“c04AggregateDemandPoliciesAndDomesticEconomicStability_PrintPDF” — 2022/6/7 — 8:31 — page 318 — #32
4.7.3 Reviewing how automatic and discretionary stabilisers work together to affect AD Putting automatic and discretionary budget stabilisers together and using the AD–AS diagram for the economy as shown in figure 4.12, it is possible to see theoretically how these measures might operate in a countercyclical way to improve Australia’s prosperity.
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FIGURE 4.12 How countercyclical budgetary policy can be used to help regulate AD and promote domestic economic stability
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Using budgetary policy in a countercyclical way helps to reduce cyclical instability in economic activity
AD2 = excess AD and a boom — a contractionary budget surplus is needed to slow spending and reduce inflation
AD0 = weak spending and recession — an expansionary budget deficit is needed
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Low inflation
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P1 P0
Demand inflation
AD1 = domestic economic stability — when the economy is at this point, a fairly neutral budget stance is typical
PA
General price level
P2
PR O
AS
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GDP1 and GDP2 = GDP0 = the economy is in the economy is at recession with its productive capacity high cyclical unemployment Real GDP/national output
CO RR EC
During a prolonged recession or slowdown in activity, when economic growth is relatively weak and cyclical unemployment is rising, the budget stance progressively becomes more expansionary. This typically involves an increase in the budget deficit to boost AD (the rise in spending from AD0 to AD1 ) and lift GDP (the increase from GDP0 to GDP1 ). The switch to an expansionary deficit can happen in two ways: • First, there are automatic reductions in the value of tax receipts and rises in welfare outlays. • Second, if required, there could also be discretionary reductions in tax receipts by cutting tax rates, and by increasing the generosity of particular budget outlays. As a result of these two types of expansionary stabilisers, the budget typically moves into deficit and the economy shifts towards domestic economic stability (moves towards AD1 , GDP1 and P1 ) where, simultaneously, there is low inflation, strong and sustainable economic growth and full employment.
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By contrast, as the economy strengthens and there is a fear of inflationary pressures, the budget stance gradually becomes more contractionary as the stimulus is withdrawn and the brakes are applied to slow AD (moving AD2 to AD1 ), economic activity (the shift from GDP2 to GDP1 ) and inflation (the fall from P2 to P1 ). Typically, the cyclical and possibly also the structural budget deficit will switch to a budget surplus. Again, this can happen in two ways: • First, automatically receipts will rise and welfare outlays fall. • Second, any discretionary stimulus measures from earlier periods could be gradually withdrawn through deliberately allowing bracket creep and/or slowing rises in outlays. Again, as a result of these two contractionary budget stabilisers, the economy shifts towards domestic economic stability (moves towards AD1 , GDP1 and P1 ) where, simultaneously, there is low inflation, strong and sustainable economic growth and full employment — the conditions needed for better living standards. 318
Key Concepts VCE Economics 2 Units 3 & 4 Eleventh Edition
