SECTION A

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.

How to use this answer guide.

The answer guide that follows includes a range of answers for each question. The aim is to give you a better understanding of what constitutes a ‘fail’, ‘standard’ or ‘good’ answer in each case.

Please note the following:

Fail answers generally contain any or all the following characteristics:

•    do not answer the question that was asked – but instead answer a different question

•    contain incorrect statements, use wrong definitions or use the wrong models to answer the question

•    have explanations that contradict their models or diagrams

•    have illegible or poorly constructed diagrams to ‘explain’ their answers

•    are illogical, illegible, make no sense or cannot be understood by the examiner

•    a text-book definition with no other explanation (when more is asked for)

•    relies on the examiner ‘guessing the writer’s meaning; ie often ‘sit on the fence’ revealing the student does not know the answer

•    present an answer that demonstrates no knowledge of the course (for example, discuss the politics of the situation rather than the economic models)

Pass level answers generally contain the following characteristics

•    a basic answer to the question asked, but with little elaboration or explanation (ie the bare bones)

•    a basic diagram, often almost ‘stand alone’and separated from any discussion (it is not referred to in the discussion)

•    a basic definition and brief explanation that does not reveal any real understanding of the question

•    maybe so poorly expressed the examiner ‘gets the idea’ – but cannot be sure the student really understands the required answer

Good or excellent answers generally contain the following characteristics

•    clear, factual statements that quickly get to the heart of the question (and answer it)

•     clear, legible, fully labelled diagrams integrated with the discussion

•    well-constructed, logical, answers that emphasise the correct aspects of the question

•    may go beyond what was asked to discuss (or comment on) a difficult or unresolved part of the question

•   demonstrate real command of the economic concepts under discussion, great clarity of expression and accuracy in their application

What follows below are a series of answers that demonstrate the difference between the above examples

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.

B 1.

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 and the unemployed?

•   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)

Fail Answer:

i.  A weaker than expected upturn means unemployment increases

ii.  Potential Gross Domestic product will be less if the upturn is weaker than expected

iii.  Australia’s standard of living in the future is unlikely to be affected too much as once the crisis is over and population increases the standard of living will increase again.

Why is this a fail answer?

(i) wrong – (an upturn will decrease unemployment – just not as fast as expected)– and doesn’t reveal

any knowledge of what unemployment is, how it is defined. Doesn’t show they have studied economics (ii) doesn’t explain anything – and basically states the given situation using different words.

(iii) Is wrong- living standards in the future will be permanently lessened due to current set-backs. Does not define terms, or explain underlying reasons for the answer.

Overall, maximum of 1 or 2   / 10

Pass Answer

i.  Unemployment is defined as the number of people currently looking for work who cannot find work. It is calculated using a regular survey by the ABS and anyone who works more than one hour a week is defined as being employed, While unemployment decreases more slowly than expected because of the slower than expected improvement, there will still be unemployed.

ii.  Potential Gross Domestic product is defined as the level of GDP that can be reached with everyone is working at normal capacity. So a weaker than expected upturn means this will be less.

iii.  The weak upturn will impact on Australia’s standard of living in the future because it means our growth rate is slower than it might otherwise be. One measure of the standard of living is GDP per capita.

Why is this a pass answer?

(i) provides a basic definition, but includes irrelevant discussion (on how u/n is calculated) and states the obvious without adding any real economic insight.

(ii) Gives correct basic definition – but doesn’t explain it (so maker would be generous to pass this)

(iii) identifies relationship between standard of living, growth rate and weak upturn – but doesn’t say any more.

Overall – a bare 5/10 (if marker generous)-

Good Answer

(i) A weaker and later than expected upturn in GDP means that unemployment, although decreasing will be decreasing more slowly than anticipated. Thus the percentage of the workforce unemployed (not working even an hour a week) will be higher than expected. This also means that more people that were expected (including families and children) are personally impacted by lower incomes, lower standards of living and all the problems caused by not having work.

(ii) A weaker than expected upturn means that Potential GDP will not be as high as expected. Not only does this mean that growth is slower, but that with more unemployed people, resources and firms than expected, the cost to the economy, in terms of lost potential is higher than it otherwise would have been.

(iii) The weaker than expected upturn has both short and long term implications for Australian’s standard of living. In the short run, the standard of living (which can be measured in a variety of ways, with the simplest being GDP per head) is less than it would have been. In the long run, this slower than expected growth means that even when the economy grows in the future, the lost capital (capital not invested,  technology  not  invested  etc)  and  lost  human  capital  (people  not  trained,  or  with  less experience) will never be entirely recovered.

Why is this a good answer?

(i) directly addresses the question in the first sentence – and then explains what this means. The answer goes further to explain how this impacts on individuals (the second part of the question) and what that means.

(ii) instead of just supplying a basic definition, the answer reveals the writer understands what the concept means in terms of potential GDP across firms, people and resources.

(iii) The answer shows a good understanding of the issues and organises the response in two dimensions (s/r and l/r) which in this case are important for a complete answer. Details as to particular aspects of GDP (real and human capital) are specifically mentioned.

