2014 y12 chapter 7_cd

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© Tim Riley Publications Pty Ltd Year 12 Economics 2014

The major economic issues in Australia involve Australia’s economic performance in termsof outcomes for economic growth, unemployment, inflation, the balance of payments and theexchange rate. Other important issues include trends in the distribution of income and wealthin Australian society, and Australia’s approach to the management of the environment and its

commitment to a policy of ecologically sustainable development (ESD).

ECONOMIC ISSUES

• Examine the arguments for and against increasing economic growth rates;

• Investigate the economic and social problems created by unemployment;

• Analyse the effects of ination on an economy;

• Discuss the effect of a continued current account decit on an economy;

• Investigate recent trends in the distribution of income in Australia and identify the impact ofspecic economic policies on this distribution;

• Analyse the economic and social costs and benets of inequality in the distribution ofincome; and

• Examine the economic issues associated with the goal of ecologically sustainabledevelopment.

ECONOMIC

ISSUES

ECONOMIC SKILLS

• Identify and analyse problems facing contemporary and hypothetical economies;

• Calculate an equilibrium position for an economy using leakages and injections;

• Determine the impact of the (simple) multiplier effect on national income;

• Explain the implications of the multiplier for uctuations in the level of economic activity in an economy;

• Calculate the unemployment rate and the participation rate using labour force statistics;

• Interpret a Lorenz curve and a Gini co-efcient for the distribution of income in an economy;

• Use economic concepts to analyse a contemporary environmental issue; and

• Assess the key problems and issues facing the Australian economy.

TOPIC FOCUS

This topic focuses on the nature, causes and consequences of the economic issues and problems thatcan confront contemporary economies as applied to the Australian economy. The issues examinedinclude economic growth; unemployment; ination; external stability; the distribution of income andwealth; and environmental sustainability. Students should learn to examine the following economicissues and apply the following economic skills in Topic 3 of the HSC course:

T

O P I C

T H R E E

3

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170

Chapter 7: Economic Growth 171

• e Components of Aggregate Demand 172

• e Measurement of Economic Growth 177

• e Sources and Eects of Economic Growth 179• Increases in Aggregate Supply and Economic Growth 181

• Trends in the Australian Business Cycle 183

• Policies to Promote Economic Growth 185

Chapter 8: Unemployment 191

• e Measurement of Unemployment 191

• Recent Trends in Unemployment 193

• e Types, Causes and Eects of Unemployment 197

• Policies to Reduce Unemployment 203

Chapter 9: Inflation 211

• e Measurement of Ination 211

• Recent Trends in Ination 212

• e Causes of Ination 214

• e Negative and Positive Eects of Ination 218

• Policies to Reduce Ination 219

Chapter 10: External Stability 225

• e Measurement of the Current Account Decit 225

• Trends in the Current Account Decit, Net Foreign Debt and Liabilities 230

• e Causes and Eects of the Current Account Decit and Net Foreign Debt 231

• Policies to Reduce the Current Account Decit 236

Chapter 11: The Distribution of Income and Wealth 241

• e Measurement of the Distribution of Income 241

• e Sources of Income and Wealth 242

• Trends in the Distribution of Income and Wealth 245• Dimensions in the Distribution of Income 248

• e Economic and Social Benets and Costs of Inequality 249

• Policies to Reduce Income and Wealth Inequality 251

Chapter 12: Environmental Sustainability 257

• Ecologically Sustainable Development 257

• Private and Social Costs and Benets 259

• Environmental Issues 262

• Environmental Policies 266

Year 12 Economics 2014 © Tim Riley Publications Pty Ltd

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© Tim Riley Publications Pty Ltd Chapter 7: Economic Growth 171


Chapter 7

Economic growth refers to an increase in a country’s productive capacity as measured by changes inits real GDP over time. Real GDP refers to the national output of goods and services adjusted forchanges in ination over time. Increases in the rate of economic growth provide the means by which acountry can raise its level of income and standard of living. Macroeconomic theory involves the studyof aggregate economic behaviour (or economic activity in the economy as a whole), and is used toanalyse the main components of economic growth and GDP. Changes in the rate of economic growthare measured by changes in real GDP, which can produce business or trade cycles in market economies.

The Equilibrium Level of National Income

e modern theory of macroeconomics was developed by John Maynard Keynes in Te General Teoryof Employment, Interest and Money which was published in 1936. According to Keynes, the level ofeconomic activity or total output (O) is determined by the total expenditure (E) of consumers, rms,the government and net exports. Keynes developed the concept of equilibrium income (Y) which isthe level of income in an economy from which there is no tendency for change. Using the circularow of income model, the three ows of Y, E, and O are separate ways of measuring the value of GDP,

with total expenditure (E) equalling the total value of output (O), which in turn equals the total valueof incomes (Y) received by the owners of productive resources in the economy. e basic accountingidentity for the equilibrium level of national income is where total income equals total expenditure,

which in turn equals the total value of output as shown in equation (1).

e equilibrium level of national income is where:

(1) Y = E = O

Income (Y) consists of consumption (C) plus saving (S) as shown in equation (2):

(2) Y = C + S

Expenditure (E) consists of consumption (C) by households, and investment (I) by rms asshown in equation (3):

(3) E = C + I

Output (O) consists of consumer goods (C) and capital or investment goods (I) as shown inequation (4):

(4) O = C + I

e equilibrium condition in an economy can be derived from where Y = O or Y = E i.e.If Y = O = E, then C + S = C + I and therefore saving (S) equals investment (I)

e two equilibrium conditions for determining national income are shown in equations (5) and (6).Either of the following approaches can be used to determine the equilibrium level of national income:

(5) S (Saving) = I (Investment) or (6) Aggregate Demand (C + I) = Aggregate Supply (C + S)

e first equilibrium condition is where saving (S) equals investment (I) and is known as the leakage/injection or S/I approach to determining the equilibrium level of national income.

e second equilibrium condition is where aggregate demand (AD) equals aggregate supply (AS) and isknown as the aggregate demand/aggregate supply or AD/AS approach to determining the equilibriumlevel of national income.

