4.10 Aggregate supply — its meaning, importance and factors affecting its level and economic activity

The exchange rate for the A$

Changes in the exchange rate for the A$ against the value of other currencies will affect the price or cost to us of imports of goods and services. A fall in the A$, for example, tends to make imports dearer, slowing their relative attractiveness. This also affects the level of consumption of Australian-made goods and services, while a rise in the A$ encourages us to buy more imports and travel abroad, slowing AD and economic activity.

4.9.3 How changing aggregate demand factors can determine the level of economic activity and macroeconomic conditions As we have seen, generally stronger or weaker aggregate demand factors cause instability in spending, bringing about changes in the level of economic activity and other domestic macroeconomic conditions. The effects of stronger aggregate demand conditions on the economy Over the short-term, generally stronger aggregate demand conditions will stimulate spending or AD, because of falls in the value of leakages (lower S + T + M) relative to injections (I + G + X). Because the size of the four flows making up the circular flow model are equal in value and interdependent, GDP, employment of resources and incomes will all need to increase to help maintain equality. However, if the economy is already operating at or near its productive capacity (close to the PPF on the production possibility diagram), stronger AD can mean that spending will outstrip national production or aggregate supply. Normally, this would cause widespread shortages of goods and services, leading to increased inflation and boom conditions in business cycle. Using the circular flow model to guide your thinking, figure 4.13 provides a step-by-step explanation of the effects of generally stronger aggregate demand conditions that can cause booms.

FIGURE 4.13 How generally stronger aggregate demand factors can increase Australia’s economic activity and impact other domestic macroeconomic conditions Stronger aggregate demand factors: Stronger demandside conditions can include … • h i g h er c on s um e r confidence • i n creas ed bus i nes s confidence • r i s i n g ov e r s e a s e con o m i c a c t i v i ty • w eak er A $ • l o w er i n t e r e s t r a t es • c u t s i n t a x e s • i n creas es i n g o vern me n t spending. Stronger AD: R i s es i n t he t ot a l v al u e of t h e components m a ki n g u p A D (i .e . C, I, G, net X) or spending on A u s t ral i an -m a de g o o d s an d s e r v i c e s , m e a n s t ha t , ov e r al l , A D i n creas e s ( fl o w 3 ) . Increased inflation: W h e n A D r i s e s , s a l es a nd n ew or de r s i n c reas e. H owe v e r , s t ock s of u ns ol d g o o d s may f a l l , a n d w i des pre a d s h o r t ages c a n d e v e lop i f t he r e i s no u n u s ed pr oduc t i v e c a p acit y a v a i l a bl e . T h i s co u ld l e a d t o i n c reas ed i n fl a t i on. Increased production: B us i n es s fi r m s wi ll t r y to expa nd GD P ( fl o w 4 ) , t o r e pl a c e t h e i r f all i n g s t oc k s . T h i s accel e r a t e s t h e r a te o f econom i c g r owt h , pr ov i di ng t h e re i s s om e s pa re o r u n u s ed pr odu c t i v e c a p acit y a v a i l a bl e . Lower unemployment and higher incomes: T o l i ft pro du c t i on , fi r m s wi l l ge ne r a l l y a t t empt t o bu y or e m p loy m or e r e s o u rces (fl ow 1 ) i n c l udi n g l a bou r . T h i s cau s e s u n empl oy m e nt t o fal l and total incomes t o ri s e ( flow 2).

And so on, t h r o u gh t he c i r c u l ar fl o w mode l . The effects of weaker aggregate demand conditions on the economy By contrast, generally weaker aggregate demand conditions will slow spending and AD reflecting rising leakages and/or lower injections. To restore equilibrium between the four flows on the model, this slows GDP creating more spare capacity. Unemployment of resources would rise, and incomes fall. Additionally, with UNCORRECTED PAGE PROOFS slowing economic activity, inflation is likely to fall. This is because firms are likely to discount their prices to clear unwanted stock caused by the drop in sales. Using the circular flow model to help guide your thoughts, figure 4.14 provides a step-by-step explanation of the impacts of generally weaker aggregate demand conditions and activity.

