Is the Australian economy heading for a severe recession? If so, what (if anything) can policy makers do about it?

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1 Is the Australian economy heading for a severe recession? If so, what (if anything) can policy makers do about it? Christopher M. Fleming Department of Accounting, Finance and Economics GriffithBUSINESS Year 12 Workshop February 2016

2 Some sobering statistics Unemployment is at 6% (761,400 workers are unemployed). GDP growth is 2.5% (c/w long-term average of 3.5%). Government debt is equivalent to 34% of GDP (highest ever). Household debt is equivalent to 122% of GDP (highest ever). In the last 12 months the ASX 200 has fallen by 18% (5,898.5 to 4,987.7). House price growth is declining and in some cases house prices are falling (some commentators predict large falls in house prices 2016/17). 2

3 Short-run economic fluctuations Economic activity fluctuates from year to year. In most years, economic activity increases. In some years, however, this growth does not occur. A recession is a period of declining real incomes and rising unemployment. A depression is a severe recession. Fluctuations in the economy are often called the business cycle. 3

4 Economic activity The business cycle Peak Peak Trough Time 4

5 5

6 6

7 7

8 A new approach 8

9 Economic activity Smoothing the business cycle Peak Peak Trough Time 9

10 How to smooth the business cycle There are two tools available to policymakers to smooth the business cycle: 1. Fiscal Policy government decisions around expenditure and taxation. 2. Monetary Policy Reserve Bank decisions around interest rates. Both work on the real economy through their influence on Aggregate Demand. 10

11 The basic model of economic fluctuations Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. The aggregate demand curve shows the quantity of goods and services that households, firms and the government want to buy at each price level. AD = C + I + G + NX The aggregate supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level. 11

12 Price level Long-run aggregate supply Short-run aggregate supply Equilibrium price A Aggregate demand 0 Natural rate of output Quantity of output 12

13 Two causes of recessions 1. A decrease (leftward shift) in aggregate demand. 2. A decrease (leftwards shift) in aggregate supply. 13

14 Price level causes output to fall in the short-run... Long-run aggregate supply Short-run aggregate supply, AS P A P2 B 1. A decrease in aggregate demand... AD2 Aggregate demand, AD 0 Y2 Y Quantity of output 14

15 There are two possible responses 1. Do nothing, because in the long-run theory suggests we will return to Y Stimulate aggregate demand through fiscal and/or monetary policy. The Rudd Government chose option 2 in response to the Global Financial Crisis. 15

16 Price level causes output to fall in the short-run... Long-run aggregate supply Short-run aggregate supply, AS AS2 P P2 P3 B A C AD but over time, the short-run aggregate supply curve shifts A decrease in aggregate demand... Aggregate demand, AD 0 Y2 Y and output returns to its natural rate. Quantity of output 16

17 Price level causes output to fall in the short-run... Long-run aggregate supply Short-run aggregate supply, AS AS2 P P2 B A 3. Push aggregate demand back to where it came from 1. A decrease in aggregate demand... AD2 Aggregate demand, AD 0 Y2 Y and output returns to its natural rate. Quantity of output 17

18 What about aggregate supply? Adverse shifts in aggregate supply cause stagflation a period of recession and inflation. - output falls and prices rise. - policymakers (who can influence aggregate demand) cannot offset both of these adverse effects simultaneously. 18

19 Price level 1. An adverse shift in the shortrun aggregate supply curve... Long-run aggregate supply AS2 Short-run aggregate supply, AS P2 P B A and the price level to rise. Aggregate demand causes output to fall... Y2 Y Quantity of output 19

20 Price level 1. When short-run aggregate supply falls... Long-run aggregate supply AS2 Short-run aggregate supply, AS which causes the price level to rise further... P3 P2 P but keeps output at its natural rate. A C policymakers can accommodate the shift by expanding aggregate demand... AD2 Aggregate demand, AD 0 Natural rate of output Quantity of output 20

21 How does fiscal policy work? Fiscal policy refers to the government s choices regarding the overall level of government purchases or taxes. In the short-run, fiscal policy primarily affects the aggregate demand. When policy makers change taxes or increases transfers to households, the effect on aggregate demand is indirect through the spending decisions of firms or households. When the government alters its own purchase of goods or services, it shifts the aggregate demand curve directly. AD = C + I + G + NX 21

22 How does monetary policy work? When the Reserve Bank increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate demand to the right. When the Reserve Bank decreases the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate demand to the left. AD = C + I + G + NX 22

23 Macro-economic debate # 1 Should monetary and/or fiscal policymakers try to stabilise the economy (i.e. to smooth out business cycles)? Yes - The economy is inherently unstable, and left on its own will fluctuate; - Policy can manage aggregate demand in order to offset this inherent instability and reduce the severity of economic fluctuations; - There is no reason for society to suffer through the booms and busts of the business cycle; and - Monetary and fiscal policy can stabilise aggregate demand and, thereby, production and employment. 23

24 Macro-economic debate # 1 cont d No - Monetary policy affects the economy with long and unpredictable lags between the need to act and the time that it takes for these policies to work; - Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made; - Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes; - It can take years to propose, pass and implement a major change in fiscal policy; 24

25 Macro-economic debate # 1 cont d No - All too often policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations; and - It might be desirable if policymakers could eliminate all economic fluctuations, but this is not a realistic goal. 25

26 Economic activity Lags and political business cycle Peak Peak Trough Time 26

27 Macro-economic debate # 2 Is it better to use fiscal policy or monetary policy to stabilise business cycles? Fiscal policy - Monetary policy is a very blunt instrument and may not have the desired effect; - Fiscal policy can be targeted to achieve other economic/social objectives. Monetary policy - Fiscal policy is controlled by politicians, monetary policy by the (more sensible) Reserve Bank. 27

28 Effectiveness of fiscal policy The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. That is, each dollar spent by the government can raise the aggregate demand for goods and services by more than one dollar. The formula for the multiplier is: Multiplier 1 (1 -MPC) An important number in this formula is the marginal propensity to consume (MPC) the fraction of extra income that a household consumes rather than saves. For example if the MPC = 0.75, the multiplier will be 4. 28

29 Effectiveness of fiscal policy cont d However.fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces the rate of investment spending. This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. 29

30 Automatic stabilisers Automatic stabilisers are changes in fiscal policy that stimulate aggregate demand when the economy goes into recession without policymakers having to take any deliberate action. Automatic stabilisers include the tax system and some forms of government spending. So perhaps no need for monetary or fiscal policy? 30

31 Our options in 2016/17 Unfortunately our policy options at the moment are quite limited: - Employing fiscal policy would involve running larger deficits and increasing the level of government debt; and - Interest rates are already very (historically) low, there is not a lot of room left to move from a monetary policy point of view (although some countries are exploring the use of negative interest rates). - It would seem that if aggregate demand was to fall, policy makers may have very little ability to respond. 31

32 Questions?

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