Economic Growth

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Chapter 7: Economic Growth © Tim Riley Publications Pty Ltd 172


THE COMPONENTS OF AGGREGATE DEMAND

e equilibrium condition in the ve sector circular ow of income model of an economy is where thetotal leakages of saving, taxation and imports (S + T + M) are equal to the total injections of investment,government spending and exports (I + G + X) as shown in equation (7):

(7) S + T + M = I + G + X

If we substitute (Y - C) for S and re-arrange equation (7) we get equation (8) for aggregate demand:

(Y - C) + T + M = I + G + X erefore: (8) Y = C + I + (G - T) + (X - M)

Aggregate demand (AD) refers to the sum of expenditure on domestic output by households, rms,the government and the foreign sector in an open economy. If we assume a ve sector circular owof income model of the economy, aggregate demand represents the sum of aggregate consumptionspending by households (C), investment spending by rms (I), net government spending (G - T) and netexports (X - M) as shown in equation (8). In equilibrium, a nation’s output, income and employmentare determined by the level of aggregate demand (AD) or expenditure as shown in equation (9):

(9) AD = C + I + G + (X - M)

where C = consumption expenditure by the household sector I = investment expenditure by the rms sector G = net government expenditure (government spending less taxation) X = export expenditure by foreigners M = import expenditure by residents

Let us now analyse each of the components of aggregate demand.

The Consumption Function

e consumption function developed by J. M. Keynes in Te General Teory is shown in equation (1)below and has two components, one autonomous or independent of changes in income (C

0), and the

other induced or dependent on changes in income (c).

(1) C = C0 + cY

where Y = income C = total consumption expenditure C

0 = autonomous consumption expenditure

c = marginal propensity to consume (MPC) = ∆C∆Y

NB: Since C + S = Y, saving is equal to Y - C. erefore the savings function is S = -C0+

sY

(where S = total saving; -C0 = dissaving; s = marginal propensity to save (MPS); and Y = income)

The Investment Function

Investment (as shown in equation 2) is spending by business rms on new capital goods used to increaseproductive capacity. Investment spending is assumed to be autonomous, since factors other than income,such as the cost of capital (the rate of interest), returns on capital, prots, business expectations, taxationrates, government policy and changes in technology, will inuence investment decisions by rms.

(2) I = I0

where I = the total level of investment expenditure by rms I

0 = the level of autonomous investment expenditure by rms

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Government Expenditure

Government spending (as shown in equation 3) consists of total expenditure on current items by local,state and federal governments, plus expenditure by government trading enterprises on capital items.Government spending is assumed to be autonomous (or independent) of changes in national income.

(3) G = G0

where G = total government expenditure G

0 = autonomous government expenditure

Net Foreign Demand

Exports represent expenditure by foreigners on domestically produced goods and services and areindependent or autonomous of changes in domestic national income as shown in equation (4).

(4) X = X 0

where X = total export expenditure X

0 = autonomous export expenditure

Imports are a leakage of funds from the circular ow of income, since they represent domestic demandfor foreign produced goods and services. Import expenditure consists of both autonomous and inducedcomponents as shown in equation (5).

(5) M = M0 + mY

where M = total import expenditure M

0 = autonomous import expenditure

m = marginal propensity to import = ∆M∆Y

The Equilibrium Level of National Income in the Three Sector Model

In the three sector model of the circular ow of income, consisting of households, rms and the nancesector, equilibrium is determined where savings equals investment (S = I) or aggregate demand (C+ I) equals aggregate supply (C + S). Table 7.1 shows hypothetical values or schedules for income,consumption, savings and investment, with autonomous components of spending for both C and I.

e consumption function is C = 50 + 0.5Y (autonomous C is 50 and the MPC is 0.5)

e savings function is S = -50 + 0.5Y (autonomous S is -50 and the MPS is 0.5)

e investment function is a constant I = 50 (all investment is autonomous of changes in income)

Table 7.1: The Consumption, Savings and Investment Schedules

Y C S I MPC MPS

0 50 -50 50 ---- ----

50 75 -25 50 0.5 0.5

100 100 0 50 0.5 0.5

150 125 25 50 0.5 0.5

200 150 50 50 0.5 0.5

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e aggregate demand function (AD) in a three sector model is represented graphically in Figure 7.1 by adding the consumption (C) and investment (I) functions together. e aggregate supply function(AS) is represented by the 45˚ line in Figure 7.1, which is a locus of points where Y = E = O. eequilibrium level of income (Ye) using the AD/AS approach in Panel A is where:

AD = AS or C + I = Y i.e.

AD = C + I = 50 + 0.5Y + 50 = AS = Y(AD) = 100 + 0.5Y = (AS) = Y 100 = 0.5Y (now multiply both sides of the equation by 2 to solve for Y):

erefore the equilibrium level of income or Ye1 = 200

Alternatively, the equilibrium level of national income can also be determined by using the leakages andinjections approach in Panel B where savings (S) equals investment (I), which coincides with the point

where AD = AS in Figure 7.1:

(S) -50 + 0.5Y = (I) 50(S) 0.5Y = (I) 100 (now multiply both sides of the equation by 2 to solve for Y)

erefore the equilibrium level of income or Ye1 = 200

Without the addition of the nance sector (and the injection of investment to oset the leakage ofsaving), equilibrium income in Figure 7.1 would be determined where C = Y or S = 0:

(C) 50 + 0.5Y = Y, with Ye = 100 or (S) -50 + 0.5Y = 0, with Ye = 100 (the breakeven point where C = Y)

The Simple Expenditure Multiplier

Changes in any or all of the autonomous (independent) components of aggregate demand or C +I + G + (X - M) will cause a change in the equilibrium level of income through the eect of thesimple expenditure multiplier. e simple expenditure multiplier refers to the extent to which an initial

change in autonomous expenditure (such as autonomous consumption or investment expenditure) ismultiplied to give a larger change in the equilibrium level of national income.

