1) How does Australia finance its current account deficit? What long-term problems will arise for Australia if it uses its capital account surplus to fund current consumption instead of increasing its productive capacity? Explain carefully. What evidence exists that this is a problem?
Current account deficit encompasses a situation where there are greater amounts of goods and services imported into the country compared to the amount of the goods and services exported outside of the country so that debits exceed credits. This means that the country’s expenditure for imports exceeds the amount that enters the country from exports. Theoretically, macroeconomic policy in this situation centres on achieving balance between aggregate demand and supply. On one hand, the government can implement demand-side policy by influencing the extent of spending of the economy. By doing so, cutbacks on import purchases will have a positive effect on production and prices of domestic products and on local employment. On the other hand, the government can implement supply-side policy by providing incentives for business people and workers to enhance the level of productivity in the economy. (Jackson and McIver, 2001)
In application, Australia focused on demand-side policy to address its persisting current account deficit cycling to and from one and a half to seven and one fourth percent or an average of four and a half percent of the gross domestic product. The federal government’s response included compulsory private-saving schemes together with sustained fiscal restraint (Gruen, 2005). These had the effect of increasing the national savings to a level that the country could not have achieved without a tight fiscal policy. In the national budget for 2005-2006 the government affirmed its commitment towards gradual but continuing tightening of fiscal policy in the medium term. Through this strategy, budget balance persists on the average above the cycle with the effect of current account deficit decreasing to one fourth to one half of GDP despite the exclusion of the Future Fund asset earnings from the budget.
Capital account comprises the record of the flow of funds coming out and getting into a country or debit and credit respectively. A capital account surplus means that funds getting into the country are higher than the amount exiting the country on capital account (Jackson and McIver, 2001). The flow of funds covers activities such as the disposal and acquisition of fixed assets such as land, fund transfer of funds by migrants, government grant payments for overseas projects, and government receipt of money for capital projects. Capital account surplus relative to the current account means that the country has sold its assets or incurred debt in order to meet the current account deficit. Current account and capital account comprise equivalent or comparable variables in the balance of payments.
With a capital account surplus, the government’s decision to use the surplus for consumption instead of investing in the enhancement of the economy’s productive capacity involves several implications. Ideally, spending on consumption instead of investment into production will not cause a significant multiplier effect over the money spent for consumption. While it is true that consumption would accrues revenue to businesses, giving them the financial capability to expand production, which in turn creates employment and provides income to people, the process does not necessarily lead to further production because of the many uncontrollable intervening factors such as the decision of the business firm not to expand or spend profit for other things. Moreover, this only has a short-term, minimal effect relative to the fiscal tightening policy of the government. This is because even with spending providing revenue to businesses, the encouragement of savings by the government would lead to the decrease in demand, which would not support the expansion of production. To motivate businesses to expand their production capacities, the expected increase in demand should be sufficient enough to equal the increase in production. If businesses perceive that people are more inclined to save instead of save, they would not invest the money derived from the spending of the surplus for consumption.
Without expansions in production to make domestic products competitive to imports, the entry of cheaper import products into the Australian market would further increase the current account deficit. Despite the tight fiscal policy of the government, this may not be enough to arrest or minimize the persisting deficit. The insufficiency of the tightening fiscal policy as a solution to current fiscal deficit is justified by the inability of the government to achieve its goal to minimize deficit to a level less than one percent of the gross domestic product. The current account deficit may stretch towards its fourth decade of unacceptable value.