FIGURE 4.14 How generally weaker aggregate demand conditions can slow Australia’s rate of economic activity and impact other macroeconomic conditions

Weaker aggregate demand factors: Weaker aggregate demand conditions can include … • L o wer c on s um e r confidence • R edu ce d bu s i nes s confidence • F al l i n g ov e r s e a s e c o n omic a c t i v i t y • R i si n g A $ • H i g h er i nt e r e s t rates • R i ses i n t a x e s • D e creas e d g o vern me n t spending. Weaker AD: F a l l s i n t he t o t al v al ue of t he components making u p AD ( i.e . C , I, G, net X) or spending o n A u s t ral i a n -m a d e g o o d s an d s e r v i c e s , m e a n s t ha t , ov e r al l , A D (f l ow 3 ) s l ows . Lower inflation: W h e n A D dr ops , s al e s an d n e w o r d ers f all . S t oc k s o f u n s o l d goods a nd serv i c e s s t a r t to i n c reas e. W i t h r i s i ng s t ock l ev el s , sometimes a glut or market surplus d e v e lops , s o fi r m s o f ten cu t or d i s co u n t t he i r p r i ces . Th i s s l ows i n fl at ion . Lower economic activity: B us i n es s fi r m s wi ll r e d u ce t he i r out put t o av oi d e x c e s s s t ock l ev el s . GD P ( f l o w 4 ) f a l l s . Thi s s l o ws t h e r a t e of e c o n omic gr owt h . I f G D P f a l l s ov e r t wo o r mo re c on s e c ut iv e q uart ers (6 m ont h s ), t h is i s cal l e d a recession. Increased unemployment and lower incomes: T o try an d r e du c e p r o du ct i on, fi r m s w i l l e mpl oy f e we r resources including l a b o ur ( f low 1). U n e mploy m e n t rises and so total i n c o m es f a l l (fl ow 2 ). And so on, t h r o u gh t he c i r c u l ar f l o w mode l .

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Track your results and progress Find all this and MORE in jacPLUS 4.9 Quick quiz 4.9 Exercise 4.9 Exercise 1. ‘The level of aggregate demand helps to determine the rate of economic growth and the extent to which the economy’s productive capacity is actually used.’ Define what is meant by the term aggregate demand (AD). (2 marks) 2. Explain what is meant by aggregate demand factors. Define each of the following aggregate demand factors and explain how each could affect the level of AD: a. consumer confidence b. business confidence c. disposable income d. the exchange rate for the A$ e. interest rates f. overseas economic activity. 3. Use the five-sector circular flow model of the economy to help predict (in a logical and step-by-step way), the UNCORRECTED PAGE PROOFS likely cyclical effects of the ten economic events listed in table 4.12 on the following: a. AD b. inflation or generally rising prices c. economic activity measured by GDP d. employment or unemployment of resources e. incomes and material living standards.

Start each answer with a brief definition of the italicised term (see the Economics dictionary), and then step through your explanation. In answering the question, remember that many of the listed events change the size of leakages, injections and hence AD (i.e. the size of flow number 3). In turn, this alters sales, orders and unsold stocks of goods and services, perhaps affecting inflation. And so, the next flow in order to be affected is the level of production or GDP (i.e. flow number 4), then the level of resources purchased and perhaps the unemployment rate (i.e. flow number 1), and finally the total level of incomes paid to households (i.e. flow number 2). The order or sequence of your step-by-step explanation is important. Try not to get sidetracked by changes in things about which we may be very unsure. To help with this aspect and to guide your response, read the sample answer provided at the end of table 4.12. As a shorthand approach here, you may also use official abbreviations, horizontal arrows (indicating ‘leads to’), and vertical arrows (meaning ‘increase’ or ‘decrease’). Notice how the explanation works its way around the circular flow model in a forward direction. (20 marks) TABLE 4.12 Events affecting the components of aggregate demand, economic activity, and the economy Aggregate demand factor or event Explanation of the likely macroeconomic effects of the aggregate demand event 1. Consumer confidence falls, as in 2020. 2. Household disposable income per person falls, as in 2020. 3. There is a slowdown overseas in China’s rate of economic growth, as in 2020–21. 4. The exchange rate for the A$ rises or appreciates against other currencies, as in early 2022. 5. Interest rates fall and remain low on bank credit that is borrowed by business firms, as in 2020–22. 6. More free trade agreements are signed, abolishing tariffs on imported goods and opening up new export markets. 7. A decision was made to stage the World Soccer Cup in Melbourne, attracting overseas tourists, and involving increased investment in new facilities. 8. You decide to spend your week’s wages on a big night out in Melbourne and reduce your level of savings by $250. 9. Some years ago, the federal government abolished the carbon tax levied of $23 per tonne on CO2 emissions by polluting businesses. 10. Australian households recently increased their savings ratio (i.e. the percentage of income not spent). UNCORRECTED PAGE PROOFS

