Question

2. a). Concerned for the current stat of the Australian economy the Reserve Bank of Australia has decided to reduce the money supply.

  b). Demonstrate on a graph how a) above will affect aggregate demand and explain why?

  c). At the same time as the RBA is reducing interest rates, the Australian Government has a policy of producing a budget surplus by the year 2020. Demonstrate on a graph how this will affect aggregate demand, discuss whether this policy aligns with the RBAS decision to reduce interest rates.

Answer 1

Assume that the economy is initially in equilibrium at point E with interest rate r1 and GDP/Income at Q1. The reduction in the money supply will shift the LM curve upward to the left from LM1 to LM2. As a result, for a given level of income in the economy the interest rate will rise. This happens because given the income level in the economy, the reduction in the money supply will raise the transaction demand of money. As a result, people will start to withdraw money from their speculative balances which will result in reduction in the bond prices and increase in their yields (interest rate).

Increase in the interest rate will reduce investment demand in the economy as firms will find it expensive to borrow money for investment in plants and machinery. As a result, the aggregate demand will fall. This will cause, the aggregate demand curve will shift downward to the left from AD1 to AD2.

Now, it is given that the Government of Australia has a policy of producing a budget surplus by the year 2020. This means that the government will reduce its expenditure. Reduction in government expenditure will cause the IS curve to shift downward to the left from IS1 to IS2. For a given level of money supply a reduction in government expenditure will reduce aggregate demand which will cause the interest rate to decline, and bond prices to increase. This happens because reduction in income level due to reduction in government expenditure will raise speculative demand for money. As a result, the aggregate demand curve will further shift leftward to the left from AD2 to AD3.

The government policy of producing budget surplus affects the interest rate in an opposite manner as compared to the decision of the RBA to reduce money supply. Decision of RBA to reduce money supply causes interest rate to rise, while the decision of the government to produce budget surplus results in decline in the interest rate.

However, with respect to aggregate demand, the government policy of producing budget surplus reinforces the impact of RBA’s decision of reducing money supply as both the decisions causes the aggregate demand to decline.