2) What effects might each of the following have on aggregate demand or short-run and long-run aggregate supply curves?
a) A widespread fear of depression among consumers
Fear of depression would dampen consumption since the anticipation of the economic downturn would cause people to save whatever money they have at present in preparation for the depression. As a result, business firms would cut-back on investment expenditures. These two components of aggregate demand would shift the curve to the left. On the supply side, in the short-run the decrease in consumption would cause a movement along the aggregate supply curve as business firms try to match the price of consumers. However, with a decline in potential output, the aggregate supply curve would shift to the right.
b) The sale of wheat to the Russian federation
The Food and Agricultural Organization (FAO) issued the forecast that in 2006, the world wheat output would decrease by 6 million tonnes compared to production in 2005. If Australia sells wheat to the Russian federation, the price of wheat would increase due to the expected increases in wheat consumption per year coupled with the decrease in supply due to the export of wheat to the Russian federation. In the short and long run, there would be movements along the aggregate supply curve due to price changes. In the long run, the demand curve would shift to the right due to the change in consumption and exports.
c) A tax leading to 5 cents per litre increase in petrol prices
An increase in the price of petrol would result to corresponding increases in consumer products. Price increases would affect the demand and supply of consumer products causing movements along the aggregate supply and demand curves as consumers and suppliers seek to find a level of equilibrium levels at a price level acceptable to both parties.
d) An increase in the money supply
An increase in money supply could translate to more money circulating the economy for the purchase of goods and services. The circulation of money affects consumption and investment expenditures shifting the aggregate demand curve to the right. In the short run, there would be movements along the aggregate supply curve as prices react to increased consumption. In the long-run the increased expectation of potential output would shift the aggregate supply curve to the right.
e) A cut in commonwealth spending for higher education
A decrease in government expenditure, assuming that all other components of aggregate demand are in ceteris paribus, would shift the aggregate demand curve to the left. In the short run, there would be movements along the aggregate supply curve as price reacts to decreased spending or demand. In the long run, aggregate supply curve would shift to the left if there is an expectation of decreased potential output due to the decreased government spending.
f) An increase in interest rates
An increase in real interest rates not influenced by price negatively affects planned investment spending. This would shift the entire aggregate demand curve to the left. In the short-run there would be negligible movements along the aggregate supply curve. In the long-run, the aggregate supply curve would shift to the left due to the expected decline in potential output.
g) The discovery of cheaper energy sources
The discovery of cheaper sources of energy would decrease the price of consumer goods and services previously dependent on oil products. In the short-run, the decrease in price would result to movements in the demand curve due to increased consumption. In the long-run, changes in consumption would shift the demand curve to the right. In the short-run, movements along the aggregate supply curve would happen due to reactions to increased demand. In the long-run, the aggregate supply curve would shift to the right when influenced by expected increases in potential output brought about by other factors apart from price/
h) Tax reductions
Tax reductions would normally increase the income of households available for consumption and the money of business firms for investments. The changes in consumption and investments shift the aggregate demand curve to the right. In the short run, there would be movements along the aggregate supply curve due to the reactions to price changes and increased demand. In the long-run, investments would increase potential output shifting the aggregate supply curve to the right.
3) a) Using the aggregate demand-aggregate supply model, explain how discretionary fiscal policy can be used to reduce the effects of demand-pull inflation.
Demand-pull inflation refers to the increase in prices due to the continuing increases in aggregate demand represented by the aggregate demand curve persistently shifting towards the right (Sloman and Sutcliffe, 2001). Fiscal policy may be adopted to address this characteristic of the business cycle. However, the fiscal policy may be either discretionary or non-discretionary. Discretionary fiscal policy refers to the government action designed to decrease or increase taxes, expenditures or both to achieve domestic output with full employment together with minimal inflation.
In addressing demand-pull inflation resulting to increased prices, contractionary fiscal policy is advisable. The government can increase taxes, decrease public spending, or do both to lower the level of inflation. Increasing taxes would lower the disposable income of families and business firms. The change in consumption would cause the aggregate demand curve to shift towards the left. The shift in turn addresses the inflationary gap. Decreasing government spending reduces expenditures resulting to a shift in the aggregate demand curve towards the left. This would in turn reduce the inflationary gap. The graph below shows the changes in aggregate demand caused by contractionary discretionary fiscal policy.
b) How may fiscal policy be used to increase the equilibrium level of real GDP while minimising the impact of inflation? Use the aggregate demand-aggregate supply model as the framework for your answer.
