Term
| Briefly discuss each of the following economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. |
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Definition
| ‘People are rational’ is the assumption that decision makers explicitly or implicitly weigh the benefits and costs of each action and then choose an action only if the benefits are expected to outweigh the costs. ‘People respond to incentives’ means that consumers and firms consistently respond to economic incentives. ‘Optimal decisions are made at the margin’ means that most decisions are not ‘all or nothing’ but involve doing a little more or a little less of an activity. Therefore, the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost |
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Term
| Explain how the concept of opportunity cost arises from the central economic problem of scarce resources and unlimited wants. |
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Definition
| Scarcity implies that every society and every individual faces trade-offs because wants are unlimited, but the ability to satisfy those wants is limited. Societies and individuals cannot have everything they want, so they have to make choices of what to have and what not to have. |
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Term
| What are the three economic questions that every society must answer? Briefly discuss the differences in how centrally planned, market and mixed economies answer these questions. |
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Definition
| The three economic questions that every society must answer are: 1) What goods and services will be produced? 2) How will the goods and services be produced? 3) Who will receive the goods and services? In a centrally planned economy, the government makes most of these decisions. In a pure market economy, almost all of these decisions are made by the decentralised interaction of households and firms in markets. In a mixed economy, most economic decisions result from the interaction of buyers and sellers in markets, but government plays a significant role in the allocation of resources. |
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Term
| What is a production possibility frontier? How can we show economic efficiency on a production possibility frontier? How can we show inefficiency? What causes a production possibility frontier to shift outward? |
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Definition
| The production possibility frontier (PPF) is a curve showing all the attainable combinations of two products that may be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully used, and the fewest possible resources are being used to produce a given amount of output. Points inside the production possibility frontier are inefficient because the maximum output is not being obtained from the available resources. A production possibility frontier will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs. |
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Term
| What is absolute advantage? What is comparative advantage? Is it possible for a country to have a comparative advantage in producing a good without also having an absolute advantage? Briefly explain. |
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Definition
| Absolute advantage is the ability to produce more of a good or service than competitors using the same amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than competitors. It is possible to have a comparative advantage in producing a good even if someone else has an absolute advantage in producing that good (and every other good). Unless the two producers have exactly the same opportunity costs of producing two goods—the same trade-off between the two goods—one producer will have a comparative advantage in making one of the goods and the other producer will have a comparative advantage in making the other good. |
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Term
| What is the law of demand? Use the substitution effect and income effect to explain why an increase in the price of a product causes a decrease in the quantity demanded. |
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Definition
| The law of demand states that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase (and when the price of a product rises, the quantity demanded of the product will decrease). An increase in the price of a product raises the relative price of the product versus other products, causing consumers to substitute away from the higher priced product. The increase in the price of the product also causes a decrease in the real incomes of consumers, and assuming that the product is a normal good, leads consumers to buy less of the product. |
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Term
State whether each of the following events will result in a movement along the demand curve for McDonald’s Big Mac burgers or whether it will cause the curve to shift. If the demand curve shifts, indicate whether it will shift to the left or to the right and draw a graph to illustrate the shift.
a. The price of Hungry Jack’s Whopper burgers declines.
b. McDonald’s distributes vouchers for $1.00 off on a purchase of a Big Mac.
c. A shortage of potatoes causes the price of fries to increase.
d. KFC raises the price of a bucket of fried chicken.
e. The Australian economy enters a period of rapid growth in incomes. |
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Definition
a. Because the price of a substitute good has declined, the demand curve for Big Macs will shift to the left from D1 to D2 in Figure 1.8 below.
b. The voucher results in a cut in the price of Big Macs, so there will be a movement down the demand curve for Big Macs.
c. Because Big Macs and fries are complements, the demand curve for Big Macs will shift to the left from D1 to D2 in Figure 1.8 below.
d. Because the price of a substitute good has increased, the demand curve for Big Macs will shift to the right from D2 to D1 in Figure 1.8 below.