SAMPLE ANSWER

Predict the likely economic effects on Australia’s economy of a large fall in business confidence

Definition: Business confidence relates to the general level of business optimism or pessimism about its future sales and profits. This affects businesses’ investment decisions. Step-by-step explanation: If there was a collapse in business confidence, firms would be pessimistic and feel that their future sales and profits will fall → ↓ investment spending (I) or injections by firms on new plant and equipment since there would be no need to expand their capacity → ↓ AD or total spending on Australian-made goods and services (flow 3) → ↓ sales and higher stocks perhaps leading to price discounting and lower inflation → ↓ production by Australian firms, hence slowing the rate of growth in national output or GDP produced (flow 4) → ↓ amount of resources needed or employed by Australian firms (flow 1) → ↓ employment and increasing unemployment → ↓ total incomes paid to Australian households (flow 2) and perhaps lower material living standards. 4. Examine the following graph showing changes in Australia’s index of consumer confidence where the base reading of 100 points indicates a neutral situation (i.e. the number of optimists equal the number of pessimists). An index of less than 100 points shows overall pessimism about the future, while one above 100 points shows general optimism.

FIGURE 4.15 Changes in Australia’s consumer confidence index Index 100 100 85 85 70 70 2010 2014 2018 2022 * Average of the ANZ-Roy Morgan and Westpac-Melbourne Institute consumer sentiment measure of respondents’ perceptions of their personal finance relative to the previous year; ANZ-Roy Morgan index rescaled to have the same average as the Westpac-Melbourne Institute index since 1996.

Consumer sentiment* Average since 1980 = 100 Index Source: RBA Chart Pack, https://www.rba.gov.au/chart-pack/household-sector.html. a. Referring to the graph data, describe the change in consumer confidence between 2019 and 2020. (2 marks) b. Explain how the change in the level of consumer confidence between 2019 and 2020 would affect the levels of AD and economic activity. (2 marks) c. Outline the macroeconomic effects of the change in consumer confidence between 2020 and late-2021 on each of the following (remember to step your explanation in the correct order or sequence, following the flows around the circular flow model): • AD (and selected components) • Economic activity UNCORRECTED PAGE PROOFS • Inflation • Unemployment and incomes.

5. Examine figure 4.16 showing changes in overseas economic activity amongst Australia’s major export markets and globally. (4 marks)

FIGURE 4.16 Changes in economic activity overseas amongst Australia’s trading partners and the world

GDP growth – World Year-ended

–10 2005 * Weighted using Australian export shares. ** PPP-weighted; accounts for 85 per cent of world GDP. 2009 2013 2017 2021 –5 5 10 Major trading partners* World** % –10 –5 0 5 10 % Source: RBA Chart Pack, https://www.rba.gov.au/chart-pack/worldeconomy.html. a. Referring to the graph data, describe the change in overseas economic activity between 2019 and 2020. (2 marks) b. Explain how the change in overseas economic activity amongst Australia’s major trading partners between 2019 and 2020 would tend to affect the levels of AD and economic activity. (2 marks) c. For each of the following, outline the macroeconomic effects for Australia of the change in economic activity amongst our major trading partners between 2020 and late-2021 (remember to step your explanation in the correct sequence following the circular flow model): (4 marks) • AD (and a selected component) • Economic activity • Inflation • Unemployment and incomes. Fully worked solutions and sample responses are available in your digital formats. 4.10 Aggregate supply — its meaning, importance and factors affecting its level and economic activity KEY KNOWLEDGE • the meaning and importance of aggregate supply • the factors that may affect the level of aggregate supply and the level of economic activity Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission. 0 UNCORRECTED PAGE PROOFS The demand for goods and services can only be satisfied if producers are able and willing to match this with adequate levels of supply or production. However, we know that because people’s wants are unlimited and the quantity and or quality of resources available is inadequate, there are restrictions or limits to how many goods and services can be supplied.

