply curve to the right. This will happen till the new AS curve intersects with the new AD curve at , thereby reducing prices further to and output raising to original level of .

(ii) The natural disaster happened last year lead to a supply shock. In the short run, the AS curve will shift from to causing a rise in prices from to and a fall in output from to , a situation called as stagflation. As a result of the price rise, the aggregate demand will adjust in the long-run and shift from to , lowering prices to with output unchanged at .