e. The demand curve for Big Mac’s will shift. If the Big Mac is an inferior good, the demand curve will shift to the left from D1 to D2 in Figure 1.8 below. If the Big Mac is a normal good, the demand curve will shift to the right from D2 to D1. |
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Term
| What is the law of supply? What are the main variables that will cause a supply curve to shift? |
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Definition
| The law of supply states that, holding everything else constant, an increase in price causes an increase in the quantity supplied (and a decrease in price causes a decrease in the quantity supplied). The main variables that will cause a supply curve to shift include: (1) changes in the prices of inputs used to make the product; (2) technological change; (3) changes in the prices of substitutes in production (other goods that the producers could be making); (4) changes in expected future prices; and, (5) changes in the number of firms. |
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Term
| A student writes the following: ‘Increased production leads to a lower price, which in turn increases demand.’ Do you agree with his reasoning? Briefly explain. |
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Definition
| The student’s reasoning is incorrect. He should have said: ‘Increased production shifts the supply curve to the right and leads to a lower equilibrium price but a higher equilibrium quantity and therefore a larger quantity demanded. The increase in quantity demanded is a result of a supply curve shifting to the right and a movement along the demand curve, but the demand curve does not shift. |
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Term
| In the circular flow of expenditure and income, why must the value of total production in an economy equal the value of total income? |
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Definition
| All of the revenue a firm receives from the sale of its output is paid out as income to the owners of the factors of production. |
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Term
| What would you expect to happen to household production as unemployment rises during a recession? What would you expect to happen to household production as unemployment falls during an economic expansion? Would you therefore expect the fluctuation in actual production—GDP plus household production—to be greater or less than the fluctuation in measured GDP? |
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Definition
| Household production would probably rise during a recession with the increased number of people at home and, conversely, fall during an expansion with fewer people at home. These two effects would cause the fluctuation in actual production to be somewhat less than the fluctuation in measured GDP. |
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Term
| Why is GDP an imperfect measure of economic wellbeing? What types of production does GDP not measure? Even if GDP included these types of production, why would it still be an imperfect measure of economic wellbeing? |
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Definition
| GDP does not include household production and the underground economy. Even if GDP included all production, it would still not be a perfect measure of economic wellbeing because it does not consider many things that affect wellbeing; for example, GDP does not include the value of leisure and is not adjusted for the negative effects of pollution and social problems. |
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Term
| Why does inflation make nominal GDP a poor measure of the increase in total production from one year to the next? How does the ABS deal with the problem inflation causes with nominal GDP? |
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Definition
| Nominal GDP can change because of either quantity changes or price changes. When there is inflation, nominal GDP overstates the increase in total production. The ABS separates price changes from quantity changes by calculating real GDP. |
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Term
| What is the most important factor in explaining increases in real GDP in the long run? What supportive government policies are crucial for long-run economic growth? |
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Definition
| The most important factor in explaining the increases in real GDP in the long run is increases in labour productivity. To support long-run economic growth, the government needs to provide secure rights to private property, including establishing an independent court system that enforces contracts between private individuals. The government should also help to develop and maintain an efficient financial system. |
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Term
| How does the financial system—either financial markets or financial intermediaries—provide risk sharing, liquidity and information for savers and borrowers? |
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Definition
| The financial system provides risk sharing by allowing savers to spread their money among many financial investments. It provides liquidity by providing savers with markets in which they can sell their holdings of financial securities. The financial system provides information by specialising in gathering information on borrowers and by communicating information on businesses by incorporating that information into the prices of shares and bonds. |
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Term
| Briefly describe the effect of the business cycle on the inflation rate and the unemployment rate. Why might the unemployment rate continue to rise during the early stages of a recovery? |
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Definition
| During an economic expansion, particularly near the end of the expansion, the inflation rate typically increases. During contractions, the inflation rate typically decreases. The unemployment rate rises during recessions and, after a delay, falls during expansions. The unemployment rate may continue to rise during the early stages of a recovery because employment may grow more slowly than the labour force (from population growth and discouraged workers reentering the labour force), and because some firms are operating well below capacity, these firms may be slow to hire laid-off workers or may continue to lay off more workers for a period of time. During an economic expansion, particularly near the end of the expansion, the inflation rate typically increases. |
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Term
a. If Australian GDP per capita continued to grow at a rate of 3 per cent per year, how many years will it take for real GDP per capita to double?
b. The economy of China has boomed since the late 1970s, having periods of double-digit economic growth rates. At an 8 per cent growth rate in real GDP, how many years would it take for China’s economy to double? |
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Definition
a. Use the rule of 70: Number of years to double = 70/3 = 23.33.