I = 50

S = -50 + 0.5Y

C = 50 + 0.5Y

C + I = 100 + 0.5Y

Y

Ye Ye1

Y

Expenditure

Panel A

Panel B

50

100

–50

50

0

S and 1

0 45o

100 200

100 200

AS = Y = C + S

Figure 7.1: The Equilibrium Level of National Income in the Three Sector Model

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Expenditure

Panel A

Panel B

C + I = 100 + 0.5YC + I1 = 125 + 0.5Y

125100

75

755025

C + I2 = 75 + 0.5Y

Y

S = –50 + 0.5Y

AS

S and I

I1 = 75I = 50I2 = 25

Y

200

200 250

250

150

150

0

–50

045o

I

- I

YY

I

- I

Figure 7.2: The Multiplier Effect of a Change in Investment on National Income

In the three sector model of the circular ow of income, the multiplier can be derived by substitutingthe consumption and investment equations into the national income identity as shown in equation (1).

(1) Y = C + I (2) Y = 1 x C0 + 1

0

Y = C0 + cY + I

0 1 - c 1

Y - cY = C0 + I0

Y (1 - c) = C0 + I

0

(divide by 1 - c to derive equation 2)

Equation (2) suggests that any change in autonomous consumption (∆C0) or autonomous investment

(∆I0) has a multiplied eect on the equilibrium level of national income equal to the size of the multiplier,

times the initial change in autonomous consumption (∆C) or investment spending (∆I). e value ofthe simple expenditure multiplier (k) in equation (3) is equal to one over one minus the MPC (c), orone over the MPS (s). e MPC plus the MPS always equals one.

(3) Multiplier (k) = 1 or 1 (NB: MPC + MPS = 1) ∆C + ∆S = ∆Y = 1

1 - c s ∆Y ∆Y ∆YIn Figure 7.2 the initial equilibrium level of national income is 200, since this is the point where S (-50+ 0.5Y) equals I (50), and aggregate demand (C + I = 100 + 0.5Y), is equal to aggregate supply (Y = C +S). If autonomous investment (I) increases from 50 to 75 (an upward shift in the investment functionfrom I to I

1 in Panel B of Figure 7.2), the aggregate demand function increases from C + I (100+ 0.5Y)

to C + I1 (125 + 0.5Y) in Panel A . e new equilibrium level of national income is where:

C + I1 = 125 + 0.5Y = Y

125 = 0.5Y (now multiply each side by 2 to solve for Y)

erefore Ye1 = 250

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REVIEW QUESTIONS

Table 7.2: The Relationship Between the MPC, MPS and the Multiplier

MPC larger smaller

MPS smaller larger

Value of the Multiplier larger smaller

A rise in autonomous investment of 25 by rms (due to improved prot expectations or a fall in thecost of capital) has increased national income by 50. Since (k) is greater than one, any change in anautonomous component of aggregate demand, will be multiplied to give a larger change in income i.e.

k = ∆Y = 1 ∆Y = 1 x ∆ I1 = 1 x 25 = 2 x 25 = 50

∆I 1 - c 1 - c 0.5

Conversely, a fall in aggregate demand (from C + I to C + I2) in Panel A of Figure 7.2 caused by a decline

in autonomous investment from 50 to 25 (I to I2 in Panel B), leads to a greater than proportionate decline

in national income. e new equilibrium level of national income is now lower at 150, determined bythe equality between aggregate demand and aggregate supply or savings and investment i.e.

k = -∆Y = 1 ∆Y = 1 x -∆ I2 = 1 x - 25 = 2 x - 25 = -50

-∆I 1 - c 1 - c 0.5

e size of the simple multiplier co-ecient is inuenced by the relative sizes of the MPC and MPS.e larger the MPC or the smaller the MPS, the larger the value of the multiplier. e smaller theMPC or the larger the MPS, the smaller the value of the multiplier (see Table 7.2). is is becauseconsumption is an injection into the circular ow of income whereas saving is a leakage from income.

THE COMPONENTS OF AGGREGATE DEMAND

1. Explain how the value of GDP can be measured in terms of total output (O), total expenditure (E)and total incomes received (Y) in the circular flow of income model.

2. What are the two equilibrium conditions for the determination of national income?

3. Distinguish between the autonomous and induced components of expenditure.

4. What is the equation for aggregate demand? How is it derived?

5. Explain the main components of aggregate demand: AD = C + I + G + (X - M)

6. Graph the consumption and savings functions C = 100 + 0.6Y and S = -100 + 0.4Y.

(i) What is the equilibrium level of national income?

(ii) If autonomous investment of 150 occurred, graph the new C + I function of AD = 250 + 0.6Y.

(iii) What is the new equilibrium level of national income?

(iv) What is the value of the investment multiplier?

7. What determines the value of the simple expenditure multiplier?

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THE MEASUREMENT OF ECONOMIC GROWTH

Economic growth is usually measured in terms of changes in real Gross Domestic Product (GDP). isis a calculation of the total value of all goods and services produced in Australia over a period of time,adjusted for changes in the price level or ination rate. GDP also measures the total incomes generated

by production taking place in Australia’s domestic territory. It is a gross measure since it does not makean allowance for the depreciation of the existing capital stock. Annual changes in real GDP are referredto as the rate of economic growth, and can be used for comparisons between time periods, and betweencountries for similar time periods. Real GDP or GDP at constant prices is calculated as follows:

Nominal GDP 100 $1,200m 100Real GDP = 1 x CPI e.g. 1 x 105 = $1,143m

In the example used above, nominal GDP or GDP at current prices is $1,200m. However the CPI hasincreased by 5% from 100 to 105, so real GDP or GDP at constant prices is $1,142.8m.

Economic growth leads to increasing productive capacity and the production of more goods and services.

Rising levels of real output help to satisfy more needs and wants in society. In terms of the circularow of income model, GDP is a measure of total production or output (P or O), total expenditure(E) and total incomes (Y or I) received, leading to the basic national income identity of Y = E = O inequilibrium. Economic growth is measured by the Australian Bureau of Statistics (ABS) in four ways,at average 1989-90 prices (real GDP) and GDP statistics are released each quarter as well as annually:

1. GDP (P) is a production measure which calculates the value added by each stage of production inthe production of goods and services;

2. GDP (E) is an expenditure measure which calculates GDP according to the total expenditure byconsumers, businesses and governments on nal output (i.e. sales receipts of nal goods and services);

3. GDP (I) is the total value of incomes received by the owners of productive resources who contribute

resources to the production of those goods and services (i.e. wages, salaries, supplements and grossoperating surplus); and

4. GDP (A) is an average of the GDP (P), GDP (E) and GDP (I) measures of GDP, and is used toachieve a standard average measure of the rate of economic growth in Australia.

