ECO10004: ECONOMIC PRINCIPLES

WEEK 12_Self-study Questions

The questions below are for your own practice.
Vu will cover these questions in his consultation (aka revision) session on Friday, 29th
October.

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).

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Short-answer Questions
Question 1)

Below is the excerpt of an article written in The Sydney Morning Herald in May 2009.

“Treasury Secretary Ken Henry’s “secret” speech to Treasury officers in March 2007 drew
heavily on the idea of crowding out to explain why government intervention in an economy
at or near full employment was counter-productive, resulting in a misallocation of resources
and reduced output.
Only by augmenting the supply side of the economy, he noted, could Australia increase
national income”

Source: Kirchner (2009), The madding crowding out, The Sydney Morning Herald.

Required:

a. In your own words, explain clearly the concept of “crowding out”.

b. It is believed that “crowding out” is unlikely to occur when the economy is in a deep
recession. However, when the economy is approaching full employment, “crowding
out” will cause excessive government spending to backfire.
With the help of an AD-AS graph, illustrate how the problem of “crowding out”
would prevent the government from spending its way toward full employment.

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Question 2)

Refer to the figure below and answer the following questions.

Required:

a. Given that the economy has moved from A to B, what would be the appropriate fiscal
policy to achieve potential GDP and why?

b. If fiscal policy is successful at moving the economy from point B to equilibrium at

potential GDP, what would happen to unemployment and what impact will this have
on the government’s budget?

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Question 3)

Based on your own understanding of monetary policy and fiscal policy, make a table to
compare and contrast the two economic policies on the following fronts:

− Who is responsible?
− How often can the policy be revised?
− Goals to be achieved.
− Main instruments for the policy.
− Impact of the policy on the economy.
− How effective is the policy to fight a recession?
− How effective is the policy to contain a boom?
− Inside lags & Outside lags
− Strengths & Weaknesses

Question 4)

The ghost of deflation may return to haunt us yet again.

Deflation has officially made its return to the Down Under. According to the ABC (2020),
the Consumer Price Index (CPI) for the quarter ending June 2020 fell by 1.9 percent
compared to the previous quarter. This is the biggest quarterly drop ever on records.

From an annual perspective, consumer prices in June 2020 were 0.3 percent lower than a year
ago (June 2019). This was only the third time in history that Australia witnessed annual
deflation.

(For more information, check out Janda & Lesker (2020), “Record deflation in consumer
prices driven by free childcare, while lockdown essentials jump”, ABC News)

With inflation rate dipping into negative territory, this heralds a deflationary period in the
Australian economy. The news of deflation is much feared among economist circles. In fact,
deflation is considered the chief cause of the 1930s Great Depression.

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Required

a. In your own words, explain what deflation is.

How does deflation differ from disinflation?
Based on your own research, identify the main causes of deflation occurring in
Australia for the quarter ending June, 2020.

b. Draw an appropriate AD – AS graph to illustrate how the COVID-19 pandemic led to

deflation. Make sure to label your graph fully.
Assume that prior to the COVID-19 pandemic, the Australian economy was at its
long-run equilibrium.

c. At first glance, deflation increases consumers’ purchasing power, therefore, may help
raise consumption, which is a positive thing.
However, deflation has been documented to have profoundly negative impacts on
consumption and business investment and, by extension, the overall aggregate
demand.
Explain clearly how consumption and business investments will be hit hard by
deflation.

d. In the wake of deflation, what type of fiscal policy do you recommend the federal
government to undertake?
Describe in detail how the government can implement such a policy stance.

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Multiple Choice Questions
1. Active changes in tax and spending by government intended to smooth out the
business cycle are called ________, and changes in taxes and spending that occur
passively over the business cycle are called ________.

a. automatic stabilisers; discretionary fiscal policy

b. discretionary fiscal policy; automatic stabilisers

c. automatic stabilisers; monetary policy

d. discretionary fiscal policy; conscious fiscal policy

2. Which of the following is a government expenditure and NOT a government

purchase?

a. The federal government buys a new ship for the defence force.

b. The federal government pays the salary of police.

c. The federal government pays unemployment benefits.

d. The federal government pays to support medical research on AIDS.

3. Consider the hypothetical information in the following table for potential GDP, real
GDP and the price level in 2013 and in 2014 if the government does not use fiscal
policy.

Year Potential GDP Real GDP Price Level

2013 $1.5 trillion $1.5 trillion 150

2014 $1.7 trillion $1.6 trillion 152

If the government wants to keep real GDP at its potential level in 2014, it should

a. decrease income taxes.

b. decrease government purchases.

c. decrease interest rates.

d. increase interest rates.

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4. If the economy is growing beyond potential GDP, which of the following would be an
appropriate fiscal policy to bring the economy back to long-run aggregate supply? An
increase in

a. liquidity and a decrease in interest rates.

b. government purchases.

c. oil prices.

d. None of the above

5. If the government purchases multiplier equals 2, and real GDP is $14 trillion with
potential GDP $14.5 trillion, then government purchases would need to increase by
________ to restore the economy to potential GDP.

a. $7.25 trillion

b. $1 trillion

c. $500 billion

d. $250 billion

6. Suppose that the government allocates $1 billion for new roads. It also raises taxes by
$1 billion to keep the deficit from growing. If the marginal propensity to consume =
0.9, what is the effect on equilibrium GDP?

a. GDP does not change.

b. GDP increases by $10 billion.

c. GDP increases by $900 000.

d. GDP increases by $1 billion.

7. If crowding out occurs, an increase in government spending

a. increases the interest rate, and consumption and investment spending decline.

b. decreases the interest rate, and consumption and investment spending decline.

c. increases the interest rate, and consumption and investment spending rise.

d. decreases the interest rate, and consumption and investment spending rise.
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8. Increases in government spending will lower the long-term growth rate of GDP if it
lowers ________ spending, and the government purchases ________ goods and not
________ goods.

a. net export spending; investment; consumption

b. consumption; investment; consumption

c. net export spending; consumption; investment

d. investment; consumption; investment

9. Government deficits tend to increase during

a. recessions and booms.

b. periods of economic contraction and recession.

c. periods of below- or above-average growth.

d. periods of increased financial uncertainty.

10. To counteract the effect of automatic stabilisers during a recession and keep the
budget balanced, the federal government would need to ________ government
spending, or ________ taxes, which would ________ aggregate demand.

a. increase; decrease; increase

b. increase; increase; reduce

c. decrease; decrease; increase

d. decrease; increase; reduce

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