b. Use the rule of 70: Number of years to double = 70/8 = 8.75. |
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Term
| Why does a country’s economic growth rate matter? |
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Definition
| A country’s economic growth rate matters because living standards tend to rise with economic growth. High rates of economic growth can improve the lives of a country’s people in many ways, including by increasing average life expectancy. |
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Term
Routine childhood immunization combined with measles vaccination in seven southern Africa nations starting in 1996 virtually eliminated measles in those countries by 2000. A national campaign in Egypt to make parents aware of the use of oral rehydration therapy from 1982 to 1989 cut childhood deaths from diarrhea by 82 percent over that period.
a. Is it likely that real GDP per capita increased significantly in southern Africa and Egypt as a result of the near elimination of measles and the large decrease in childhood deaths from diarrhoea? If these events did not increase real GDP per capita, is it still possible that they increased the standard of living in southern Africa and Egypt? Briefly explain.
b. Which seems more achievable for a developing country: the elimination of measles and childhood deaths from diarrhoea or sustained increases in real GDP per capita? Briefly explain. |
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Definition
a. Real GDP per capita most likely did not increase significantly from the near elimination of measles and the large decrease in childhood deaths, but because the health of many people improved, the standard of living did increase significantly.
b. For a developing country, the elimination of measles and childhood deaths from diarrheoa is more achievable than sustained increases in real GDP per capita. Fewer additional resources and less time are required to achieve the elimination of disease than the additional investment and the institutional changes needed for sustained increases in real GDP per capita. |
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Term
| What are the consequences for economic growth of diminishing returns to capital? How are some economies able to maintain high growth rates despite diminishing returns to capital? |
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Definition
| Diminishing returns to capital imply that, holding technology constant, additional capital per hour worked results in smaller and smaller increases in real GDP per hour worked. Therefore, sustained increases in real GDP per hour worked require more than continuing increases in capital per hour worked. To maintain high growth rates despite diminishing returns to capital, economies must experience technological change. |
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Term
Which of the following will result in a movement along Japan’s per-worker production function, and which will result in a shift of Japan’s per-worker production function? Briefly explain.
a. Capital per hour worked increases from ¥5 million per hour worked to ¥6 million per hour worked.
b. The Japanese government doubles its spending on support of university research.
c. A reform of the Japanese school system results in more highly trained Japanese workers. |
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Definition
a. An increase in capital per hour worked results in a movement along the per-worker production function.
b. and c. Both result in a shift in the per-worker production function because they are likely to lead to technological change by increasing real GDP per hour worked, holding capital per hour worked constant. |
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Term
| What are the problems in measuring the unemployment rate? In what ways does the official ABS measure of the unemployment rate understate the true degree of unemployment? In what ways might the official ABS measure overstate the true degree of unemployment? |
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Definition
There are some problems with measuring the unemployment rate.
a. Discouraged workers are measured as ‘not in the labour force’.
b. People are measured as being employed even if they are working only one hour per week, which means the official measure of unemployment does not account for under-employment.
c. Some people claim to be unemployed but they are not.
The ABS measure of the unemployment rate understates the true degree of unemployment to the extent that it does not count discouraged workers as unemployed because they have stopped looking for a job, and it counts involuntary part-time workers as employed even though these workers would prefer to work more hours. The official measure overstates the true degree of unemployment because (1) some people claim to be actively looking for work but are not because they are embarrassed or think they will not remain eligible for government payments to the unemployed and (2) some people have jobs in the underground economy although they claim to be unemployed. |
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Term
| Suppose between January 2014 and January 2015 the total number of people employed and the unemployment rate both fell. Briefly explain how this is possible. |
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Definition
| This would be possible if there was a prolonged economic downturn and the people who had been persistently unemployed (long-term unemployed) took themselves out of the labour force. They would then be classified as discouraged workers who are no longer actively looking for paid employment. This scenario could explain the fall in employment and the fall in the unemployment rate at the same time. |
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Term
| Briefly describe the economic costs to the economy that result from unemployment. |
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Definition
| The costs to the economy include the loss of GDP, loss or deterioration of human capital and retraining costs. Note that unemployment benefits are not a loss to the economy but a transfer payment from those paying taxes to those on benefits. They do, however, represent an opportunity cost in terms of government expenditure. Some argue that there are external costs to society due to unemployment, such as increased crime and increased health expenditure. |
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Term
| 3.3 What is the natural rate of unemployment? What is the relationship between the natural rate of unemployment and full employment? |
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Definition
| The natural rate of unemployment is the normal rate of unemployment, consisting of frictional unemployment plus structural unemployment. The natural rate of unemployment is considered the full-employment rate of unemployment. |
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Term
In each of the following explain whether you think the CPI would overestimate, underestimate or accurately estimate the general price level, assuming all else remains constant.