Aggregate supply (abbreviated AS) represents the total volume of goods and services that all producers in the country can make available over a period of time. It strongly relates to the nation’s productive capacity or the potential level of national output to help satisfy the demand for goods and services. You might remember that this is shown on the production possibility diagram as the PPF. The level of aggregate supply reflects the impact on producers of aggregate supply conditions or factors. These can include: • the quantity or efficiency of natural, labour and capital resources available for production • business production costs, profitability and whether firms close down, open up, or expand • climatic events • pandemic lockdowns and disruptions to supply chains • various government economic policies including rates of company tax, education, and infrastructure projects. By affecting the availability of resources, production costs, and business profits, they can greatly affect the country’s productive capacity, potential level of economic activity or GDP, and other domestic macroeconomic conditions. 4.10.2 How aggregate supply factors affect the level of AS and economic activity Over the longer-term, aggregate supply conditions determine Australia’s productive capacity and the potential level of AS. These factors usually do this by affecting the quantity and quality of natural, labour and capital resources available, production costs of firms, and business profitability. In turn, aggregate supply factors influence the willingness and ability of producers to supply goods and services. We will now take a look at a few of these factors. Some aggregate supply factors that affect producers and influence productive capacity Ultimately, a country can’t produce more than the available natural, labour and capital resources permit. Having access to more resources would potentially allow for higher levels of output, whereas reduced access would cut productive capacity and the potential level of GDP. In addition, unless costs are low and profits are reasonable, businesses will close, limiting AS. So, what sort of aggregate supply factors or developments might influence the availability of resources, business expansion, costs, profits and AS? As a starter, table 4.13 summarises just a fewUNCORRECTED PAGE PROOFS aggregate supply factors that can affect economic activity.

TABLE 4.13 Some aggregate supply factors that can affect productive capacity and the potential level of economic activity

Demographics and the population’s age structure: The size of the population and its age distribution affect the size and growth of the nation’s labour force. Population can grow because of the excess of births over deaths and because of net migration. For example, immigration can increase the number and skills of the labour force available. In contrast, Australia’s ageing population (where there is a rising proportion of the population in older age groups and retiring) is causing labour shortages that limit the expansion of our productive capacity and the level of aggregate supply.

The labour resources

available (Provide mental talents and physical power)

Education, skills, and labour productivity: High labour efficiency or productivity allows for a greater level of output per worker. This is often measured by the annual percentage change in GDP per hour worked. Many factors affect labour efficiency, including the levels of education, training, skills, and innovativeness. Here, there is an important role for government spending. This might include the use of financial incentives (free and subsidised education and training courses) that could help to grow our productive capacity, potential GDP, and AS. Investment levels: The quantity and quality of capital resources is increased through high levels of private and government investment in new plant and equipment. Increased investment can also come from foreign capital inflow used to set up or finance new firms. These grow productive capacity and AS. Interest rates: Interest rates are the cost of borrowing credit used by firms to purchase new, more efficient plant and equipment. Borrowing credit can help expand productive capacity and perhaps grow the business profitability. Lower interest rates tend to increase investment in new equipment, while higher interest rates deter investment, slowing the growth in productive capacity and AS. The capital resources available (Investment in new or better plant and equipment) Outlays on technology and R&D: The use of new technology like robotics in various industries such as manufacturing, warehousing, and medicine, along with investments in research and development (R&D), can help increase the volume and efficiency of capital resources, adding to productive capacity and AS. Mineral exploration: Exploration can help us find new deposits of minerals. This can increase the quantity of resources available, and hence grow productive capacity, AS, and the potential level of GDP. Land management: Lifting the productivity of land and the sustainability of mining and farming practices, can help grow Australia’s productive capacity and our potential level of GDP. In reverse, poor management will eventually see capacity shrink. The natural resources available (Productive inputs found in nature) Climate change and severe weather events: Increased carbon emissions, global warming and severe weather events are limiting the growth in productive capacity and AS. Floods, drought, and fires have destroyed some businesses and infrastructure. To grow capacity, it is now essential that we have policies in place designed to reduce global warming, perhaps by putting a price on carbon emissions (e.g. a tax or the introduction of an emissions trading scheme). Wage costs and labour productivity: Businesses won’t exist if they can’t make a profit. High wages costs, as in Australia, combined with relatively low worker productivity can be a disincentive for business expansion because they reduce after-tax profits and cause business closures, limiting the growth of productive capacity, potential GDP, and AS. Rates of taxation: Rates of company tax affect after-tax profits and hence alter the willingness and ability of firms to expand. Currently, higher rates of tax in Australia, compared with many countries, act as a disincentive, make local firms less internationally competitive, drive firms to relocate overseas and hence restrict the growth in Australia’s productive capacity, potential GDP, and AS. The level of production costs and after-tax profits for businesses (These affect business expansion and survival.) UNCORRECTED PAGE PROOFS Government outlays on infrastructure: Infrastructure includes roads, rail, shipping ports, airports, water and power supply, and telecommunications. It is used by businesses to produce other goods and services. If there is congestion and inadequate provision of infrastructure, production costs are higher, businesses are less internationally competitive and profitable, and capacity is more limited. This restricts AS and the potential level of GDP.