Question:
What Fiscal Policy Austerity Response in the UK explain by using the Multiplier AD Model

Answer:




Q1:

The multiplier AD model can help illustrate the likely negative impacts if the UK government ramps up austerity measures to combat high inflation. Figure 1 shows the UK economy in mid-2023 represented by the initial aggregate demand (AD) and aggregate supply (AS) curves.






As noted in the articles, decades of underinvestment by both the public and private sectors have left the UK economy in a "growth doom loop" where persistent stagnation and weak productivity growth are limiting aggregate demand. AD captures the state of a sluggish economy with stagnant GDP around Ye and subdued investment and consumer spending holding back any strong recovery.

Now if the government introduces fresh austerity measures through spending cuts and tax increases, this will reduce aggregate demand further via two channels. Firstly, higher taxes will directly reduce disposable incomes and consumer spending. Secondly, cuts to government spending will reduce expenditures on public services, investment and jobs - dampening economic activity.

This results in a leftward shift of the AD curve to AD1. With the initial multiplier of spending cuts and tax rises estimated to be around 2 based on the closed nature of the UK economy, the initial £1 reduction in government spending and taxes results in a £2 decline in national income. As national income falls from Ye to Y1, consumption and private investment will also drop off according to the multiplier process. With depressed private sector activity adding to the downturn, GDP could realistically drop 1-2% over the next year while inflation remains elevated above targets. Unemployment start to rise too if firms cut jobs due to weaker demand. This would further weaken consumption and compound the negative impacts according to the multiplier. Stalling growth would also offer little scope to ease the fiscal squeeze or rising inflation as notes in the Guardian articles.

Overall, ramping up austerity amid an already stagnating economy risks tipping the UK into a prolonged period of contraction rather than reviving private sector investment as intended. A balanced fiscal approach combined with supply-side measures to boost skills, infrastructure and productivity seems a more advisable course of action to achieve stronger and more inclusive growth over the long-run.

Q2: Explained the US labour market from 2020 to 2023 using the wage-setting/price-setting (WS/PS) model.

The US labour market from 2020 to 2023 can be explained using the wage-setting/price-setting (WS/PS) model. In Q2 2020, the COVID-19 pandemic severely disrupted the US economy. Pandemic containment policies caused a steep fall in aggregate demand, cutting global production and raising the unemployment rate to 14.8%. With weak bargaining power and falling wages, workers could not resist layoffs.



In the WS/PS model, the initial steep fall in aggregate demand is shown by a leftward shift of the aggregate supply (SA1S) curve to SAS2. This reduced firms' price-setting (PS) schedule to PS1. With lower output and profits, firms cut wages. The wage-setting (WS) schedule shifted left to WS1. At the intersection of WS and PS1, equilibrium output (Ye) and the price level (Pe) fell sharply. The unemployment rate rose to U2 as many firms laid off workers.

To ease the impact, the CARES Act introduced unemployment benefits like PUA, PEUC and FPUC. These boosted laid-off workers' disposable incomes above pre-pandemic wages, reducing their incentive to work. As Dupor and Arbogast found, terminating these benefits in 2021 significantly increased employment as workers' incentives were restored.

In the model, generous unemployment benefits flattened the WS schedule from WS to WS1. At the intersection of WS1 and PS1, equilibrium remained at the lower level of Y1 with higher unemployment U2. Benefits termination pushed the WS schedule back to its original slope of WS. Equilibrium shifted to U1, and  increasing output and employment but reducing unemployment. By late-2021, aggregate demand recovered as the economy reopened, shifting the SAS2 curve rightwards to SAS1. Firms' PS schedule improved to PS. However, weak unions after decades of decline meant workers had limited bargaining power. As Rosalsky and Ghilarducci explained, weak unions were unable to secure substantial wage increases even as job openings rose. The WS schedule remained flat at WS2.



Equilibrium was now at point U1, with output higher at Ye but unemployment only moderately lower. While aggregate supply and demand recovered substantially by 2022-2023, wage growth lagged inflation. Equilibrium wages rose slowly as the WS schedule inched right to WS original position. Even as the unemployment rate fell to 3.8% in late 2023, real wages declined for most workers except in industries like leisure and hospitality.

Overall, the WS/PS model shows how different factors shaped equilibrium wages, prices and unemployment in the US labour market recovery from 2020-2023. Generous benefits initially reduced work incentives while weak unions failed to secure better compensation despite record job openings. While economic activity improved, many workers saw real wage losses. Only further rightward shifts of the WS schedule can drive stronger, more inclusive recoveries.

 

Q3:

a)

When central banks, such as the Reserve Bank of Australia (RBA), raise interest rates through monetary policy tightening, it leads to higher mortgage repayments for households with housing loans. The way households respond depends on their credit constraints. Less credit-constrained households, usually those with larger financial buffers, have more flexibility to adjust. Some refinance their loans to lower interest rates, while others negotiate with banks for better deals. They reduce discretionary spending temporarily but can still service their debts.

However, rates hikes disproportionately burden households living closer to the financial edge. The ABC News articles note a growing number of these households are at risk of financial stress as essential expenses exceed their incomes. Approximately 5-7% of owner-occupiers already face this situation. Highly indebted households with little savings have limited options. Some may ask banks for hardship arrangements, extending loan terms to cut repayments. But this increases long-term costs. Others are selling properties, with CoreLogic data showing short-term resales and loss-making sales rising significantly in 2022-23.