a. A severe drought reduces the production of tropical fruit, causing the price of tropical fruit to rise significantly.
b. Consumers switch to buying front-loading clothes washing machines instead of the less water-efficient top-loading washing machines, even though front-loading washing machines are more expensive.
c. New technology significantly decreases the price of 3D televisions. |
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Definition
a. Overestimate, substitution bias, because consumers would substitute cheaper foods for tropical fruit.
b. Overestimate, similar to new product bias.
c. Accurately reflects a fall in price of consumer goods. |
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Term
| Which is a greater problem: anticipated inflation or unanticipated inflation? Briefly explain. |
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Definition
| Unanticipated inflation is the greater problem. Anticipated inflation can be incorporated into nominal interest rates and nominal wage contracts. Unanticipated inflation causes the actual real interest rate and actual real wage rate received to differ from the expected real interest rate and the expected real wage rate. |
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Term
| 5.1. Distinguish between demand-pull inflation and cost-push inflation, and give an example of a factor that might cause each to occur. |
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Definition
| Demand-pull inflation arises during full employment through an increase in aggregate demand such as a tax cut or an increase in government expenditure. Cost-push inflation arises through factors which shift the aggregate supply curve to the left, such as a rise in the price of oil or a sudden fall in the value of the Australian dollar. |
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Term
| What are inventories? What usually happens to inventories at the beginning of a contraction or recession? At the beginning of an expansion? |
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Definition
| Inventories are goods that have been produced but not yet sold. Inventories usually rise at the beginning of a contraction and usually fall at the beginning of an expansion. |
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Term
| What are the five main determinants of consumption spending? Which of these is the most important? How would a rise in share prices or housing prices affect consumption spending? |
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Definition
| The five main determinants of consumption spending are current disposable income, household wealth, expected future income, the price level and the interest rate. The most important determinant is current disposable income. A rise in stock prices or housing prices would increase household wealth, which would increase consumption spending. |
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Term
| What are the four main determinants of investment? How would a change in interest rates affect investment? |
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Definition
| The four main determinants of investment spending are expectations of future profitability, the interest rate, business taxes and cash flow. An increase in the interest rate would decrease investment spending and a decrease in the interest rate would increase investment spending. |
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Term
| Unemployed workers receive unemployment benefits from the government. Does the existence of unemployment benefits make it likely that consumption will fluctuate more or fluctuate less over the business cycle than it would in the absence of unemployment benefits? Briefly explain. |
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Definition
| Consumption will fluctuate less. The five main determinants of consumption spending are current disposable income, household wealth, expected future income, the price level and the interest rate. The most important determinant is current disposable income. Therefore, as unemployment benefits reduce fluctuations in income, fluctuations in consumption are also reduced. |
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Term
| Explain the difference between autonomous consumption and induced consumption. |
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Definition
| Consumption actually has both an autonomous component, which does not depend on the level of income, and a non-autonomous component, or induced consumption, that does depend on income. |
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Term
| What is the macroeconomic consequence if firms accumulate large amounts of unplanned inventories at the beginning of a recession? |
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Definition
| If firms accumulate excess inventories, firms will decrease production until they sell the unintended inventories. Even if spending quickly returns to its normal levels, firms will have to sell these excess inventories before they can return to producing at normal levels. In the early twentieth century, the inability of many firms to control their inventories contributed to the length and severity of recessions. |
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Term
| What are the variables that cause the AD curve to shift? For each variable, identify whether an increase in that variable will cause the AD curve to shift to the right or to the left. |
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Definition
| The variables that cause the aggregate demand curve to shift are interest rates, changes in government policies (such as increased government purchases and changes personal income taxes and business taxes), household expectations of future incomes, firms’ expectations of the future profitability of investment spending, the growth rate of domestic GDP relative to the growth rate of foreign GDP, and the exchange rate value of the Australian dollar. An increase in interest rates will decrease consumption and investment spending and shift the aggregate demand (AD) curve to the left. An increase in government purchases will directly increase government purchases and shift the AD curve to the right. An increase in personal income taxes will decrease consumption, and an increase in business taxes will decrease investment spending and both will shift the AD curve to the left. An increase in households’ expectations of future income will increase consumption and shift the AD curve to the right. An increase in firms’ expectations of the future profitability of investment spending will increase investment spending and shift the AD curve to the right. An increase in the growth rate of domestic GDP relative to the growth rate of foreign GDP will decrease net exports and shift the AD curve to the left. An increase in the exchange rate value of the dollar will decrease net exports and shift the AD curve to the left. |
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Term
Explain how each of the following events would affect the AD curve.
