Question

1. At the same time as the RBA is reducing interest rates the Australian Government will be running a budget deficit in 2020. How this will affect aggregate demand? A diagram would assist your answer here and attract further marks
2. How will the size of the marginal propensity to consume affect the size of the multiplier and how will this impact on this fiscal policy initiative?
3. If consumers decide to increase their rate of savings due to increasing uncertainty about the future, explain how this will affect the fiscal policy initiative.
4. Discuss whether this fiscal policy initiative aligns with the RBA’s decision to reduce interest rates.          

Answer 1

a. RBA is reducing the interest rates and the government will be running a budget deficit as the government has borrowed more and spending more than their revenue base. Thus they are trying to increase the aggregate demand in the economy, which had fallen from previous levels led by Covid and lockdown.

Thus as the interest rate is reduced, LM curve shifts to the right and down as interest rate is reduced and money supply increases. IS curve shifts to the right as government expenditure increases. This will shift the aggregate demand to the right as government will spend more in order to spur up the economy and people will borrow more and spend as interest rates have declined.

b. Multiplier is given by 1 / 1 - mpc

Where mpc is the marginal propensity to consume. The Greater the marginal propensity to consume, the greater is the multiplier. Thus fiscal initiative will benefit everyone as extra income is generated when mpc is high, as people spend more and save less.

c. If consumers decide to increase their savings due to increasing uncertainty about the future, then this will reduce the effect of the fiscal policy initiative as enough extra money won't be generated because the money doesn't get circulated in the economy, which reduces the demand and thus impacts the efficacy of the fiscal policy initiative.

d. The fiscal policy of increasing aggregate level of demand in the economy does align with the RBA's decision to reduce the interest rates as the monetary policy decides to reduce the interest rate in order to spur investment in the economy, and increase output, which is what the fiscal policy is also trying to do by increasing government expenditure and thus the budget deficit.