Please help me with the following questions from my macroeconomics homework. I have answered the questions but I struggled with the answers. INSTRUCTIONS: Read the following excerpt and answer...

Please help me with the following questions from my macroeconomics homework. I have answered the questions but I struggled with the answers.

INSTRUCTIONS:

Read the following excerpt and answer all the questions. You are expected to use graphs to explain your answer.

Australia central bank stresses policy limitations, wants businesses to step up

SYDNEY: Australia's central bank chief said on Wednesday that record low interest rates alone cannot drive confidence or spur business activity, suggesting that firms should do more to stimulate stronger economic growth.

Reserve Bank of Australia Governor Glenn Stevens told lawmakers at his semi-annual testimony the economy now needs 'animal spirits' in order to support an expansion of non-mining firms, and this is not what monetary policy can directly do.

"We need an environment where there is more confidence to move ahead. I've allowed the horse to come to the water of cheap funding, but I can't make it drink," Stevens said.

"It isn't that I'm unwilling to consider lower rates if that really would be helpful but it is just a sense that interest rates aren't the answer at the moment," he told the House of Representatives Standing Committee on Economics.

His comments led markets to pare back the probability of a cut in rates anytime soon, with a move by December now put at no more than a one-in-four chance.

Stevens conceded that it is "pretty normal" at this point of the economic cycle that companies may be reluctant to expand due to uncertainty about the future pace of demand. But that should change over time, he said, citing low funding costs, a hefty rise in household net worth, strong population growth and opportunities to tap Asia's expanding middle class.

When it does, the central bank's forecasts for sub-par growth "will very likely prove to be conservative", Stevens said. In its quarterly monetary policy report released earlier this month, the Reserve Bank of Australia (RBA) said it expected the economy to grow at a below-potential 2.5 percent pace by December this year, down from around 2.7 percent for 2013. It saw the slowdown in mining investments deepening.

Questions:

  1. The economy now needs 'animal spirits' in order to support an expansion of non-mining firms, and this is not what monetary policy can directly do”. Use the Aggregate Expenditure model to explain the given statement made by RBA Governor Glenn Stevens. In your answer make sure you explain currently what phase of business cycle Australia is in
  2. Use the Aggregate Demand (AD)/Aggregate Supply (AS) analysis to explain the prediction made by RBA governor about the factors that can cause change in economic cycle. Make sure to explain why AD is expected to change and use your diagram to show the importance of the shape of the AS curve and the positioning of initial output equilibrium.
  3. Use the AD/AS model to show the implications of slowdown in mining investment on output, price and employment. In your answer explain the impact of the multiplier effect.

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Top Answer

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

1) When Glenn Stevens talks about “animal spirits,” what he really means is confidence.  He is saying that Australian firms need to be more confident.  If they are more confident, they will be more willing to take advantage of the low interest rates that the RBA is currently maintaining. 

The aggregate expenditure model says that a nation’s GDP is made up of expenditures on consumption, investment, government purchases, and net exports.  Stevens is talking about the effect of monetary policy on investment.  In theory, a looser monetary policy (for example, lower interest rates) will increase investment because businesses will be able to borrow money at a lower cost.  They will use that money to invest.  But here, Stevens is saying that interest rates are low and businesses are still not willing to invest.  This is because Australia is in the expansion phase of the business cycle and businesses are worried that growth is slowing and a recession may be in the offing.

2)  Stevens says that both aggregate demand and aggregate supply are likely to rise in the future.  He gives more reasons for the predicted rise in AD.  He says that AS will rise because of the lower cost of borrowing (which comes out of the looser monetary policy described above).  He mentions two main reasons for an increase in AD.  The first reason is an increase in household wealth.  As people become wealthier, they are willing to spend more of their money and AD increases.  Second, there are going to be more people (he says) buying goods and services in the Australian market.  This increase will be partially due to population increase in Australia itself, but it will also be due in part to greater opportunities to sell to people in Asia.  When there are more consumers buying from firms in a given economy, AD will rise. 

If you look at the BYUI.edu link below, you will see why the shape of the AS curve and the positioning of the economy on that curve matters.  You will see that there are three ranges to the AS curve.  If the economy is in the Keynesian range and AD increases, RGDP will increase without an increase in the price level.  If the economy is in the intermediate range, an increase in AD will cause both RGDP and price level to rise.  Finally, if the economy is already in the classical range, an increase in AD will lead only to an increase in the price level and not to any increase in RGDP.

3) If there is less investment in mining the supply of mine products will go down.  This will cause the overall Australian economy’s aggregate supply to decrease as well.  As investment goes down, mines will be less able to expand.  This will reduce supply in the long term.  When supply goes down, prices go down, but so does employment because fewer people are employed in the mining sector. 

Australia’s AD will also decline in this scenario.  This is because fewer people will be employed.  This will mean that people have less money and consumption will decrease.  This, too, will cause lower prices (or at least slower inflation) and reduced employment.

Sources:

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