a. An increase in the price level
b. An increase in government purchases
c. Higher income taxes
d. Higher interest rates
e. Faster income growth in other countries |
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Definition
a. An increase in the price level would cause a movement along the aggregate demand curve.
b. An increase in government purchases would cause the aggregate demand curve to shift to the right.
c. Higher income taxes would decrease disposable income, thereby decreasing consumption spending and causing the aggregate demand curve to shift to the left.
d. Higher interest rates would decrease investment spending, net exports and consumer spending, particularly on durable goods, causing the aggregate demand curve to shift to the left.
e. Faster income growth in other countries would increase Australian exports, causing the aggregate demand curve to shift to the right. |
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Term
| What variables cause the SRAS curve to shift? For each variable, identify whether an increase in that variable will cause the SRAS curve to shift to the right or to the left |
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Definition
| The variables that cause the short-run aggregate supply to shift are: the size of the labour force, the size of the capital stock, productivity, the expected future price level, workers and firms adjusting to having previously underestimated the price level, and the expected price of an important natural resource. Increases in the labour force, the capital stock, and productivity will cause the short-run aggregate supply curve to shift to the right. Increases in the expected future price level, increases in the price of an important natural resource, and workers and firms adjusting to having previously underestimated the price level will cause the short-run aggregate supply curve to shift to the left |
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Term
Explain how each of the following events would affect the LRAS curve.
a. A higher price level
b. An increase in the size of the labour force
c. An increase in the quantity of capital goods
d. Technological change |
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Definition
a. A higher price level would cause a movement up along the long-run aggregate supply curve.
b. An increase in the labour force would cause the long-run aggregate supply curve to shift to the right.
c. An increase in the quantity of capital goods would cause the long-run aggregate supply curve to shift to the right.
d. Technological change would cause the long-run aggregate supply curve to shift to the right. |
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Term
| In the early to mid-2000s the Australian economy was experiencing rapid economic expansion, leading to an economic boom. By 2007 data indicated that actual real GDP had exceeded potential GDP, and the unemployment rate was the lowest it had been in over 30 years. Explain how it was possible for actual real GDP to be greater than potential GDP at this time. |
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Definition
| If firms operate beyond their ‘normal’ capacity and structural and frictional unemployment drop below their normal levels, then actual real GDP can be above potential GDP. During this period actual real GDP was higher than potential GDP due to rapidly expanding aggregate demand, in part due to the mining boom in Australia. The mining boom was fuelled by rising mineral prices and strong demand for Australia’s minerals from China and India. In turn, this led to an increase in investment and consumption (due to higher wages) and higher net exports, which increased aggregate demand above the level of potential GDP. Eventually, when the economy is above long-run equilibrium, output must fall to potential GDP, and the only lasting effect of increased aggregate demand is a higher price level. |
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Term
| Why does the RBA use more than one definition of the money supply? |
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Definition
| The RBA uses several different definitions of the money supply. Each definition includes a different group of assets. A narrow definition of money would include only those assets that obviously function as a medium of exchange: currency and accessible bank account deposits. These assets can be easily used to buy goods and services, and thus act as a medium of exchange. This strict interpretation is too narrow, however, as a measure of the money supply in the real world. Many other assets can be used as a medium of exchange, although they are not as liquid as currency or a deposit in a bank demand account. For example, you can purchase goods and services at most stores by electronic funds transfer at point of sale (EFTPOS). You can convert your savings account or term deposit at a bank into cash. Although these assets have restrictions on their use and there may be costs to converting them into cash, they can be considered part of the medium of exchange. |
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Term
| Give the formula for the simple deposit multiplier. If the reserve ratio is 20 per cent, what is the maximum increase in demand account deposits that will result from an increase in bank reserves of $20 000? |
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Definition
| Simple deposit multiplier = 1/RR = 1/0.2 = 5. The maximum increase in demand account deposits would be $20 000 x 5 = $100 000. |
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Term
| How does the RBA control liquidity in the overnight money market? |
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Definition
| Through the use of open market operations – the buying and selling of bonds and securities either through repurchase agreements or, less frequently, outright sale – to affect the overnight cash rate and subsequently other interest rates. |
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Term
| Explain the most frequent reason why the RBA uses open market operations in Australia. |
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Definition
