VCAA Economics Aggregate demand policies and domestic economic stability

Answer(s) could include:
Australian economy:

• reference to severe contraction (recession) and nature of demand and supply shock from exogenous factors particularly the coronavirus
• main economic indicators and how they have changed over the year: GDP growth, unemployment, inflation, investment, exchange rate, consumer spending etc.
• reference to industries hardest hit by contraction
• global financial crises and uncertainty
• effect of slowdown of global economic growth on local economy.

Monetary policy:

• reduction in cash rate by RBA and market interest rates - expansionary
• intended effect on consumption, investment and exchange rate via transmission mechanism
• aim to support aggregate spending and create employment
• role of multiplier effect.

Fiscal policy:

• range of significant stimulus payments to households and government policy support for businesses during time of collapsing consumer spending
• reduction in government revenue and increase in expenditure
• movement to a significant budget deficit from planned budget surplus
• role of multiplier effect..

AE model:

• 45 degree line, AE on vertical axis, Real GDP on horizontal axis
• parallel AE lines demonstrating impact of recession and policy effect
• increase in equilibrium real GDP to reduce deflationary gap.

Answer(s) could include:

Monetary policy:

• overall effectiveness is likely to be poor; no guaranteed increase in aggregate spending such as, cost of borrowing and asset prices channels
• interest rates were already very low, further reductions likely to have limited impact due to low consumer and business confidence
• household debt is high making it more likely households will seek to retire debt rather than borrow
• depreciation of Australian dollar will have increased net exports despite a significant fall in world growth
• significant effect time lag.

Fiscal policy:

• more effective because government spending can increase aggregate spending directly
• government expenditure multiplier likely to be low because of low MPC
• government reluctant to go into too much debt given experience post-GFC
• other criticisms relevant to success of policies implemented in 2020.

A number of factors effect both policies, i.e. multiplier effect, expectation, and crowding out effects.

The government may struggle to achieve a budget surplus due to falling levels of economic activity across the nation due to the ongoing Covid-19 pandemic. Given that some industries will not recover in many years such as aviation, the budget outcome is likely to deteriorate due to automatic stabilisers. This refers to changes in the budget outcome which occur automatically in response to changing levels of economic activity. Lower levels of economic activity reduces company profits and income levels, reducing the receipts of company and income tax, thus worsening government revenue. This is particularly evident in 2020 due to the Covid-19 pandemic, due to ongoing lockdowns, making it more difficult to achieve a budget surplus in the short to medium term. A second reason the government may find it difficult to achieve a surplus in the near future is the significant outlays expended on discretionary stabilisers, which refer to deliberate changes to the composition of government outlays. The significant cost of some measures such as Jobkeeper (＄101 bn) and Instant Asset Write-Off (＄30 bn) makes it hard for the government to consolidate its finances due to its significant stimulus measures to support the collapse in AD during the Covid pandemic.

Automatic stabilisers are components of the budget which vary in a generally counter-cyclical manner in correspondence to changes in the level of economic activity. As such, they occur independently of government decision making. During 2020, the Covid pandemic has led to an unprecedented downturn in the level of economic activity. Consequently, automatic stabilisers or the cyclical component of the budget has changed, helping to support economic activity. For instance, the downturn led to an increase in the unemployment rate from about 5% to a approx 7.5% leading to an increase in the amount of Australians eligible to receive unemployment benefits. In addition, many income earners moved into lower tax brackets, which reduced their tax liability to the government. Both these factors helped to protect disposable incomes (or reduce the fall in incomes) for a substantial portion of Australians, which had a favourable influence on both consumption expenditure and AD. As a result, the recessionary trough of the business cycle is likely to be somewhat reduced, which stabilises the business cycle by counter-cyclically increasing injections relative to leakages in the economy and supporting AD and economic activity.

Strong and sustainable economic growth involves achieving the strongest growth rate possible, consistent with employment growth, but without adding to unacceptable inflationary, external, or environmental pressures often around 3 to 3.5% per annum. A discretionary initiative designed to influence AD and the achievement of the goal is JobKeeper. This is a ＄130 billion wage subsidy of ＄1500 per fortnight which are designed to allow businesses to retain employees in light of lockdowns and the covid pandemic’s economic shock. Hence, it ensures that employees are able to continue to contribute to levels of consumption during this time, increasing levels of AD. Additionally, it reduces the need for any re-employment processes after the pandemic, reducing the potential for immediate labour bottlenecks and skill shortages, as well as allowing AD to rebound more easily and sustainably.

