Question

The Australian government has recently announced a raft of fiscal expansionary/stimulus measures that will lead to a significant increase in the level of Australian government debt. Given the material presented in this course cover the pros and cons of government debt, we know that one view put forward is that ‘government debt is bad’. Do you agree or disagree with this statement? Briefly justify your answer.​​​

b. Consider the current economic conditions in Australia, where (eventhough official data is not yet in) current output (real GDP) is currently below potential GDP.

(i) What type of fiscal policy has the government used to try and get Australia to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation). Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changing (if any), and in which direction.​​​

(ii) Can the existence of a fiscal multiplier help the government in terms of its commitments to reach potential GDP level of output? Provide a brief example.​​​​​​​​​​

Answer 1

I agree with that statement. This is because in the market for loanable funds, an increase in budget deficit leads to an increase in demand for loanable funds. This creates an excess demand for loanable funds at the existing interest rate. Now this leads to an increase in interest rate. Increase in interest rate leads to a decrease in investment spending in the economy. Decrease in investment spending leads to decrease in capacity of the economy o produce output. This leads to a decrease in potential output in the economy.

This is why Government deficits are bad.