| The RBA mainly uses open market operations to sterilise, or offset, the daily deficits and surpluses in the financial system in order to maintain the interest rate at its desired level, and from time to time to adjust the interest rate to a desired target. |
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Term
| According to the quantity theory of money, if the money supply is growing at a rate of 6 per cent per year, the economic growth rate is 3 per cent per year and velocity is constant, what will the inflation rate be? If velocity is increasing at 1 per cent per year instead of remaining constant, what will the inflation rate be? |
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Definition
| The inflation rate = Growth rate of the money supply + Growth rate of velocity – Growth rate of real output. So, if velocity is constant the inflation rate would be: 6% + 0% – 3% = 3%. If velocity grows at 1 per cent, then the inflation rate would be: 6% + 1% – 3% = 4%. |
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Term
| Explain the effect open market purchases have on the equilibrium interest rate. |
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Definition
| An open market purchase by the RBA will increase the level of liquidity in the overnight money market. This will lower the cash rate and lead to a lower equilibrium rate of interest. |
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Term
Explain the effect that each of the following has on the demand for money curve.
a. A decrease in real GDP.
b. An increase in interest rates.
c. An increase in the general level of prices. |
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Definition
a. A decrease in real GDP would decrease the amount of buying and selling of goods and services, decreasing the demand for money as a medium of exchange and therefore decreasing the quantity of money held at each interest rate. There would be a shift of the money demand curve to the left.
b. An increase in interest rates would not shift the money demand curve, but would see a movement along the curve, with a decrease in the quantity of money demanded.
c. An increase in the general level of prices would increase the quantity of money required for a given amount of buying and selling of goods and services. There would be a shift of the money demand curve to the right. |
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Term
| Between 2005 and early 2008 oil prices and house prices in Australia rose significantly, increasing the cost of living for Australians. During the same period the RBA increased interest rates eight times. Do you think that the RBA was aiming to make Australians worse off by raising interest rates at a time when other expenses were also increasing? |
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Definition
| Monetary policy does not produce equitable outcomes. It is used to reduce inflationary pressures in the economy but not everyone bears the burden of high interest rates equally. While not specifically aiming to make some Australians worse off from interest rate rises, the RBA knows that this is a consequence. Higher interest rates affect the one-third of the population who have home mortgages, and also businesses and investment projects – particularly the marginal/less profitable ones – while providing more interest earnings for those who have savings in financial institutions. Higher interest rates also increase the exchange rate (ceteris paribus) reducing incomes for those in export industries and increasing incomes for those in import industries. It is for these reasons that monetary policy has been criticised as a blunt and inequitable instrument, and the RBA has faced criticism for using it to make numerous short-term changes, which introduce uncertainty and force frequent household budget and investment changes. |
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Term
| Most of the countries of the European Union use a common currency, the euro, and have a common monetary policy determined by the European Central Bank. What are the implications for any member country wishing to control its own rate of inflation? |
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Definition
| With a common currency it is not possible for one country to have a different interest rate to that of another. If two countries have different interest rates then households and firms will borrow from the country with the lowest interest rate and lend in the country with the highest, making it impossible for two countries with the same currency to have different interest rates. Therefore, a country that uses the euro as its currency cannot pursue an independent monetary policy and control its own inflation rate. |
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Term
| If the government decides that expansionary fiscal policy is necessary, what changes should it make in government spending or taxes? What changes should it make if it decides that contractionary fiscal policy is necessary? |
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Definition
| For expansionary fiscal policy the government could increase its expenditures and/or cut tax rates. For contractionary fiscal policy the government could decrease its expenditures and/or increase tax rates. |
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Term
| Why does a $1 increase in government purchases lead to more than a $1 increase in income and spending? |
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Definition
| A $1 increase in government purchases initially increases real GDP and national income by $1. The $1 increase in national income increases consumption spending by, say, $0.50. The $0.50 increase in consumption spending increases income, which increases consumption spending again. The process continues as increases in income lead to increases in consumption spending, which lead to increases in income, which lead to increases in consumption spending, and on and on. This process is referred to as the multiplier effect. |
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Term
Identify each of the following as (i) part of an expansionary fiscal policy, (ii) part of a contractionary fiscal policy or (iii) not part of fiscal policy.
