Name: Duong Hoang Ha

Student ID: SWH01095

ECO10004: ECONOMIC
PRINCIPLES
WEEK 12_TUTORIAL QUESTIONS
The key concepts covered in this topic are as follows:

− The multiplier effect (Tutorial Question 1 & 2).

− Discretionary fiscal policy vs. Automatic stabilisers (Tutorial Question 3).
− Three options for discretionary fiscal policy (Tutorial Question 4).
− Crowding-out effect (Self-study questions)
− Contractionary fiscal policy (Self-study questions)
− Balanced budget vs. Counter-cyclical budget (Self-study questions).
− Deflation and how to deal with it (Self-study questions).

Short-answer Questions
Question 1)

Suppose the Australian government has decided to increase its purchases by $1 billion.
Assume the Marginal Propensity to Consume (MPC) is constant and equal to 0.8.

Required:

a. How much will Real GDP increase as a result of the above increase in government
purchases?

The increase in Real GDP will be more than the initial increase in government
purchases of $1 billion.

This is because of the multiplier effect.

- Multiplier : k = 1 : ( 1 – mpc ) = 5

- Increase in real GDP : DeltaY = k x DeltaG = $5bn

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b. Explain clearly, with the help of a flow chart, the process through which Real GDP
will increase.

• Initially, the $1 bn of additional government purchases increases real GDP and

national income by $1bn.

• This increase in spending becomes someone's income. A proportion of this income

will be spent on consumption while the remainder will be saved.

• Given that MPC = 0.8, the increase in consumption = $1 bn * 0.8 = $800 mil. The
additional consumption of $800 mil ends up again as someone's income and 0.8 of
this (or $640 mil) becomes new consumption.

• The process continues as increases in income lead to increases in consumption,

which lead to increases in income, which lead to increases in consumption, and on
and on.

c. In the real world, the increase in Real GDP will be less than predicted in this question.
Identify and explain the reasons why the increase in Real GDP will be lower than
expected.

• Disposable income is different from income: certain proportion of this additional

income will be taxed -› additional disposable income is lower than $1 billion

- The additional consumption will be less than $800 mil.

• The scenario above assumes consumers only purchase domestic goods: as people
spend on imports, their consumption does not return as additional income.

• The scenario above assumes the MarginalPropensity to Consume is constant at 0.8:

In reality, MPC tends to drop lower as income rises.

- When income is low, households tend to put the maiority into C

- When income is high, households are able to save more -> lower MPC -› smaller
multiplier effect.

• It is estimated that the government purchase multiplier in Australia is between 1.2

and 1.5: for every $1 increase in government purchases in Australia, Real GDP
increases between $1.2 and $1.5.

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Question 2)

Suppose that real GDP for an economy is currently $300 billion and potential GDP is $360
billion. The marginal propensity to consume (MPC) is 0.6.
Required:

a. Holding other factors constant, by how much will government purchases need to be
increased to bring the economy to equilibrium at potential GDP?
Tip: You should first calculate the multiplier effect for government spending.

- Actual GDP: Y= 300

- Potential GDP: Y* = 360

- GPD gap = 60

- Multiplier: k = 1 : ( 1 – mpc ) = 2.5

- Multiplier effect : DeltaY = k x DeltaG

- Require goverment purchase change : $24 bn

=> G increase in $24 bn

b. Holding other factors constant, by how much will taxes have to be cut to bring the
economy to equilibrium at potential GDP?
Tip: You should first calculate the multiplier effect for tax cut.
- Actual GDP: Y= 300
- Potential GDP: Y* = 360
- GPD gap = 60
- Multiplier: kT = - mpc : ( 1 – mpc ) = - 1.5
- Multiplier effect : Y = kT x T
- Require tax change : - $40 bn
 T decrease in $n0 bn
c. In the early months of 2008, the US economy slumped into a severe recession
(dubbed the “Great Recession”). In an attempt to rescue the economy, the US
government under President Barack Obama opted for increasing government
purchases instead of cutting taxes.

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 Can you explain why government purchases was selected as the centre of the stimulus
package instead of tax cuts?
Tip: Compare the multiplier effect for government purchases versus the multiplier
effect for tax cuts

• Based on our calculations above and the formulas for the multiplier effect, it can be
observed that the multiplier effect for government purchases (Kg) is always higher
than that for tax cut (K-).

 This formed the cornerstone for the Obama administration's push to increase
government purchases to the tune of $800 billion (around 5% of the US annual
GDP) back in 2009.

• It should be noted that the size of the multiplier effect in real life is much smaller
than that in theory : kG = 157 while kT = - 0.99

Question 3)

Below is the excerpt of a paper published by the Brookings Institute in July 2019, discussing
how the US should prepare for the next recession.
“Someday, the U.S. will suffer another recession. With interest rates already
very low, monetary policy may not be able to carry the entire burden of
mitigating economic downturns. Thus, the role of fiscal policy in economic
stabilisation is being viewed with increasing importance (...). With respect to
fiscal policy, the contribution of automatic stabilisers to fiscal stabilisation
has been historically as much as, if not more than, discretionary fiscal
policy”

Source: Lee & Sheiner (2019), “What are automatic stabilizers”, Brookings
Institute, Washington D.C.

a. In your own words, explain clearly what “discretionary fiscal policy” is.

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 • "Discretionary Fiscal Policy" refers to the government taking deliberate action to
alter the government spending or taxes.

• In Australia, the Treasurer initiates "discretionary fiscal policy" through a proposed

federal budget unveiled in May each year.

- The budget proposal would then be voted in both Houses of parliament: the House
of Representatives and the Senate.

- Normally, the government will have majority support in the House of

Representatives.

- Meanwhile, there could be long and arduous debates in the Senate.

- It would usually take a long time from "discretionary fiscal policy" being proposed
to it being implemented, commonly known as "inside lags"

b. In your own words, explain clearly what “automatic stabilisers” is.

Explain clearly how “automatic stabilisers” helps cushion the blow to, thus, stabilise
aggregate demand amid a recession.

• Automatic stabilisers help stabilise the AD in the economy through two main
mechanisms: (i) the progressive tax system and (il) transfer payments (e.g.
unemployment benefits, family benefits, food stamps,...)

• The progressive tax system

- For individuals: falling incomes move people from a higher to lower tax bracket -›
Fall in disposable income < fall in gross income.

- For businesses: face lower profit

- tax liabilities will be automatically reduced during recession.

• Transfer payments

- $550 of the JobSeeker payment every fortnight helps one pay for basic needs such as
food, groceries, rent, etc.

- Income does not necessarily crash to zero -> preventing AD from diving further and
keeping businesses afloat.

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 • Data from the US from 2009 to 2012:

- Automatic stabilizers contributed 1.8% of potential GDP

- Discretionary fiscal policy put in 1.3% of potential GDP.

c. What are the advantages of “automatic stabilisers”, when compared to “discretionary

fiscal policy”?

• Discretionary fiscal policy suffers from lengthy "inside lags", while automatic
stabilisers are built-in mechanisms, which would operate automatically.

-> no time lag -› many economists have been advocating for an expansion of
automatic stabilisers so as to ensure the economy's resilience through downturns:

- Recommended policies include increasing the unemployment benefits payment,

providing temporary, refundable tax credit for working households, etc.

• It should be noted that these policies are better targeted to low-income households
as the marginal propensity to consume is the highest among these households.

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