Read the following edited article by Ross Gittens of the Sydney Morning Herald

August 10, 2020

'Extreme uncertainty' causes RBA's bright-side mask to slip

… The new forecasts the Reserve Bank issued on Friday were significantly different to those it issued three months ago. Worse, they laughed at Treasury’s forecasts in the economic update just two weeks earlier.

The general story is that, thanks to the setback in Victoria, the upturn in the economy’s production (real gross domestic product) will now come later than expected, and be weaker. When Reserve    governor Dr Philip Lowe says the recovery is “likely to be both uneven and bumpy” you can be    confident he’s not exaggerating. “Uneven” means stronger in some states than others. “Bumpy”   means not every post will be a winner.

Reading between the lines, the lockdown's full contractionary effect on GDP was expected to come in the June quarter (for which we’ll see the figures in three weeks’ time), with the recovery starting in    the present September quarter.

The first quarter after the contraction should always be pretty strong (and, this time, particularly     because the end of the lockdown meant people could get out, visit shops and restaurants and pubs), even if subsequent quarters aren’t as strong.

This time last week, the smart money was expecting the recovery in the September quarter to be followed by a contraction in the December quarter, as demand was hit by the wind back in the   JobKeeper wage subsidy and the JobSeeker supplement.

Now, the September quarter recovery in the other states is likely to be overwhelmed by the effects of Victoria’s move to a harder lockdown. This, in turn, probably means there's less likely to be a further contraction in the December quarter – just continuing weakness. We do know that, in response to      Victoria’s problems, Scott Morrison has modified JobKeeper at a cost of more than $15 billion.

Friday’s statement on monetary policy acknowledged “extreme uncertainty” about the course of the pandemic and, hence, its economic effects. In response to this uncertainty, the Reserve has moved   from a single set of forecasts to three scenarios: baseline, upside and downside.

… . the baseline scenario assumes that the rate of infection subsides, the tightening of restrictions in  Victoria succeeds, there are no new lockdowns elsewhere, and restrictions are eased progressively    over the rest of the year. The upside scenario assumes the pace of decline in the number of cases is a bit faster than in the baseline, so the restrictions are eased a bit faster – like recent experience in the smaller states. People take more comfort from this and so confidence recovers faster than in the        baseline. Households are thus willing to spend more of the savings they accumulated during the first half of this year, compared with what’s assumed in the baseline scenario.

The downside scenario assumes that infection rates continue to escalate around the world this year and next. Australia faces a series of outbreaks and periods of stage three and four restrictions in some         states. The result is further near-term weakness in economic activity. Confidence is damaged and so    the recovery is much slower as well.

The other main point of variation between the three scenarios is how long Australia’s international      borders remain closed. Three months ago, the Reserve was assuming travel restrictions would be lifted by the end of this year. In the new baseline and upside scenarios, it’s assumed that the borders reopen  mid next year. In the downside scenario, it’s assumed continuing spread of the virus overseas causes   our borders to be closed for the whole of next year.

There is, of course, another major source of uncertainly that the [authorities] are too polite to mention: whether Morrison retains his pragmatic approach and keeps the government-spending tap open to fill  whatever gaps emerge during the slow and troubled recovery, or succumbs to his ideological instincts and eschews further spending. My scenario: he’ll do more, but not enough.

SECTION B

There are four questions in total. Attempt all questions.

Where appropriate use diagrams to explain your answer.

You do NOT need to include precise datafrom the reading in your answers/diagrams.

B1.  The article states (in August last year) that “…the upturn in the economy’s production (real gross

domestic product) will now come later than expected, and be weaker.”

Explain what a weaker than expected upturn means for:

•   Unemployment

•   Potential Gross Domestic Product

•   Australian’s standard of living in the future.

Be sure to explain the underlying reasons/assumptions for your answers.

(10 marks)

B2 Use the aggregate expenditure (AE) model to outline the potential affects on economic output and (un)employment if the ‘government-spending tap’ does not open  ‘…enough’  to fill ‘whatever gaps emerge’ … or ‘succumbs to … ideological instincts and eschewsfurther spending’. In your answer make sure to discuss the linkages affecting AE and the equilibrating process of moving to a new equilibrium (Ye) output.

(10 marks)

B3 Use the static AD-AS model to describe the intended impact of the government economic stimulus, on macroeconomic equilibrium output and (un)employment. In your answer outline the purpose

of the government intervention.                                                                                 (5 marks)

B4 Use the dynamic AD-AS model to analyse the ‘downside’ and ‘upside ’ scenarios described by the Reserve Bank and compare this against the ‘baseline scenario’ referred to in the article as the initial starting position. First, examine the ‘downside’ scenario against the ‘baseline’ .  Then, in a separate diagram, examine the ‘upside’ scenario against the ‘base’ scenario. Make sure to outline the  assumptions you have made with regards to the  dynamic  effects  on  long run aggregate supply and aggregate demand in both cases.

B4 (i) Discussion of downside situation

B4 (ii) Discussion of upside situation

(10 marks)

(10 marks)