a. The company income tax rate is increased.
b. Defence spending is increased.
c. Families are allowed to deduct all their expenses for child care from their taxable income.
d. The personal income tax rate is decreased.
e. The state of New South Wales builds a new highway in an attempt to expand employment in the state. |
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Definition
a. Contractionary fiscal policy.
b. Although an increase in defence spending will lead to an increase in aggregate demand, it is not part of fiscal policy because it is not intended to achieve a macroeconomic policy goal.
c. Not part of fiscal policy (unless it is a change to existing policy to stimulate spending).
d. Expansionary fiscal policy.
e. Not part of fiscal policy (as fiscal policy refers to federal government policy). |
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Term
| Which can be changed more quickly: monetary policy or fiscal policy? Briefly explain. |
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Definition
| Monetary policy can be changed more quickly. The Reserve Bank Board can change monetary policy at any of its monthly meetings, or more frequently if need be. Fiscal policy has to go through the legislative process of the parliament approving a fiscal policy action. Even once approved, it takes time to implement the fiscal policy change. |
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Term
Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long-run growth rate of real GDP.
a. Is this most likely to happen if the private spending being crowded out is consumption spending, investment spending or net exports? Briefly explain.
b. In terms of its effect on the long-run growth rate of real GDP, would it matter if the additional government spending involves (i) increased spending on highways and bridges, or (ii) increased spending on national parks? Briefly explain. |
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Definition
a. Investment spending, because accumulating more machinery, equipment and structures by the private sector are necessary for economic growth.
b. Increased spending on highways and bridges may promote economic growth, whereas increased spending on national parks is unlikely to, (although there may be a small effect on the tourism industry). |
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Term
| In what ways does the federal budget serve as an automatic stabiliser for the economy? |
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Definition
| When real GDP falls below potential GDP, households and firms pay less in taxes to the federal government and the federal government makes more transfer payments to the unemployed. These changes in taxes and transfer payments make the decline in income smaller than it would otherwise be, which results in a smaller decline in consumption spending. With aggregate demand not declining by as much as it otherwise would, the decline in real GDP is reduced. When real GDP increases above potential GDP, households and firms pay more in taxes and the federal government makes fewer transfer payments. These changes reduce the increase in income that would otherwise take place, which results in a smaller increase in consumption spending. With aggregate demand not increasing by as much as it otherwise would, the increase in real GDP is reduced. By reducing the size of changes in real GDP, the federal budget serves to stabilise the economy. |
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Term
| Suppose we know that a country has been receiving large inflows of foreign investment. What can we say about its current account balance? |
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Definition
| We would have to know if the country’s capital inflow was greater or less than its capital outflow to determine whether it has a surplus or deficit in its financial account. If we ignore the capital account and statistical discrepancy, if the country’s capital outflow was greater than its capital inflow, it would have a financial account deficit and a surplus on its current account. It would have a current account deficit if its capital outflow was less than its capital inflow. |
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Term
| What are the three main sets of factors that cause the supply and demand curves in the foreign exchange market to shift? |
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Definition
| The three main sets of factors are: changes in the demand for Australian produced goods and services and changes in the demand for foreign-produced goods and services; changes in the desire to invest in Australia and changes in the desire to invest in foreign countries; and changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies. |
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Term
| What factors should be considered when determining whether or not foreign debt is a problem for a country? Do you think Australia’s foreign liabilities are a problem? |
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Definition
| The relevant issue here is whether Australia can service its debt and make its repayments on borrowing. The data indicate that Australia’s net foreign debt is not a problem. Over time, as a proportion of GDP, net debt and net liabilities have not been persistently rising to unmanageable levels |
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