Question

b. Consider the current economic conditions in Australia, where (even though official data is not yet in) current output (real GDP) is currently below potential GDP.

(i) What type of fiscal policy has the government used to try and get Australia to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation). Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changing (if any), and in which direction.

Answer 1

Answer: Type of fiscal policy the govt. has used to try and get Australia to potential GDP:

The fiscal policy is the use of govt. spending and taxation to influence the economy. The fiscal policy comprises of expenditure policy and taxation policy of the govt. The objective of fiscal policy is to increase aggregate demand.

Main tools of fiscal policy are :

1. Expenditure policy: (increase expenditure) the objective of this policy is to pump more money in the system that gives a fillip to the demand. during a period of deficiency in demand, the govt should increase investment in public works like construction of roads, bridges, buildings, railway lines, health facilities, etc. the aim is to give more money in the hands of people so that they should spend more.
2. Revenue policy: ( Reduce tax rate) taxes on personal incomes and corporate incomes should be reduced to encourage private consumption and investment. If possible, tax on lower-income groups is abolished. this will increase their disposable income for spending. in addition subsidies, old age pension, unemployment allowances and grants should be given. incentives like interest-free loans, installment schemes, etc. should be given to consumers to boost aggregate demand.

AD-AS APPROACH

It is the level of income at which AD=AS. At equilibrium, whatever output of goods and services is produced is either is consumed by the household and invested by the firms.

The following changes take place when AD is not equal to AS :

1) When AD> AS means the planned expenditure(AD) on goods and services is more than the planned output(AS) . as a result, producer's inventories will fall below the desired level. To meet the excess demand, firms will start raising production until inventories reach the desired level, and AS is equal to AD.

2) When AD< AS this means that planned expenditure in the economy is less than what the producers expected. in such a situation there would be an excess supply of goods and services due to an unplanned increase in inventories of unsold stock. in this situation, producers will produce less. this continues till AS=AD