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1

How fiscal policy influences aggregate demand

Changes in government purchases

Changes in taxes

Supply side economics

2

Changes in government purchases

When the government changes the level of its purchases it influences aggregate demand directly. A decrease in government purchases shifts the aggregate demand curve to the left. An increase in government purchases shifts the aggregate demand curve to the right.

The multiplier effect and the crowding out effect

3

The multiplier effect

The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

4

Expansionary fiscal policy

A planned decrease in the budget surplus (e.g. tax cut) to increase household's income and consumption.

5

Contractionary fiscal policy

A planned increase in the budget surplus (e.g. reduced government spending without any reduction in taxes.)

6

The crowding out effect

The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

7

The multiplier and crowding out effect

If the multiplier effect e.g. 3 billion is greater than the crowding out effect e.g. 2 billion, aggregate demand will rise by more than 1 billion and vice versa

8

Changes in taxes

Changes in taxes affect affect a households take-home pay. If the government reduces taxes, households income will increase which results in higher saving and consumption. The aggregate-demand curve will shift to the right and vice versa. The size of the shift in the aggregate demand curve will also depend on the sizes of the multiplier and crowding-out effect.

9

Supply side economics

Tax policy and work incentives

Fiscal policy and AS curve

10

Tax policy and work incentives

A decrease in tax rates may cause individuals to work more because they get to keep more of what they earn. The aggregate supply curve would increase (shift to the right). However most economists believe that a cut in tax rates only has a small effect on the AS curve

11

Fiscal policy and AS curve

If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right.

12

Using policy to stabilise the economy

Active stabilisation economy

Automatic

Against active stabilisation policy

13

Active stabilisation policy

The level of aggregate demand can be influenced by a change in government spending or taxation (fiscal policy) or a change in the interest rate (monetary policy). Keynesians believe that it is necessary for the central government to use its tax, government purchase ad interest rate (open market operation) policies aggressively to stimulate the economy during recession and slow the economy down during inflationary times.

14

Automatic

Fiscal policy

Government spending

Tax system

15

Fiscal policy

Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

16

Government spending

Government spending is also an automatic stabiliser. More individuals become eligible for transfer payments during a recession. E.g. unemployment payments to the unemployed.

17

Tax system

The most important automatic stabiliser is the tax system. The government's revenue falls during a recession. Tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn.

18

Against active stabilisation policy

Fiscal and monetary policy tools should only be used to help the economy achieve long run goals such as low inflation and economic growth. Policy tools may affect the economy with a large time lag.

19

Policy tools may affect the economy with a large time lag.

With monetary policy, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly.

With fiscal policy the lag is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate.

20

How monetary policy influences aggregate demand

The aggregate demand curve is downward sloping.

The theory of liquidity preference

21

The aggregate demand curve is downward sloping

3 reasons

Pigou's wealth effect

Keyne's interest rate effect

Mundell-flemings exchange rate effect

22

Pigou's wealth effect

Keyne's interest rate effect

Mundell-flemings exchange rate effect

All three effects occur simultaneously but are not of equal importance. Household's money holdings are a small part of the total wealth (small wealth effect). Imports and exports are a small fraction of Australian GDP, the exchange rate effect is also fairly small for Australia. The most important reason for the downward sloping aggregate demand curve is the interest rate effect.

23

The most important reason for the downward sloping aggregate demand curve is the interest rate effect.

A higher inflation rate induces the RBA to reduce interest rate. A higher interest rate reduces the quantity of goods and services demanded.

24

The theory of liquidity preference

An explanation of the supply and demand for money and how they relate to the interest rate. 29/9

The money supply is assumed to be controlled by the central bank. Since the money supply does not depend on other economic variables, it's a vertical line.

Interest rate is the opportunity cost of holding money. As the interest rate rises the quantity of money demanded will fall. Therefore, the demand for money will be downward sloping.

25

5. Which of the following policies would Keynes have supported when the economy is experiencing unemployment?
a. An open-market purchase
b. A reduction in tax rates
c. An increase in government purchases
d. All of the above

Keynes would have supported a policy that directly increases spending within the economy. An open market purchase by the RBA would lower interest rates, encouraging increased consumption and investment spending. A reduction in tax rates would encourage greater consumption spending. An increase in government purchases would directly contribute to an increase in national expenditure. Thus, Keynes would have supported all the possible options presented here.

26

9. Why do people still hold cash in their wallets, despite the fact that they receive no returns compared to storing cash in their bank accounts?

According to the liquidity preference theory, people hold cash because it is by far the most liquid asset for completing transactions. In other words, people derive the benefit from holding cash not by receiving interest payments; the benefit flows through in the form of convenience.

27

10. What are the key determinants of the interest rate in the short run? What are the key determinants of the interest rate in the long run?

In the short run, we can think of the interest rate as being determined in the money market, so its key determinants are the supply of and demand for money. In the long run, we can think of the interest rate as being determined in the loanable funds market, so its key determinants are the supply of and demand for loanable funds.

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11. What are the impacts of an expansionary fiscal policy on output and the inflation rate in the short run? How about in the long run?

An expansionary fiscal policy will raise both output and the inflation rate in the short run. However, without corresponding changes to long-run aggregate supply, such a policy will only lead to a permanent increase in the inflation rate.

29

12. Define expansionary and contractionary fiscal policy, giving examples of each.

expansionary = a planned decrease in the budget surplus (T-G); e.g. a tax cut

contractionary (or tight) = a planned increase in the budget surplus (T-G); e.g. reduced government spending without any reduction in taxes