(1) The Australian government has abandoned its policy of returning the budget to surplus, because of unexpected fall in tax revenues. Suppose a decrease in planned investment and exports caused the decline in tax revenues.
(a) Use the AD-AS supply model to explain how a decrease in investment and exports would change PAE and equilibrium output.
Planned Aggregate expenditure is the sum total of the expenditures incurred by the economic sectors, i.e. the households, firms, government and rest of the world during a period of time. Investment is made by the firms and exports are a part of the rest of the world. If investment and net exports fall, then there is a reduction in the planned aggregate expenditure, due to which the aggregate demand in the economy falls. When the aggregate demand in the economy falls, the AD curve shifts leftwards as shown in the figure. This leftward shift leads to reduction in the output from Y to Y’ due to the multiplier effect.
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(b) What would be the impact on national saving? Use the saving equation and diagram to illustrate your answer.
We know that Y = C + I and S = I, which leads to Y = C + S
The national income falls due to fall in investment and this reduction leads to fall in savings. When the national income in the economy falls, the consumption also falls. The relationship between savings and income is direct. When income increases, savings increases and when income falls, the savings also falls. This can be established with the diagram below:
Y is the income line and C is the Consumption. As Income rises, the savings keeps on rising.
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(c) What type of monetary policy could the RBA implement to offset the impact of the decline in investment discussed in part (a)? Your answer should include a discussion of the RBA’s policy reaction function
RBA uses policy reaction function to stabilize the prices and output in the economy. Taylor rule is a form of monetary policy reaction function which sets out a nominal interest rate in response to the inflation rate in the economy.
r = r* + g(π – π*)
To offset the impact of decline in investment in the economy, the RBA can reduce the rate of interest in the economy. A reduction in the interest rate will induce the investors to undertake investment which will lead to increase in Aggregate Expenditure and hence the output in the economy would increase too.