Table 7.3 shows the value of Australian GDP and other aggregates using chain volume measures with2009-10 used as the reference year. Real GDP reached a value of $1,451,588m in 2011-12, an increaseof $47,700m or 3.4% from the 2010-11 gure of $1,403,888m. e rate of growth in real GDP for

Australia in 2011-12 was around trend (because of post GFC recovery) and can be calculated as follows:

Growth Rate Current GDP - Previous GDP 100 $1,451,588m - $1,403,888m 100of Real GDP = Previous GDP x 1 = $1,403,888m x 1 = 3.4%

Table 7.3: Measures of GDP and other Selected Aggregates for Australia ($m)

Year GDP Real Gross Domestic Final Gross Gross National(P) Domestic Demand Non Farm Expenditure

Income (Y) Product (E)

2009-10 $1,370,540m $1,318,604m $1,329,418m $1,340,485m $1,325,502m

2010-11 $1,403,888m $1,403,888m $1,376,818m $1,371,732m $1,382,588m

2011-12 $1,451,588m $1,452,954m $1,449,257m $1,417,067m $1,454,155m

Source: ABS (2013), Australian National Accounts, Catalogue 5206.0, March.

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Recent Trends in Australian Economic GrowthRates of real GDP growth in Australia between 2000-01 and 2012-13 (with the forecast for 2013-14)are shown in Figure 7.3. Australia’s rate of economic growth averaged about 2.8% between 2000and 2008, helped by the external stimulus of the global resources boom and the rising terms of tradebetween 2003 and 2008:

• In 2000-01 real GDP growth slowed to 2.1% because of slower US and global growth. However Australian growth recovered in 2001-02 to 3.9% as global growth strengthened.

• In 2002-03 real GDP growth was reduced to 3.2% because of slower world growth and the impact

of the drought on farm production and rural exports. In 2003-04 growth was a strong 4.1% dueto a housing boom, global economic recovery and the start of the mining resources boom.

• Higher interest rates in 2003 led to lower spending and the end of the housing boom, slowingreal GDP growth to 2.8% in 2004-05. Capacity constraints, higher ination, a rural drought andinterest rate rises led to modest growth of real GDP of 3% in 2005-06.

• e strength of the terms of trade (through rising export prices) and domestic demand underpinnedreal GDP growth of 3.3% in 2006-07. Real GDP growth remained rm at 3.7% in 2007-08.

• Higher domestic interest rates, the global credit crisis and the Global Financial Crisis (GFC) andrecession in late 2008 caused the economy to slow dramatically. Real GDP grew by just 1.4% in2008-09 largely due to the impact of the government’s use of scal and monetary stimulus.

A global recovery after the GFC led to 2.3% growth in Australian real GDP in 2009-10. However theimpact of the European Sovereign Debt Crisis in 2010-11 led to slower world growth, including slowergrowth in China, which impacted on Australia’s exports and restricted growth to 1.9% in 2010-11.

In 2011-12, the high value of the Australian dollar reduced competitiveness, and with slower growthin consumption spending, led to an uneven pattern of growth in the Australian economy. Whilst there

was strong investment in mining activity and increased commodity exports to China and Asia, othersectors of the economy such as manufacturing, retailing, building and construction, and education andtourism recorded below average growth and unemployment rose in some industries. However growthin real GDP in 2011-12 was still above trend at 3.4%.

In 2012-13 growth slowed to around trend at 3% with a weaker outlook for global growth and falling

commodity prices and the terms of trade. e Reserve Bank cuts interest rates between 2011 and 2013to support growth and employment, with Treasury forecasting lower growth of 2.75% in 2013-14.

0

1

2

3

4

5

% GDP

13-1412-1311-1210-1109-1008-907-806-705-604-503-402-301-200-1

Figure 7.3: Real GDP Growth in Australia 2000-01 to 2013-14 (f)

Sources: ABS (2013), Australian National Accounts, Cat. 5206.0, March and Budget Paper No. 1, 2013-14.

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Table 7.4: Expenditure on Australian Gross Domestic Product 2009-2012 ($m)

Household Private Government Change in Net Exports Statistical GDP Consumption (C) Investment (I) Spending (G) Inventories (X-M) Discrepancy

2009-10 726,979 279,036 323,400 -2,472 44,948 -1,351 1,370,540

2010-11 753,148 295,035 328,628 5,770 21,308 -1 1,403,888

2011-12 777,709 337,517 334,031 4,898 2,385 -4,952 1,451,588

Source: ABS (2013), Australian National Accounts, Catalogue 5206.0, March. The reference year is 2010-11.Note: Figures are rounded and may not total. Total GDP = C + I + G + (X - M)

THE SOURCES OF ECONOMIC GROWTH

e main sources of economic growth in Australia include positive growth in the major individualcomponents of aggregate demand or spending in the economy (C + I + G + X - M) such as the following:

• Consumption spending by households (C): Consumption spending by households is mainlyinuenced by the level of household disposable income and consumer expectations. ese factors areinuenced by the level of taxation, the level of interest rates and the general state of the economy.

• Investment spending by rms (I): Private business investment is inuenced by the level of businessprots, interest rates, taxation and business expectations about the state of the economy.

• Government spending (G): e level of government spending is largely inuenced by the amountof taxation revenue collected, the government’s budget priorities and the state of the economy.

• Net exports (X-M): is refers to the income from exports of goods and services (X) minus theexpenditure on imports of goods and services (M). If net exports are negative they will detract fromeconomic growth, but if net exports are positive they will add to economic growth.

e rate of technological change is also an important driver of economic growth as it can lead toimprovements in productivity (i.e. the rate of increase in output per unit of inputs used in production).Improvements in labour and capital productivity allow for existing resources to be utilised moreeciently in production. Higher productivity was one of the main reasons for Australia sustaininghigher rates of economic growth in the 1990s and early to mid 2000s compared to the 1980s. is ledto rising levels of real income per capita, employment growth and improvements in living standards.

