BUS702 : Economics For Managers

1. a. M. Keynes provided the simple idea of reviving economic activity through fiscal stimulus given by the national government. Keynes stressed an increase in government expenditure or low tax rate help to boost economic activity through pulling up aggregate demand. The Keynesian theory attempted to offer demand side solution to the problem of recession. As government increases total spending people has a greater opportunity to save more. This in turn helps to revive the depressed private saving.

                                                            

                                                 

Government spending being one of the components of aggregate demand, an increase in government spending leads to an increase in aggregate demand. This in turn causes in an increase in GDP and price level.

b. Fiscal policy is an instrument used to stabilize the economy. There are two main instruments of fiscal policy – automatic stabilizer and discretionary policy. Automatic stabilizers are in built mechanism that are designed to automatically adjust government expenditures or taxation to influence aggregate demand. For example, during recession government expenditure on unemployment benefit automatically increases. On the other hand, because of lower income during this time, government tax revenue reduces. As spending exceeds government revenue, there is a deficit in fiscal budget during recession.

Discretionary fiscal policy refers to the non-compulsory changes in government spending, tax and other fiscal activity with respect to change in state of the economy. Examples of discretionary fiscal policy include expenditure on roads, stadiums, bridges and other public expenditure and cut in taxes. Expansionary policy results in surplus in budget while tight fiscal policy leads to a deficit in budget.  

c . The fiscal contraction is undertaken in the form of a decline in government expenditure or increase in tax rate. Decline in government spending in wasteful program may have a positive impact on the economy and help to improve macroeconomic performance. Cutting down of unnecessary expenditure strengthens fiscal position. This in turn has a crowd in impact on private on private investment. The increase in private investment helps to increase national income. A contraction in the government expenditure therefore works through the channel of a decline in interest rate, which stimulate investment and national income. This contradicts Keynesian view of fiscal policy as an effective counter cyclical policy instrument.

d . Monetary policy stimulus is given in the form of lowering the interest rate. A decline in interest rate reduces the cost of investment. The low cost of investment boosts investment, which in turn contribute to expansion of economic activity. In nation like Australia, monetary policy is more accommodating due to their heavy dependency on external borrowing. Since the attack of global financial crisis, RBA cut the interest rate to a substantially low level. This boosted the economic activity through depreciation of exchange rate. With status of the economy as an international borrower, fiscal stimulus ultimately proves unproductive by worsening fiscal position

2. Tax on unhealthy food item

The objective of taxation is to restrict consumption or production. In order to curb health expenditure resulted from consumption of unhealthy food government adapt the policy of taxing unhealthy foods. The incidence of taxation depends on relative elasticity measures. For Sweets and sugary snacks, the given price elasticity are -0.270 and -0.295 for high and low calorie respectively. Both the elasticity measures are relatively inelastic that is change in demand is less compared. After tax, buyers thus need to bear a greater tax burden, which induces them to reduce consumption. The effect of tax is explained in the following figure with supply and a relatively inelastic demand.

                                                           

Subsidy on healthy food products

Subsidy on the other hand is given to encourage consumption and production of specific items. The given elasticity measures show that fruits and vegetables have a relatively elastic demand. Demand thus changes more in response to change in prices. The effectiveness of a subsidy measure is illustrated in the following figure