Overall 7.5 /10

B2 Use the aggregate expenditure (AE) model to outline the potential effects 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)

Fail Answer

The aggregate expenditure model shows the short-run relationship between total spending and real GDP assuming prices remain constant. If the government does not open the spending tap enough this means that  aggregate  expenditure will be high  enough to  expand the  economy  and there will be more unemployment. This means that if Aggregate expenditure is defined as C + I + G + X- M, than G is not high enough.

Why is this a fail answer?

This is a fail for numerous reasons. It does not answer the question (to use the model; to outline effects; to discuss linkages, to discuss the equilibrating process). Given the marks indicated it is far too brief an answer, There is no diagram (which is critical for this sort of question) that could be used to outline the effects of not ‘opening the tap’ etc. The fact the student gives the correct definition of the AE model is irrelevant (not asked for) and demonstrating knowledge of the components of AE in this model is what gains the student 1 mark.

Overall 1 /10

Pass Answer

If the government does not spend enough then the AE is lower than it would be if they spent ‘enough’– as expenditure on output falls via fall in C, I and NX. This fall means that overall GDP is less than it would otherwise be. This means the economy ends up at Y3 and not back at Y1

Real AE

AE1 = C1+I1+G1+NX1

AE3 = C3+I3+G3+NX3

AE2=C2+I2+G2+NX2

Y2           Y3    Y1                Real GDP/year

The downturn caused people to buy less and this meant a big fall in AE. the government expenditure (G) meant more was spent, running down inventories and causing business to produce more, pushing the economy to the final equilibrium- which was higher than at its worst in the recession but less than the original equilibrium position.

Why is this a Pass answer?

This is a pass (but not a very good one) because the student has just done enough to demonstrate the idea of the AE model and applied it to the problem. The diagram is the best part of the answer – because it is fully labelled, clear and correct. They have mentioned the components of AE in part of their answer and they have touched on the equilibrating process (as required) when explaining how the system reaches the post-government spending equilibrium. It coves the basics. It is not a really good pass because despite the accuracy of the diagram, the answer doesn’t really explain it- and the explanations that are given are too brief. (Note- long answers are not always good answers- but too often students

skip details and do not demonstrate they understand how the model works).                     Just     5/10

Good Answer

The pandemic caused AE to fall. AE = C + I + G + NX, and with the pandemic initially C and NX fell as people bought less   but then I also  fell as businesses were closed. As businesses had unsold inventories rapidly building in their store areas, they cut back production, and as the fear of closures spread, (cutting C and I further) they responded by cutting even harder. The multiplier effect of this meant that the impact on GDP was larger than the original drop in C, I and NX. This is shown in the diagram with the economy falling from Y1 to Y2 and the falls in AE components (eg C1 to C2, I1 to I 2 etc (the vertical distance between AE1 and AE2) being less than the fall from Y1 to Y2.

1

Real AE

AE1 = C1+I1+G1+NX1

AE3 = C3+I3+G3+NX3

AE2=C2+I2+G2+NX2

Y2           Y3    Y1                Real GDP/year

The  government  (both  G – although this refers to  government  infrastructure,  services  etc- NOT transfers) and the increase in C (caused by transfers such as jobseeker) mean that AE is increased. The increase in C and G (and the multiplier impacts of these) means that businesses find they sell more stock than they anticipated and they respond by producing more. The overall impact is to shift AE from AE 2 to AE3 and raise GDP from Y2 to Y3. While there is a big improvement on Y2, the government- spending tap’ has not opened enough’  to fill ‘whatever gaps emerge’ . Thus GDP is less than before’ and unemployment higher

Why is this a good answer?

In addition to accurately drawing the model and applying it correctly, the answer demonstrates a good grasp of the whole economic situation (correctly depicted), a good understanding of the equilibrating process, the concept of  the multiplier and the consequences of the governments positive (but not

positive enough) expansion of C (through transfers) and G (through direct expenditure) – and the

difference between these. At least 6.5-7.5/10 – higher marks if well written.

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)

Fail answer

The government intends to stimulate the economy and reduce unemployment by expanding demand. It does this shifting AD in the diagram below.

Price

GDP

Why is this a fail answer?

There are several things wrong with this answer, and not many that are right. Even though the              question is only worth 4 marks – two sentences is nowhere near enough explanation. The response       does not actually answer the question, because it does NOT use the static AD-AS model – it merely     asserts the governments (intention (which can be gathered from the question and requires no economic knowledge). The diagram is insufficient – as it is not fully drawn (no LRAS and not fully labelled and

what is labelled (such as GDP is incorrect – it should be GDP/year). Maybe 1 / 5 marks.

Pass answer

The government intends to counter falling GDP and rising unemployment by increasing expenditure. In the static AD-AS model (which does not take change in technology, or growth into account) this   means trying to offset the fall in AD caused by the COVID crisis though increasing G and                 encouraging C  and I.

This approach is depicted in the diagram below, where the initial impact of the crisis saw a large fall in AD and the government’s policy efforts attempted to move AD back to the original position. Thus the fall from Ye to Y1 and the aim was to get back to Ye

SRAS

Y1    Ye

GDP/year

Why is this a pass answer?