Australia is a major importer of information and communications technology (ICT) and other typesof specialised capital equipment used in the mining, agriculture, manufacturing and service industries.is capital has helped to raise both single factor (e.g. labour and capital productivity) and multifactorproductivity, which in turn increases the rate of sustainable economic growth. e major contributionsto Australian economic growth or GDP between 2009-10 and 2011-12 are listed in Table 7.4:

• Household consumption spending (C) represented 53.6% of expenditure on GDP in 2011-12.Household consumption grew by 3.2% in 2011-12, recovering from the 0.2% growth in 2008-09because of the impact of the Global Financial Crisis on consumer spending and condence.

• Private investment (I) by rms accounted for 23.2% of GDP in 2011-12, expanding by 14.3%between 2010-11 and 2011-12 mainly due to strong investment in the mining industry.

• Government spending (G) accounted for 23% of GDP in 2011-12, growing by only 1.6% between2010-11 and 2011-12 as the government pursued a programme of scal consolidation.

• Net exports of goods and services (X - M) was a small surplus of $2,385m in 2011-12 comparedto the large surpluses in 2009-10 and 2010-11 resulting from a surge in commodity exports duringthe second mining boom which started after the end of the Global Financial Crisis in 2010.

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THE EFFECTS OF ECONOMIC GROWTHEconomic growth can lead to a number of important benets for the Australian economy, including:

• Higher real per capita incomes and living standards can be achieved from increases in productivityand resource use. Higher real incomes allow individuals to have greater purchasing power in raising

their material standard of living through purchases of more goods and services to improve theirmaterial wellbeing. is may include better standards of nutrition, housing, clothing, education,health care, transport and recreation. Australia had a high per capita gross national income (GNI)of US$34,340 in PPP terms in 2012 according to the World Bank.

• Higher levels of economic growth in Australia can also encourage higher levels of saving fromincreases in income in both the private and public sectors. In the private sector increases inreal income can lead to a rise in the household saving ratio (which had risen to 10% in 2012), with households able to reduce their levels of debt and save for retirement. e introduction ofcompulsory superannuation in 1991 has led to households accumulating more retirement savings

which has been assisted by rising real incomes and the returns on savings vehicles. Businesses canalso increase their saving rates because of higher levels of economic growth. is comes from the

retention of business prots, which provide funds for future investment in productive capacity.• Higher levels of economic growth tend to lead to higher rates of productivity growth and

technological progress. is arises from more ecient resource use, as producers are able to reduceproduction costs and innovate in keeping pace with the rising demand for goods and services.Higher productivity, especially labour productivity, can lead to increased demand for labour byemployers, helping to reduce the level and rate of unemployment in the labour market.

• Higher rates of economic growth which result in employment creation, can lead to new entrantsto the workforce (through a higher participation rate) and higher levels of employment. Economicgrowth may also create jobs for previously unemployed workers, and underemployed workers, whomay switch from part time to full time jobs and enjoy a rise in their real incomes, whilst those infull time employment may work overtime or second jobs to increase their real incomes.

• Economic growth which generates higher real GDP also leads to increasing taxation revenue for thegovernment (known as the ‘growth dividend’). e Australian government can use this additionaltaxation revenue to provide social and economic infrastructure, and to fund the social security and welfare system to provide income support for the aged, sick, disadvantaged and unemployed.

• Higher levels of economic growth can also contribute to new business investment as higherconsumption spending can have an ‘acceleration eect’ on net investment (i.e. new investmentin addition to the replacement of depreciated capital). Investment opportunities in new resourceprojects and in new plant and equipment may result from higher sustained economic growth.

• Economic growth necessarily involves increases in real output, some of which may be exportedto other countries. Export income can then be used to nance imports of consumer, capital and

intermediate goods produced more cheaply overseas. e gains from international trade includelower prices, higher output, employment, economies of specialisation and living standards.

• Economic growth may allow some resources to be released from current production for theprotection of the environment . Increased leisure time and higher incomes may lead to moreconcern for the environmental protection of natural resources, including endangered species andrainforests, and the minimisation of pollution and the rate of climate change through the use ofpollution abatement schemes (e.g. cleaner technologies and a system of tradeable emission permits),and government legislation to limit negative externalities caused by private production activities.

• Another benet of economic growth is the additional leisure time that workers may ‘trade o’ forextra work as real incomes rise. is enables Australians to use leisure time to travel, play sport, orenjoy entertainment, literature, the arts, music, hobbies and to participate in voluntary community

organisations. ese interests have developed into growth service industries which oer newemployment opportunities in areas such as sport, recreation, travel, tourism and entertainment.

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e benets of economic growth for Australia must be balanced against the costs of structural change which occur in the economy as it grows in real terms over time. Economic growth should not bepursued as an end in itself but as a process of assisting the Australian economy to achieve higher livingstandards and improvements in the physical and human quality of life and level of human development. A number of problems can result from the pursuit of economic growth as an end or goal in itself:

• A problem experienced by both advanced and developing economies in pursuing high rates ofeconomic growth is the damage caused to the natural environment through pollution, deforestationand land degradation. More natural resources are needed to sustain higher rates of economicgrowth and this may lead to the depletion of non renewable and renewable resources, pollution ofthe atmosphere, land degradation, and a consequent decline in environmental quality.

• Economic growth is a vehicle for great technological and structural changes in production, whichcan lead to some structural unemployment of labour. Governments need to fund retrainingschemes to re-skill the structurally unemployed for future employment in other industries.

• Economic growth can often lead to an emphasis on materialism and consumerism in society.Some loss of traditional cultural and family values is an inevitable outcome, but economic growth

should not be pursued at the expense of a decline in traditional cultural or family values.• Economic growth may lead to a widening in inequality of the distribution of income and wealth

in a society, if the benets of growth do not ‘trickle down’ to low and middle income groups, butare concentrated in high income groups. Progressive taxation can be used by governments toredistribute incomes and nance social security and welfare payments to lower income earners.

