Economic Prosperity Study Notes

Australia's Economic Prosperity

Key Knowledge: The Purpose of Economic Activity

Material vs. Non-Material Living Standards
- Material: Access to goods and services. Higher access results in higher material living standards.
  - Generally measured using GDP per capita.
- Non-material: Elements of human well-being unconnected to material possessions.
  - Includes environmental quality, physical and mental health, crime rates, and literacy rates.
  - Various indicators including the Human Development Index (HDI) and the Better Life Index (BLI).
Factors Affecting Living Standards
- Environmental Quality
  - Better air, water, and natural environments improve living standards.
  - Short-term enjoyment and long-term sustainability of natural resources.
  - Indicators may include:
    - CO2 emissions per capita
    - Species extinction rates
    - Average global temperature
- Physical and Mental Health
  - Better health outcomes improve productivity and income earning potential.
  - Reduces prices and allows greater spending on nation-building projects.
  - Indicators may include:
    - Infant mortality rates
    - Life expectancy
    - Suicide rates
    - Rates of drug and alcohol abuse
- Crime Rates
  - Negative impacts:
    - Reduces quality of life.
    - Negatively impacts government budgets.
    - Reduces sense of freedom.
  - Positive impacts:
    - Spending to tackle crime included in GDP.
  - Indicators may include:
    - Incarceration rates
    - Murders per capita
    - Trends in rates of assault
- Literacy Rates
  - Higher rates generally result in higher living standards.
  - Relationship between literacy levels and employment.
  - Increases productivity and international competitiveness.
  - Indicators may include:
    - Average years of schooling
    - Percentage of population with tertiary qualifications

The Five-Sector Circular Flow Model of Income

Sectors:
- Households
- Businesses
- Government
- Financial Institutions
- External Sector

*Diagram Description: A circular flow model shows the flow of money and resources between households, businesses, the government, the financial sector, and the external sector. Households supply labor to businesses and receive income in return. This income is either used for consumption, savings, taxes, or imports.
The financial sector receives savings and provides investment. The government receives taxes and provides government spending. The external sector is affected by imports and exports.

Household Sector: Supplies labor to businesses.
Business Sector: Pays consumers an income.
Consumption (C): Paid by households back to businesses.
Leakages:
- Savings (S) to Financial sector
- Taxes (T) to Government sector
- Imports (M) to Overseas sector
Injections:
- Investment (I): Household & Business sectors borrow from Financial sector
- Government spending (G): From Government sector
- Exports (X): From Overseas sector
Key Ideas:
- Over time leakages will be offset by injections.
- If Leakages exceed injections:
  - Slowdown in aggregate demand (AD) and economic growth.
  - Cyclical unemployment, lower living standards.
- If Injections exceed leakages:
  - AD exceeds economy’s productive capacity.
  - Shortages and increases in the general price level (demand-pull inflation).
  - Erodes purchasing power and living standards.
- The government and RBA use budgetary and monetary policy to influence leakages and injections to regulate AD, economic growth rates, inflation, and cyclical unemployment.

The Business Cycle

Definition: Cycle of economic activity.
- Downturns: Contractions, troughs, and sometimes recessions.
- Recovery: Expansions, peaks, and sometimes booms.
Causes:
- Changes in aggregate demand (AD) generally determine the phase of the cycle.
- Contractions and troughs occur when AD falls.
- Expansions and peaks occur when AD rises.
- Aggregate supply generally tries to keep pace with AD.

Aggregate Demand (AD)

Definition: Total expenditure on final Australian-made goods and services.
Equation: $AD = C + I + G + (X - M)$
- C = Consumption
- I = Investment
- G = Government
- (X - M) = Net Exports (Exports – Imports)
Components:
- Consumption (C):
  - Household spending, the most stable component of AD.
  - Approximately 60% of AD.
- Investment (I):
  - Business spending, the most volatile component.
  - Approximately 15-20% of AD.
- Government (G):
  - G1: Government Consumption spending
    - Current spending on health, education, etc.
    - Relatively stable.
  - G2: Government Investment spending
    - Capital spending such as infrastructure.
    - Volatile.
- Net Exports (X - M):
  - Exports minus Imports, both volatile.
  - Approximately 20-25% of AD.
Importance of AD:
- Provides incentive for firms to increase production.
- Determines allocation of resources, including labor.
- Generates income growth in the economy.
- A lack of AD could precipitate unemployment.
- Excessive AD could result in inflation.
- 'Final' goods and services are used to ensure intermediate products aren’t counted twice.