This answer does a solid job in answering the question. The diagram is correct, and correctly labelled. The answer defines the static AD-AS model and uses it to describe the government’s intentions. It has

all the basics correct, although it does not address the whole question entirely Mark 2.5 / 5.

Good Answer

The impact of the virus, and government shutdowns was that AD (which consists of C +I+G+ X-M) to fall. This caused a jump in unemployment, and the closure of many businesses. As this was also           occurring overseas, exports fell too.

The government’s policies (such as jobkeeper, jobseeker) business assistance, building infrastructure etc was increase AD so as to move GDP back to its initial level and reduce unemployment back to its original (pre crisis) levels.

Price

Y1    Ye

Unemployment initially low

at Ye, increases at Y1 and

increase from AD2 to Ad1

returns it to original level.

The government’s aim therefore was to offset the fall in AD through economic stimulus and counter   the rise in unemployment at Y1– attempting to bring the economy back toward its potential GDP level (Ye)

Why is this a good answer?

The answer demonstrates a good understanding of the AD-AS model, and uses it to answer the            question. The answer shows an awareness of the overall economic situation and the reasons behind the governments expansionary policies. The diagram (with the text and the use of a text book) clearly

links the diagram to the answer. Done succinctly. - 3.5 or more marks out of a maximum of 5

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)

[Hint: Start by considering the initialposition ofthe economy ‘pre-COVID’ and that the ‘base’ scenario is the situation in early 2020 when little measured impact had occurred). Then consider the impact of each of the two scenarios separately.]

B4 (iii) Comment explicitly on the long run impact of the COVID pandemic on the economy, giving

reasons for your answer (5 marks)

B4(i)

Y1    Ye

GDP/year

Fail Answer

The base line situation is where the LRAS, SRAS and AD cross and GDP is at Ye. With the downside situation  (where the COIVID crisis is worse than anticipated) the fall to Y1 is larger and the increase in unemployment is much higher than anticipated.

Why is this a fail answer?

The most obvious error here is that this is NOT the dynamic model – so even if the remainder of the answer was 100% correct this answer could not pass. The answer is too vague, and far too broad. It   contains insufficient detail for a question worth 10 marks and does not demonstrate any real depth of understanding. Likely mark 0 or 0.5 / 10

Pass Answer

The dynamic AD-AS model captures the impact of the COVID crisis in both the short and longer term.

LRAS 2     LRAS1               SRAS 2       SRAS1

Y2

Y1

GDP/year

Initially the economy was at Y1 with close to ‘full employment’ . After the COVID crisis hit, it caused a large fall in AD ((through drops in C and I), shown by the drop from AD1 to AD 2. The fall in         investment, and cut in business costs (like rent freeze, deferred repayments0 cause the SRAS to shift   left. The LRAS curve also shifts left with less technology invested – but unemployment increases (the gap between LRAS and Y2) because AD has fallen a long way – and the new equilibrium is much      lower.

Why is this a Pass answer?

This is a pass answer, mostly because of the diagram (again). The ‘explanation is OK – but doesn’t     have enough detail to be a good answer (it doesn’t explain all the steps, it doesn’t reveal a good           understanding of the economic situation). It most ‘describes the model (in a quite ‘mechanical’ way – but without providing any insight into what is really happening in the economy. Again the ‘basics’ are there (mostly in the diagram) – but the answer misses a number of opportunities to demonstrate a

good depth of knowledge or a more sophisticated understanding. Mark around 5.5 to 6 /10

A Good answer.

The COVID crisis has both short and long term impacts. The initial impacts were a large fall in AD.   So even thought the economy was close to full employment – there was some unemployment above   the natural rate (as seen as the difference between Yo and Y1). The fall in C and I in particular, but     also NX reduced AD significantly. On top of this, in the short run, the fall in business (ie despite a      freeze on rents, tax breaks) meant scaled back operations and is likely to have shifted the SRAS to the left. Taken together this meant the economy shifted to Y2 – a far lower equilibrium. No only did this  cause a large increase in unemployment in the short run, it had longer run impacts as the fall in           technological development, migration and investment in human capital (less business experience,       reduced university places, reduced skill investment) shifted the LRAS to the left. The overall effect is that while unemployment increased a little, the overall potential GDP of the economy is reduced         permanently by the crisis.

The government has attempted to counter this by increasing C and G and encouraging I – but the net effect is still a smaller economy at a lower level of equilibrium than before.

LRAS 2     LRAS1               SRAS 2       SRAS1

Y2     Yo’    Y1Yo

GDP/year

Why is this a good answer?

This answer has both a more sophisticated depiction of the economy than the pass answer (as it reveals unemployment both before and after the crisis- but of differing amounts) – but it also discusses the underlying factors (such as business costs – SRAS; capital investment and human capital – LRAS) and the impact of the virus on these. It addresses the question directly and does not include a lot of ‘extra’ material – just enough to answer the question and reveal a good understanding of the model).

Probably 7.5 /10 perhaps more, depending on the quality of the writing.

B4(ii) Discussion of upside situation

(10 marks)