As more fixed-rate loans expire, CoreLogic also found higher interest rates impacting the resale market. Borrowers transitioning to pricier variable loans face tough choices between selling or suffering higher costs. Some accumulate debt, risks further issues down the track if rates continue rising. While mortgage defaults remain low overall, RateCity.com.au warns upcoming fixed-rate expirations place nearly 600,000 households at the "mortgage cliff". Combined with higher living costs, more borrowers struggle under additional payment burdens, even without further RBA increases.

Overall, monetary tightening disproportionately impacts credit-constrained households with little payment flexibility. Responses range from negotiating deals, to distress sales or even risks of eventual defaults, highlighting distributional effects.

B)

Effective Date

Cash rate target% Australia

Australia exchange rate

Cash rate target% USA

USA exchange rate

2-Mar-22

0.1

0.737927

0.2

0.7374

6-Apr-22

0.1

0.735774

0.33

0.7364

4-May-22

0.35

0.704928

0.77

0.7041

8-Jun-22

0.85

0.702644

1.21

0.7025

6-Jul-22

1.35

0.685952

1.68

0.6856

3-Aug-22

1.85

0.695654

2.33

0.6961

7-Sep-22

2.35

0.669108

2.56

0.6671

5-Oct-22

2.6

0.635892

3.08

0.637

2-Nov-22

2.85

0.661812

3.78

0.6596

7-Dec-22

3.1

0.674747

4.1

0.6748

8-Feb-23

3.35

0.695193

4.33

0.6955

8-Mar-23

3.6

0.688502

4.57

0.6893

5-Apr-23

3.6

0.667484

4.65

0.6676

3-May-23

3.85

0.668288

4.83

0.6688

7-Jun-23

4.1

0.664104

5.06

0.6643

5-Jul-23

4.1

0.672073

5.08

0.6713

2-Aug-23

4.1

0.672935

5.12

0.6742

6-Sep-23

4.1

0.648152

5.33

0.6486

 

The table shows cash rate and exchange rate data for Australia and the US for late-March 2022 and late-September 2023. In late-March 2022, Australia's cash rate was 0.1% and the AUD/USD exchange rate was 0.737927. The US cash rate was slightly higher at 0.2% and their exchange rate was similar at 0.7374. By late-September 2023, both countries had significantly increased their cash rates in response to high inflation. Australia's cash rate had risen to 4.1% by this point, up from 0.1% originally. The US cash rate was also higher at 5.33%, up from 0.2%.

The Australian dollar weakened noticeably against the US dollar over this period. In late-September 2023, the AUD/USD rate was 0.648152, down over 12% from its March 2022 level. This decline occurred as the RBA raised rates to combat inflation, following suit of earlier and faster US Federal Reserve rate hikes. One winner from the lower Australian dollar would be exporters, as their overseas sales are now more affordable in foreign currency terms. Conversely, importers and foreign travelers to Australia would be losers, as imports and expenses here are now 12% more expensive. The depreciating currency aids export competitiveness but pushes up costs for those relying on imports or spending abroad.

Overall, the rising cash rates in both countries have weakened the Australian dollar significantly against the US dollar as their respective central banks tackle high inflation. Exporters benefit from this currency change while importers and travelers face higher prices.

           

 

c)

Central banks in countries like Australia are implementing contractionary monetary policy through sharp interest rate hikes to bring down inflation from multi-decade highs. While effective at reducing inflation expectations, this policy comes with implications for households, businesses and the economy. The RBA aims to raise unemployment from the current rate of 3.5% up to 4.5% by the end of next year. Using the aggregate demand-aggregate supply model, this will require a contraction of aggregate demand.

In the AD-AS model, the Phillips curve shows the inverse relationship between unemployment and inflation. At the current unemployment rate of 3.5%, inflation is positive. To raise unemployment to 4.5%, aggregate demand must fall, shifting the Phillips curve upward and to the left. This will dampen inflationary pressures in the economy.



The multiplier formula demonstrates how a change in autonomous spending affects total spending and output through the multiplier process. Initially, aggregate demand (AD1) intersects the short-run AS curve at the current unemployment rate and inflation rate. To shift AD left necessitates a tightening of monetary policy by the RBA to reduce autonomous components of spending such as investment and consumption. Higher interest rates discourage borrowing and raise the cost of credit-fueled spending. They also appreciate the currency, making imports cheaper and exports less competitive.

This downward influence on autonomous spending lowers the AD function to AD2 through the multiplier. As total spending and output contract, firms respond by laying off more workers to cut costs. The resultant higher unemployment moves the economy along the short-run Phillips curve to Point B, achieving the RBA's 4.5% unemployment target.

Inflation will also fall as demand decreases, satisfying the RBA's implicit inflation target. The new intersection of AD2 and the short-run AS curve indicates the targeted level of output, unemployment and price pressures have been reached through monetary tightening and the planned AD shift. Overall, tighter credit conditions are expected to cause a recessionary AD reduction to fulfill the unemployment objective.