Economics Unit 2 SAC Study

Economic activity

The production and exchange of goods and services to satisfy society’s needs and wants.

Purpose of economic activity

To create goods and services, generate income and consumption, satisfy needs and wants, and improve living standards.

Material living standards

The quantity of goods and services that individuals can afford to consume, determined mainly by income and purchasing power.

Non-material living standards

The quality of daily life, including health, happiness, leisure time, relationships, safety, freedom and environmental quality.

Main measure of material living standards

Real GDP per capita, although it is only an approximate measure.

Relationship between production, income and expenditure

Production generates income for resource owners, and this income allows households to spend on the goods and services produced.

Five sectors of the circular-flow model

Household, business, financial, government and overseas sectors.

Household sector

Supplies resources to businesses, receives income, consumes goods and services, saves money, pays taxes and purchases imports.

Business sector

Employs resources, pays incomes, produces goods and services and undertakes investment spending.

Financial sector

Receives household savings and provides funds to businesses for investment.

Government sector

Collects taxation and undertakes government spending on goods and services.

Overseas sector

Includes Australian spending on imports and overseas spending on Australian exports.

Flow 1 in the circular-flow model

The flow of productive resources, including labour, capital and natural resources, from households to businesses.

Flow 2 in the circular-flow model

The flow of incomes, including wages, rent, interest and profit, generated by the sale of resources.

Flow 3 in the circular-flow model

Aggregate demand or total expenditure on Australian-produced goods and services.

Flow 4 in the circular-flow model

The production of final goods and services, measured by GDP.

Equality of the circular flows

Aggregate demand equals national production, national income and the value of resources employed.

Leakages

Income removed from domestic spending: savings, taxation and imports.

Leakages formula

S + T + M.

Injections

Spending added to the circular flow: investment, government spending and exports.

Injections formula

I + G + X.

What happens when injections equal leakages?

Aggregate demand and economic activity remain stable.

What happens when injections exceed leakages?

Aggregate demand, production, employment and incomes increase.

What happens when leakages exceed injections?

Aggregate demand, production, employment and incomes decrease.

Government budget deficit

Government spending is greater than taxation revenue: G > T.

Government budget surplus

Taxation revenue is greater than government spending: T > G.

Aggregate demand

The total value of spending on Australian-produced final goods and services over a period.

Aggregate demand formula

AD = C + I + G + X − M.

Consumption (C)

Household spending on goods and services and the largest component of aggregate demand, at approximately 60%.

Investment (I)

Business spending on capital goods such as machinery, equipment and buildings.

Government spending (G)

Government expenditure on goods and services such as health, education, transport and defence.

Exports (X)

Overseas spending on Australian-produced goods and services; exports increase aggregate demand.

Imports (M)

Australian spending on overseas-produced goods and services; imports are subtracted from aggregate demand.

Net exports

Exports minus imports: X − M.

Effect of stronger aggregate demand

AD rises, business sales rise, production and real GDP rise, employment and incomes rise, and inflation may increase.

Effect of weaker aggregate demand

AD falls, business sales fall, production and real GDP fall, unemployment rises, incomes fall and inflation usually slows.

Disposable income

Income available for spending and saving after taxes have been paid and government benefits received.

Effect of higher disposable income

Higher disposable income normally increases consumption and aggregate demand.

Consumer confidence

The degree of household optimism or pessimism about future employment and income.

Effect of higher consumer confidence

Consumption rises, savings usually fall and aggregate demand increases.

Effect of higher interest rates

Borrowing becomes more expensive and saving becomes more attractive, reducing consumption, investment and aggregate demand.

Business confidence

The degree of business optimism or pessimism about future sales and profits.

Effect of higher business confidence

Businesses increase investment spending, causing aggregate demand to rise.

Effect of lower income tax

Disposable income and consumption rise, increasing aggregate demand.

Effect of higher government spending

G increases directly, causing aggregate demand and economic activity to rise.

Effect of population growth

More consumers increase consumption and aggregate demand.

Effect of an appreciation of the Australian dollar

Australian exports become more expensive and imports become cheaper, so net exports and aggregate demand generally fall.

Effect of a depreciation of the Australian dollar

Australian exports become cheaper and imports become more expensive, so net exports and aggregate demand generally rise.

Effect of stronger overseas economic growth

Overseas demand for Australian exports rises, increasing aggregate demand.

Business cycle

The recurring rises and falls in the growth rate of real GDP over time.

Business-cycle vertical axis

Annual rate of change in economic activity or real GDP.

Business-cycle horizontal axis

Time in years.

Four phases of the business cycle

Peak or boom, slowdown, trough or recession, and recovery.

