What are the costs and benefits of using fiscal policy to manage an economys short-term and long term growth rates? Discuss.

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Assignment 2

Part A: Short Answer Questions

Business Economics

(ECO 501)

Zaved Mannan

D-6 Tower Bhaban, Fuller Road

Dhaka University Campus

Dhaka 1000

Bangladesh

Student ID: 11320053

Date: 04.02.2011

Charles Sturt University

Australia

Answer to Question 1:

  1. Aggregate demand decreases if interest rate increases. Any increase in interest rates will raise the cost of borrowing, Consumption spending will fall, Investment will fall, International competitiveness will decrease – exports fall, imports rise. Therefore – a rise in the price level leads to lower levels of aggregate demand.
  2. a fall in the value of the Australian dollar will increase aggregate demand.

Answer to Question 2:

In 2008, Australia experienced $50b Current Account Deficit (CAD). This CAD was paid by a combination of foreign debts (capital account balance was $46b) and foreign currency reserves ($4b) (McTaggart et al, 2010). Australia always had CAD, but before 1980 these deficits were on average lower and not associated with foreign debt. Australia experienced high CAD in 1980 and foreign borrowings ($20b) were necessary to finance CAD. However, by 1996/7 the foreign debt went up to $190b to cover up deficits.  (Brooks & Fuasten, 1998).

CAD can be financed in two ways: foreign borrowings and equity investments by foreigners in Australia. There is a gap between theory and practice. In theory, CAD can be paid entirely by foreign equity investments and no need to borrow overseas funds at all. But in practice, CADs are financed by a combination of borrowing and equity investments. Consider a situation in which Australia has CAD and borrows foreign funds to cover the CAD. Valuation effect causes the Australian dollar value of our debt to fall. Australian dollar appreciates in value against other currencies.  If the value of our foreign debt falls far enough, it may offset the additional funds borrowed during the quarter so that net foreign debt is lower at the end of the quarter than it was at the start. A CAD in a given period is therefore equal to the change in net foreign liabilities (debt plus equity)—minus valuation effects—that occurred over that period (Krayger, 1996).

If Australia wants to reduce CAD and its net foreign debt, then a simultaneous progress is required on two fronts. First, exports have to grow faster than imports. Second, a corresponding increase in savings is required. So our investment can be financed by domestic savings, not by foreign funds. If savings is not increased then any income gain from a rise in exports will be lost to an increase in expenditure on imports (Krayger, 1996).

Answer to Question 3:

Classical economist argued in figure 1 that an increase in saving, by depressing interest rates, causes an increase in investment, and thus stimulates growth. Saving is a benefit to society; it makes us better off in the future. In contrast, Keynes argues in figure 2 that this is not necessarily so. Indeed, he argued that saving may be antisocial; it may decrease national product and employment. And Keynes believed that it is more correct to argue that a change in investment demand causes a change in saving than to argue that

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 a change in the desire to save causes a change in investment. Thus, said Keynes, classical economists had gotten things backwards. (Jhinghan, 1998)

Part B: Essay (30 marks)

What are the costs and benefits of using fiscal policy to manage an economy’s short-term and long term growth rates? Discuss.

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