• Excessive rates of economic growth can lead to demand pull and cost push inflation as resourcesbecome scarce in relation to the increased demand for goods and services. Economic growth mighttherefore conict with the objective of price stability. It can also conict with full employment astechnical progress may lead to structural unemployment. e other conict that can arise is withthe goal of external balance. As the economy increases its demand for imported goods, this can leadto an increase in the current account decit and the level of net foreign debt to nance the decit.

INCREASES IN AGGREGATE SUPPLY AND ECONOMIC GROWTH

In the long run the rate of economic growth is heavily inuenced by the Australian economy’s productivecapacity. e economy’s productive capacity refers to the quantity and quality of resources needed tosustain the rate of increase in real output or economic growth in the future. e main resources usedto sustain economic growth are land, labour, capital and enterprise. Improvements in the quantity andquality of these resources will help to raise the production of goods and services and living standards.

Aggregate supply represents the total volume of the economy’s output. e aggregate supply curve (AS)is shown in Figure 7.4 and represents the total volume of the economy’s output at various price levels.It slopes upwards to the right as producers will have the incentive to increase output at higher prices in

order to maximise prots. A shift to the right (AS to AS1) or increase in the long run aggregate supplycurve (AS) or productive capacity is shown in Figure 7.4. is results in a higher rate of economicgrowth. In this model used by supply side economists, the price level is exible unlike the Keynesianmodel which assumes a xed price level. e aggregate demand curve is downward sloping from leftto right as consumers will be willing to buy more output but only at lower prices or a lower price level.

e intersection of the aggregate demand (AD) and aggregate supply (AS) curves represents theeconomy’s equilibrium level of income and output at Y e and at price level P. Any increase in aggregatedemand without a corresponding increase in aggregate supply will lead to a higher price level andination. is represents a constraint on the economy’s future growth and more resources or an increasein the productivity of existing resources is needed to increase economic growth by increasing aggregate

supply. is capacity constraint occurred in the Australian economy between 2005 and 2008 as fullemployment was reached in the labour market, and economic and social infrastructure was fully utilised.

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In Figure 7.4 the shift in the economy’s aggregate supply curve to the right from AS to AS1 leads to

more economic growth (Y e to Y e1) and a lower price level (P to P

1), since more output is available at a

lower price level. An increase in aggregate supply could be sourced from higher productivity (i.e. moreoutput being produced from a given level of inputs) or from more resources being used to increaseoutput. is could come about from business rms using more ecient work practices and the latesttechnology to raise labour and capital productivity. Education and training of labour could also increaseskills and raise labour productivity. It could also come about from the use of more resources such ashigher rates of immigration of skilled labour to increase the size of the workforce and more investmentin resource projects (such as oil, gas, coal and iron ore) to increase the resources available for industry.

Government policies called microeconomic reforms are important mechanisms for improving theefficiency of resource allocation in the economy in the long term. ese policies include the reductionin taris and other barriers to international trade; the relaxation of barriers to international investment;changes to the structure and rates of taxation; domestic competition policy reforms; and reforms innancial, labour and product markets. ese reforms along with changes in markets, have led tochanges in the structure of the economy (i.e. structural change) to make it more productive, ecientand competitive. e three types of potential eciency gains from microeconomic reform policies andmarket induced structural change are the following:

• Technical or productive efciency refers to rms producing output using the least cost combinationof resources. is means producing the maximum output at the minimum average cost. is isknown as achieving technical optimum in microeconomic theory.

• Allocative efficiency involves rms charging prices which reect the marginal cost of production sothat resources are allocated in such a way as to reect consumer preferences for goods and services.

• Dynamic efficiency refers to rms adapting to changing economic circumstances (such as changesin demand and technology) by using the latest cost reducing technology to meet changing consumerpreferences. is is also known as inter-temporal eciency as rms respond to changes in domesticand global markets over time by producing output at minimum cost.

One of the main sources of the growth in GDP per capita in Australia between 1990 and 2001 was theimprovement in labour productivity. Australia’s annual labour productivity growth was 2.2% between1990 and 2001, which was higher than in most other OECD countries. However annual productivitygrowth fell to about 1% between 2001 and 2013 as capacity constraints emerged. ese included a

shortage of some forms of skilled labour (such as professionals and tradespersons) and the need forincreased investment in infrastructure such as transport, communications and education.

Figure 7.4: The Effect of an Increase in Aggregate Supply on Economic Growth

AS AS1

AD

AD

Real GDP ornational income

Price Level

0

P

P1

Ye Ye1

AS1AS

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Figure 7.5 shows the trend in Australian labour productivity (as measured by GDP per hour worked)between 1999 and 2013. Key inuences on labour productivity include technological advances,improvements in labour skills, the quality of management practices and work arrangements:

• Knowledge and innovation are closely linked to the adoption of new technologies and theirapplication in industry. Australian businesses have a high ‘take up’ rate of new technologies.

• Expenditure on research and development (R & D) in Australia is important for encouraginginnovation in industry. However Australia only spends 1.6% of its GDP on R & D compared toan average 3% of GDP in other OECD countries.

• Business use of the Internet (through the expansion of broadband services and new computer

software) in Australia is a major means of innovation and the conduct of modern business, includingelectronic commerce and accessing global markets.

• Labour quality is linked strongly to the levels of education and training at school, as well asvocational and tertiary levels of education. Improvements in education and training have becomea major focus of government policy as a means of raising the quality of the Australian labourforce.

TRENDS IN THE AUSTRALIAN BUSINESS CYCLE

e business cycle refers to uctuations in the level of real GDP over time in market economies like Australia. Figure 7.6 shows the main phases of the business cycle as economic activity deviates fromthe general long term upward trend in the rate of economic growth over time. One complete business

cycle is measured from trough to trough, or peak to peak. In Australia one cycle is estimated to averageabout seven years. e four phases of the business cycle in Figure 7.6 are the following:

• e trough of the cycle is where output and employment ‘bottom out’ to their lowest levels. It isthe lower turning point of the business cycle. Income is at its lowest level, whereas unemploymentis at its highest e.g. the 1990-91 recession in Australia was characterised by negative economicgrowth of -0.2% in real GDP and the unemployment rate rose to 11% of the workforce. e1990-91 recession was caused by excessive monetary tightening which reduced growth and raisedthe unemployment rate. A recession in economic activity is dened as two consecutive quartersof negative economic growth. e Australian economy recorded below average growth of 1.3% in2008-09 due to the Global Financial Crisis but did not experience a recession in economic activity.