Real GDP refers to the real value of aggregate final commodities produced in an economy after being adjusted for inflation. Equilibrium level of real GDP is the value where aggregate demand and aggregate supply meet at a certain price level. In considering the AD-AS model, a decrease in price would increase the value of real commodities demanded while an increase in price would result to increases in real supply of commodities. Equilibrium for an aggregate economy is similar to the demand supply relationship in a single product. The intersection of AD and AS determines the equilibrium, overall price level, and the equilibrium real GDP. Concurrently, prices above the equilibrium create aggregate surpluses while prices below the equilibrium create aggregate shortages. The graph below shows real GDP equilibrium.
Increasing the equilibrium level of real GDP without increasing price means shifting the aggregate supply and aggregate demand to the right without utilizing or affecting price such as through fiscal policy. To shift aggregate demand to the right, the government has the option to cut-back on taxes to change consumption or increase government spending in order to shift the demand curve towards the right. Simultaneously, the government may also create a business environment conducive to investments such as tax holidays or relaxed regulations to influence increase in expected or potential output shifting the aggregate supply curve to the right. These policies should be simultaneously implemented so as aggregate demand increases so will aggregate supply resulting to an increase in equilibrium level without affecting price.
4) Show the implications of the supply-siders' arguments in the aggregate demand-aggregate supply framework. Do you think that tax-transfer disincentives have a short-run or long-run impact, or both? Explain.
Tax transfer system in Australia creates the situation where the government spend in providing benefits and assistance to unemployed Australians. As much as this system secures the welfare of the population, it also creates the disincentive for people to work or to gain employment offering them income at levels that would disqualify them from the transfer payments. This is due to the burdens of working considered with the expected compensation from employment relative to the amount received for transfer payment eligibility. Overall, tax transfer disincentives influence the motivation for people to work depending upon the comparison of expected benefits. Transfer disincentives also influence the motivation to work since receiving benefits usually outweigh the burdens involved in employment, especially if the income received is not enough to offset these burdens. The security of receiving an amount of welfare money every month also works against the motivation to save and invest because of the security.
Tax transfer disincentives have short-run and long-run impact. Short-run impact of the transfer payments comprises the sustained expenditures of households because of the secured amount they receive every month. However, the impact is not that radical because of spending is not expected to increase. In the long-run, transfer payments will have an impact on economic growth in the area of productivity. Transfer payments negatively affect production because the money transferred from those with income able to pay tax to the people without income involves government expenditure without a resultant production. In the circular flow of income, this means that there is a withdrawal without necessarily being compensation with an injection. The bulk of transfer payments withdrawn from the government do not necessarily coincide with an inflow of tax revenue especially with the dragging of tax reforms, which would increase the tax burden upon the people belonging to the highest income percentile. Relative to the AD-AS dynamics, expenditure without direct impact on production will not have a significant multiplier impact towards aggregate demand or supply indicating economic growth.
Moreover, production depends upon resource factors such as labour and savings. With the tax transfer disincentives, there would be no motivation for employment, when employment is a key ingredient in production. The impact of the decision to remain unemployed due to transfer payments depends upon the supply and demand of labour. In situations where there is labour surplus, the unemployment of certain segments of the population would not influence the price of labour because of the voluntary decision not to work instead of competing for limited employment opportunities. In situations where there is labour shortage, the voluntary decision of people not to work due to the security of transfer payments would increase the price of labour. This would in turn increase the price of commodities produced. Depending upon the characteristic of the product, the general trend would a decrease in consumption of the product. Decreased consumption would translate to decreased revenue and lesser amount for allocation to further production. Concurrently, scarcity of labour has a shrinking effect to production. On a larger scale, a shrinking production causes movements along the aggregate demand and supply curves resulting to an equilibrium point representing lower output at higher prices.
With tax transfer disincentives, there would be no motivation for people to save or invest. Production suffers from lack of savings and investments. The increase in the level of production of goods and services depends upon the availability of funds and the conduciveness of fund access to business ventures. Lack of savings and investments resulting to limited funds hamper production even with a conducive environment for borrowing. On the bigger scale, lack of savings and investments would result to an AD-AS equilibrium point involving lesser output at higher price levels.
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