*Diagram Description: An aggregate demand curve shows the relationship between the general price level and real GDP/Employment. The demand falls and the price level increases.

Factors Affecting AD:
- Disposable Income:
  - Changes to wages, welfare, income tax rates, or dividends impact household consumption.
  - Impacts C and shifts the AD curve.
- Interest Rates:
  - Higher rates reduce discretionary incomes of households and reduce cash flows for firms.
  - Impacts C & I and shifts the AD curve.
- Consumer Confidence:
  - Higher levels of household sentiment increase spending levels.
  - Impacts C and shifts the AD curve.
- Business Confidence:
  - Improved outlook for business increases business spending.
  - Impacts I and shifts the AD curve.
- Exchange Rate:
  - Higher exchange rates are good for importers but bad for exporters.
  - Impacts (X-M) and shifts the AD curve.
- Rates of Economic Growth Overseas:
  - Higher growth in our trading partners results in higher exports but also higher inflation, so imports will be more expensive.
  - Impacts (X-M) and shifts the AD curve.

Aggregate Supply (AS)

Definition: Total real value of production producers are willing and able to supply
No Aggregate Supply equation
Factors Affecting AS:
- Quantity and quality of the factors of production:
  - Higher quantities of resources increase resource availability.
  - Improves productive capacity and the ability to increase AS.
  - Improved quality of land, labor, and capital improves efficiency of production.
  - Increases productivity and the ability to increase AS.
- Cost of Production:
  - Lower costs of production mean the inputs are spread over a greater quantity of output.
  - Increases productivity, productive capacity, and the ability to increase AS.
- Technological Change:
  - Improves the efficiency of factors of production, increasing productivity and reducing costs of production.
  - Increases productive capacity.
- Productivity Growth:
  - Stronger growth in productivity means fewer inputs are used to make a given quantity of outputs.
  - Increases productive capacity and reduces costs of production.
- Exchange Rates:
  - A stronger AUD will make imported factors of production cheaper.
  - Reduces costs of production and increases productivity resulting in greater productive capacity.
  - Raw materials and capital equipment.
- Climatic Conditions:
  - Droughts, floods, bushfires, cyclones, etc., reduce supply in certain industries.
  - Reduces availability of resources and thus, costs of production of businesses using affected resources in production.
- Government Regulations:
  - Policies such as COVID restrictions.
  - Reduces the ability of producers to supply due to the reduced supply of labor.
- Disruptions to International Supply Chains:
  - The War in Ukraine and Chinese lockdowns.
  - Reduces the availability of resources and increased costs of production for businesses using affected raw materials and capital equipment.

*Diagram Description: An aggregate supply curve shows the relationship between the general price level and real GDP. The supply increases as the price level increases.

*Rationale for the curve shape: At the low price level, the economy has spare capacity. As the economy expands, it experiences an increase in the general price level. At some point, producers will be unable to increase supply, thus the AS curve will become vertical.

*Diagram Description: A graph plots real GDP/employment on the x axis and the general price level on the y axis. Aggregate supply and aggregate demand are plotted on the graph, intersecting at one point.

Changes in general price levels will cause a movement along AS and AD
- Expansions
- Contractions
Changes in other factors will result in a shift in AS or AD
- Favourable AD/AS conditions shift right
- Unfavourable AD/AS conditions shift left
- Any shifts in AD results in a movement along AS
- Any shifts in AS, result in a movement along AD
If AD shifts right
- Increases inflationary pressure
- Increases economic growth rates
- Increases employment
- Due to greater demand for labour to produce more goods and services
If AS shifts right
- Reduces inflationary pressure
- Increases economic growth rates
- Increases employment
- Due to a movement along AD and greater demand for labour
- But not if increased AS is a result of higher productivity. Growth rates should be higher than productivity to ensure there is not ‘jobless growth’

Ceteris Paribus

All other things being equal. This is an assumption used in economics to isolate the impact of one factor by holding all other factors constant.