• e recovery or upswing of the business cycle is a phase between the peak and trough, characterisedby an expansion of the economy’s level of output and employment towards full employment.

Figure 7.5: Australian Productivity 1999-2013 (Quarterly % change)

Source: ABS (2013), Australian National Accounts, Catalogue 5206.0, March.

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Figure 7.6: The Phases of the Business Cycle

Unemployment falls because higher spending creates new job opportunities e.g. an economicupswing occurred in 2009-10, with real GDP rising by 2.3% and the unemployment rate fallingfrom 5.8% to 5.1%, due to a recovery in domestic and global economic activity after the GlobalFinancial Crisis. is recovery continued in 2010-11 (despite the impact of natural disasters) witheconomic growth of 2.25% and a fall in the unemployment rate to 4.9% of the workforce.

• e peak or boom of the business cycle is the upper turning point, where the economy has grownto its capacity and income, employment and output are at a maximum. Aggregate demand exceedsaggregate supply causing over full employment of resources. Ination may arise because resourcesare scarce and their prices are bid up by competing users. Between 2003 and 2004, the Australianeconomy boomed with real GDP growth averaging over 4%, and unemployment fell to below 5%,but inationary pressures increased, with the CPI rising to 3.2% by 2005. ese boom conditionscontinued between 2006 and 2008 as Australian growth was supported by the expansionary eectof a rising terms of trade and strong growth in domestic demand. Real GDP growth averaged over3% between 2006 and 2008 and levels of capacity utilisation in the economy peaked.

• e downswing of the business cycle is characterised by falling output and employment and theemergence of excess capacity. Spending falls in a recession and unemployment of labour rises, as

aggregate demand is insucient to generate full employment. A downswing occurred in 2000-01,as growth slowed to 2%, largely because of a mild recession in the USA, after the collapse of thetechnology boom. Growth slowed again from 3.9% in 2001-02 to 3% in 2002-03, as the droughtand lower world economic growth impacted on Australia.

A further slowdown in economic growth occurred in 2008-09 as the global economy experiencedthe GFC, which was the worst recession since the Great Depression of the 1930s. According to theIMF world GDP contracted from 3% growth in 2008 to negative growth of -0.6% in 2009.

In Figure 7.6 government intervention in the business cycle is shown by the dotted line. is representsthe government’s use of counter cyclical or stabilisation policies to ‘smooth out’ uctuations in thebusiness cycle, and is known as ‘lopping the peaks and lling the troughs’. In a trough or recessionthe government could use expansionary monetary and/or scal policies to support growth in aggregate

demand and reduce unemployment. In a peak or boom the government could use contractionarymonetary and/or scal policies to reduce the growth of aggregate demand to contain ination.

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POLICIES TO PROMOTE ECONOMIC GROWTH

e Australian economy has performed remarkably well since the 1991 recession, recording twentytwo years of consecutive economic growth from 1991 to 2013. e rate of economic growth averagedbetween 3% and 4% in real terms in this period due to a combination of positive world economic

growth (including the resources booms between 2003 and 2008; and 2010 and 2011) and the benetsof major macroeconomic and microeconomic reforms in Australia. ese reforms included the moreeffective conduct of macroeconomic policy in keeping ination and interest rates low, which has ledto greater certainty and underpinned consumer and business condence in their spending decisions.However the Global Financial Crisis in 2008-09 led to below average growth, rising unemployment andthe use of expansionary monetary and scal policies to support growth and employment.

e main macroeconomic policy instruments used by the Australian government include monetaryand scal policies. Monetary policy refers to the Australian government’s use of changes in the ocialcash rate by the Reserve Bank of Australia to achieve the government’s economic objectives of economicgrowth, price stability, full employment and external balance. Since 1996 the Reserve Bank has set anination target of 2% to 3% consumer price ination over the economic cycle for conducting monetarypolicy. e achievement of this ination target on average has been important in containing inationarypressures and expectations in the economy which could undermine the government’s achievement of thegoal of sustainable economic growth and the maintenance of Australia’s international competitiveness.

Fiscal policy is the use of changes in taxation and government spending in the annual federal budgetto aect economic activity, resource allocation and income distribution. e Australian governmentadopted the Charter of Budget Honesty Act in 1998 to ensure that the budget was kept in balance over theeconomic cycle; that there was no increase in the tax burden on 1996-97 levels; and a commitment tothe retirement of public debt through the accumulation of budget surpluses when economic growth waspositive. e Australian government achieved budget surpluses between 1996 and 2007 and paid o

Australia’s public debt in 2005-06. Budget surpluses were used to fund tax cuts, and implement a rangeof reforms in health, education, social security, infrastructure, superannuation and the labour market.However the impact of the Global Financial Crisis in 2008-09 reduced taxation revenue and increasedgovernment expenditure, leading to budget decits and increased public debt. e government usedexpansionary monetary and scal policies to support economic growth, but with an economic recoveryin 2010-11 the Australian government committed to returning the budget to surplus.

Macroeconomic policies can be used to promote and sustain economic growth in the short to mediumterm through demand management. Microeconomic policies can be used in the longer term to addressspecic structural problems on the supply side of the economy which may limit future growth. Manyof these microeconomic policies have the objectives of increasing eciency and productivity:

• Cuts to Australian protection such as taris and quotas have increased import competition, andencouraged greater eciency in industry and the export of more manufactured goods;

• Reforms to competition policy through the implementation of a national competition policy in1995 has strengthened competition in Australia’s product and factor markets;

• Labour market reforms such as the adoption of enterprise or workplace bargaining in linking wageoutcomes to changes in labour productivity has increased workplace eciency and productivity;

• Reforms to infrastructure such as electricity, transport, gas, water and telecommunications havemade these markets more ecient and competitive; and

• Taxation reform including the introduction of a broad based consumption tax (the GST) in 2000has secured more taxation revenue for state governments to fund their spending on goods andservices, infrastructure and welfare payments. In addition to the broadening of the tax base andplacing more emphasis on indirect taxes, the Australian government has cut marginal rates of

income tax and increased income tax thresholds to reduce the tax burden on income earners. esemeasures were designed to increase incentives to raise productivity, saving and investment.