Another policy is the instant asset tax write off scheme, allowing firms to claim back the full costs of depreciable assets, such as machinery and equipment. This encourages greater business investment and stimulates AD and real GDP. In addition, by incentivizing businesses to invest, it is likely that new capital will drive down average production costs, encouraging growth in productive capacity or aggregate supply. This helps to reduce prices and encourage further growth in AD, which leads to stronger and more sustainable growth once the pandemic ends.

The goal of employment refers to achieving the situation where everyone who wants a job is employed as well as achieving the maximum rate of reduction in unemployment, including the elimination of cyclical unemployment and achievement of a natural (or NAIRU) rate of unemployment of about 4.5%. Given that the unemployment rate has remained well above this rate in 2020, it suggests that monetary policy has been ineffective. Despite having an inflationary first target, the current deflationary environment has allowed the RBA to instead focus on ‘jobs growth and economic recovery’. However, due to the low levels of consumer confidence and high levels of household indebtedness, the very expansionary monetary policy setting (CR = 0.1%) has largely been ineffective as the higher level of discretionary income of consumers has either been saved or used to repay debt, with relatively little being spent in the economy on goods and services, thereby having a minimal impact on the demand for labour and unemployment. Due to the reduced effectiveness of the cash flow and cost of credit channels, the RBA has adopted less conventional methods, including quantitative easing, with the purchase of government bonds to further increase liquidity in the economy. This highlights a strength of monetary policy as the RBA has the freedom and flexibility to do more than simply reduce the cash rate during a recession in an effort to boost employment and reduce the rate of unemployment. Overall, with the economy experiencing negative economic growth and growing unemployment, it is clear that monetary policy has largely been ineffective at achieving full employment over 2020. In particular, and in stark contrast to budgetary policy, it would not have been able to prevent the rate of unemployment climbing above 10%, because its relatively one-dimensional and blunt nature does not allow it to target specific areas of the economy, such as wage subsidies for employers.

If there is a lower than expected unemployment rate, there may be lower than expected [number of] people receiving unemployment benefits, decreasing government expenses on welfare. Also, there may be a higher than expected number of people not earning taxable factor incomes as they are employed, causing personal income tax receipts to be raised upwards. With rising receipts to falling expenses, this improves the budget outcome and may lead to a lower budget deficit than expected.

The announcement of the extension of the energy rebate for another 6 months in the 2025–26 budget outcome will see households’ electricity bills reduce by ＄150 in total, ＄75 per quarter. Thus this will see a rise in discretionary income (factor income + welfare – direct taxes – necessities) as electricity is a necessity and has inelastic demand. This will thus increase C and hence the AD. Firms will thus notice rising sales and falling stock levels thus increasing production levels (GDP) hence increasing economic growth. As the current rate of economic growth is 1.8%, this will help assist in the achievement of the goal by making economic growth more ‘strong’ (increasing it closer to the unofficial target of 3–3.5%). Furthermore, as electricity is counted under ‘housing policy’ category in the CPI, this will help reduce the growth in the CPI and hence inflation rate, therefore making economic growth more ‘sustainable’ (causing less inflationary pressures) assisting with the achievement of the goal.

The goal of low and stable inflation (price stability) is to maintain general price levels in the economy, typically a rate of 2–3% inflation. In global uncertainty, one strength of monetary policy in particular is its lack of political bias. The RBA being an independent body would not be affected by changing political stances, making them focus solely on achieving this goal. This allows them to become more contractionary when required to reduce inflation, helping it to achieve price stability. One strength of budgetary policy during uncertainty is it swings into action automatically with automatic stabilisers. If tariffs increase and countries retaliate, it may decrease overseas economic growth and negatively impact economic growth and AD in Australia. Since the cyclical component automatically takes effect, it will quickly increase outlays via welfare payments and decrease receipts via lower tax payments if unemployment goes up. This allows it to maintain a higher inflation rate to protect it from going below 2–3% as going below can lead to delayed consumption etc. However, a weakness of monetary policy in particular is its inability to control cost inflation. In global uncertainty and when geopolitical events arise, the economy may have higher cost inflation as other countries may have high inflation and if Australia increases tariffs, increasing the price of intermediate goods required for production. Since the RBA can only control demand inflation, it makes it ineffective at targeting this cost inflation, reducing its ability to achieve price stability. Additionally, since budgetary policy is controlled by the government, political bias may increase cost inflation. During global uncertainty, the government may introduce tariffs, increasing the cost of imported intermediate goods which raises cost inflation, undermining its ability to achieve price stability.