Tutor: (Danielle Hayek)
Question 1: AS-AD Diagram (Please refer to Diagram 1)
In January 2011 Core Inflation per Quarter was 2.6%, represented by point A on the diagram where the Long Run Aggregate Supply (LRAS), Short Run Aggregate Supply (SRAS) and Output curves intersect. Point B represents the increase in inflation to 2.7% in January 2014. Increased inflation causes the SRAS curve to shift upwards to SRAS’s signalling a decrease in short run aggregate supply. Unemployment increased from 5.1%-6%. This causes a decrease in output depicted by Y* falling to Y’ (contractionary gap since potential output is more than actual output). This sequence creates a movement along the output curve from A to B creating a new equilibrium point. (Please refer to Charts 1 and 2)
Question 2: Fiscal Policy after the GFC
Examining information from Table 1 regarding 2008-2009 it is clear that the fiscal stimulus has worked. This is because most actual economic growth indicators contradict the budgeted predictions. The budget predicted that household consumption would decrease by -0.25%. In fact, household consumption rose by 2.3%. One indicator that stands out is business investment. The budget predicted that business investment would undergo a severe decline of 18.5%. However, it only fell by 3.2%. The unemployment budget forecast was 8.25% for 2008-2009. However, yet again, this was a false alarm as unemployment was 5.3% in June 2010. This indicates that the government’s expansionary fiscal policy had a positive effect on the economy contradicting the forecasted high unemployment.
Monetary policy was also responsible for this effect. In Chart 3 there is empirical evidence that the RBA manipulated the cash rate. Between December 2008 and June 2009 it dropped from around 4% to 0%. This decrease saw households and businesses increasing their level of borrowing since borrowing (interest) became cheaper. This fuelled consumption and investment leading to economic stimulation. The decreased cash rate also led banks to create more money.
Discretionary fiscal policy’s underlying problem is huge time lags between policy implementation and desired results. Dynamics of change, according to Milton Friedman, associated with time presents the problem of when to implement the correct policy. One problem with the government’s expansionary fiscal policy is that not all of the government’s spending stimulates the economy. Most of this money will be saved by households. Saving is a withdrawal of money from the economy and will not benefit the economy greatly. Inflation has peaked at 4.5% in December 2008, as seen in Chart 2. This can be attributed to the decreased cash rate creating stimulation within the economy and prices of goods rising.
Question 3: The Direction of Monetary Policy and