Peak or boom

Aggregate demand and GDP growth are very strong, unemployment is low and inflation is usually high.

Slowdown or downturn

Aggregate demand and GDP growth slow, unemployment begins rising and inflation usually slows.

Trough

The lowest point of the cycle, where economic activity and GDP growth are at their weakest.

Recession

A fall in real GDP for at least two consecutive quarters, equal to six months.

Conditions during a recession

Weak aggregate demand, falling production and incomes, high unemployment and low inflation.

Recovery

Aggregate demand and GDP growth accelerate, unemployment begins falling, incomes rise and inflation may begin increasing.

Domestic economic stability

Sustainable economic growth of approximately 3%, unemployment of around 4–4.5%, and inflation of approximately 2–3%.

Why can a boom end?

High interest rates, excessive wage growth and inflation can reduce spending, profits and international competitiveness.

Leading indicator

An indicator that predicts future changes in economic activity.

Examples of leading indicators

Consumer confidence, business confidence and building approvals.

Coincident indicator

An indicator that changes at approximately the same time as economic activity.

Examples of coincident indicators

Retail sales, share prices and new car registrations.

Lagging indicator

An indicator that changes after economic activity has already changed.

Examples of lagging indicators

Real GDP figures, unemployment, inflation and average weekly earnings.

Aggregate supply

The total volume of goods and services that producers are willing and able to produce over a period.

Importance of aggregate supply

It determines the economy’s productive capacity and potential long-term level of real GDP.

Main aggregate-supply factors

Resource quantity and efficiency, production costs, profitability, technology, productivity, climatic events, supply chains and government policies.

More favourable aggregate-supply conditions

Increase productive capacity, potential real GDP, employment and incomes while reducing inflationary pressure.

Less favourable aggregate-supply conditions

Reduce productive capacity and potential real GDP while increasing production costs and inflationary pressure.

Economic growth

An increase in the total volume of goods and services produced by an economy over time.

Gross Domestic Product (GDP)

The total value of final goods and services produced within a country over a period.

Nominal GDP

GDP measured using current prices without removing the effects of inflation.

Real GDP

GDP adjusted to remove changes in the general price level, revealing changes in production volume.

Why is real GDP better than nominal GDP?

Real GDP removes the effects of inflation, allowing production in different periods to be accurately compared.

Economic growth formula

Percentage growth = (current real GDP − previous real GDP) ÷ previous real GDP × 100.

Three methods of measuring GDP

The production method, income method and expenditure method.

Aggregate demand formula

C + I + G + X − M.

Real GDP per capita

Real GDP divided by the population.

Requirement for rising material living standards

Real GDP must generally grow faster than the population so real GDP per capita increases.

Employment benefit of economic growth

Higher production causes businesses to employ more workers, reducing cyclical unemployment.

Material living-standard benefit of economic growth

Higher production creates higher incomes and purchasing power, allowing increased consumption.

Government-finance benefit of economic growth

Tax revenue rises and welfare expenditure falls, allowing improved government services.

Non-material benefit of economic growth

Lower unemployment can improve health, self-esteem, social inclusion and life satisfaction.

Economic costs of rapid growth

Possible inflation, boom-and-bust cycles, structural unemployment and reduced future growth due to resource depletion.

Environmental costs of economic growth

Pollution, congestion, climate change, biodiversity loss and depletion of natural resources.

Social costs of economic growth

Reduced leisure, stress, health problems, family pressures, inequality and affluenza.

Affluenza

An unhealthy obsession with wealth and material possessions that can damage happiness, relationships and non-material living standards.

Negative externality

A cost from production or consumption imposed on an uninvolved third party, such as pollution affecting nearby residents.

How can growth widen inequality?

The additional income and wealth created by growth may be distributed unevenly across society.

Limitation of GDP: excluded production

GDP excludes unpaid household work, volunteer work, cash-in-hand activity and illegal production.

Limitation of GDP: imputed production

The value of some production, such as owner-occupied housing, must be estimated and may be inaccurate.

Limitation of real GDP per capita: inequality

It is an average and does not reveal how evenly income, goods and services are distributed.

Limitation of real GDP per capita: non-material factors

It ignores happiness, health, leisure time, relationships, environmental damage and other quality-of-life factors.

Limitation of real GDP per capita: environmental damage

Environmental destruction can reduce wellbeing even while the production causing it increases GDP.

Measures of Australia’s Progress (MAP)

A collection of indicators covering society, the economy, the environment and governance.

Human Development Index (HDI)

A measure combining income per person, life expectancy and education to assess material and non-material development.

Limitation of HDI

HDI provides a broader measure than GDP but does not properly include environmental quality.