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THE MEASUREMENT, SOURCES AND EFFECTS

OF ECONOMIC GROWTH

1. Explain how real GDP is calculated. How does the ABS measure GDP in Australia?

2. Calculate the value of real GDP in year 2 for an economy from the data in the following table:

Year Nominal GDP Consumer Price Index (CPI)

1 $1,000m 1002 $1,200m 104

3. Distinguish between the value added, expenditure and incomes received methods of calculatingthe value of total production.

4. Refer to Table 7.3 and describe the trends in measures of Australian GDP between 2010-11 and2011-12. How is the rate of growth in real GDP measured?

5. Refer to Figure 7.3 and describe the trends in Australia’s rate of economic growth between2000-01 and 2012-13.

6. Outline the main sources of economic growth in Australia. Refer to the data in Table 7.4in your answer.

7. Discuss the main benets to Australia of sustaining high rates of economic growth.

8. Discuss the main costs associated with sustaining high rates of economic growth in Australia.

9. Explain how improvements in efciency, productivity and technology can increase aggregatesupply and economic growth in the long run.

10. Explain the main features of each stage of the business cycle. Refer to Figure 7.6in your answer.

11. Explain how the government can use counter cyclical or stabilisation policies to smooth outfluctuations in the business cycle.

12. Discuss the main trends in the Australian business cycle between 1990-91 and 2011-12.

13. Discuss the main government policies used to promote economic growth in Australia.

14. Discuss the reasons for the Australian government’s use of scal stimulus to support aggregatedemand and economic growth in 2008-09. Refer to Figure 7.7 in your answer.

15. Discuss the potential effects of population ageing on Australia’s future growth performance.

16. Dene the following terms and add them to a glossary:

REVIEW QUESTIONS

aggregate demandaggregate supplyboombudget decitbudget surplusbusiness cycle

consumption spending

counter cyclical policiesdownswingscal stimulusgovernment spendinginvestment spendingmicroeconomic reform

net exports

per capita incomepopulation ageingproductivityrate of economic growthreal GDPrecession

upswing

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Refer to diagram above of the determination of the equilibrium level of national income in ahypothetical economy and answer the questions below. Marks

1. What is the equilibrium level of income at Ye? (1)

2. What is meant by autonomous investment? (1)

3. State the formula for the multiplier and calculate the value of the multiplier if the MPC is 0.8. (2)

4. What is the change in the equilibrium level of national income from Ye to Ye1? (2)

5. Explain TWO costs and TWO benets for this economy in achieving a higher rate of economic growth. (4)

[CHAPTER 7: SHORT ANSWER QUESTIONS

C = 80 + 0.8Y

C + I = 140 + 0.8Y

Income

Expenditure

0 45o

Ye Ye1

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[CHAPTER FOCUS ON ECONOMIC GROWTH

“Well timed monetary and scal policy stimulus in Australia ensured that the economy’s deviation

from its potential growth was kept to a minimum during the Global Financial Crisis. As a result therecent downturn in Australia has been particularly mild compared with the experience of the restof the world. Prior to the global economic downturn Australia’s economy was growing above trendat 3.7% in 2007-08 with the unemployment rate falling to 4% in early 2008.

In the economic downturn growth slowed to 1.3% in 2008-09 and is expected to remain belowtrend at 2% in 2009-10. However growth is forecast to pick up in 2010-11 and 2011-12 and theeconomy is expected to return to around its full employment level of output.”

Contributions to GDP Growth 2009-10 to 2011-12 (f)

Source: Commonwealth of Australia (2010), Budget Strategy and Outlook 2010-11.

Explain the main sources of economic growth and the use of scal and monetary policy stimulusto support economic growth in Australia during a recession.

Explain the main sources and benets of economic growth in Australia and the policies that thefederal government can use to sustain economic growth in the medium term.

[CHAPTER 7: EXTENDED RESPONSE QUESTION

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ECONOMIC GROWTH

1. Economic growth refers to an increase in a country’s productive capacity as measured by changesin real GDP over time. Economic growth results from using more resources or increasing theproductivity of existing resource use in production.

2. The equilibrium level of national income is the level of income towards which an economy moves.Equilibrium is a situation in which there is no tendency for the level of national income to change.The equilibrium level of national income can be determined by using the saving/investment(leakage-injection) approach or the aggregate demand/aggregate supply (AD/AS) approach:

In equilibrium S = I or AD = AS.

3. Aggregate demand is the sum of the main components of spending in the economy including

consumption spending by households (C), investment spending by rms (I), net governmentspending (G) and net exports (X - M).

4. The simple expenditure multiplier (k) in a three sector model of the economy is the extent to whichan initial change in autonomous consumption or autonomous investment spending is multiplied togive a larger change in the equilibrium level of national income.

5. Economic growth is measured by changes in real GDP over time. Real GDP is nominal GDP orGDP at current prices adjusted for changes in the price level or rate of ination. In 2011-12 realGDP in Australia was valued at $1,451,588m and the Australian economy grew by 3.4% in realterms between 2010-11 and 2011-12.

6. The main sources of economic growth in Australia in 2011-12 were consumption spending (C)accounting for 53.6% of GDP; investment spending (I) which accounted for around 23.2% ofGDP; government spending which accounted for around 23% of GDP; and inventories (or unsoldstocks) which added 0.3% to economic growth. Net exports add to economic growth when theyare positive (i.e. the value of exports exceeds imports e.g. 0.2% in 2011-12) and detract fromeconomic growth when they are negative (i.e. the value of exports is less than imports).

7. Some of the main benets of economic growth include rising real incomes and living standards aswell as employment creation, and the ability to export goods and services to overseas markets.Economic growth may also result in higher tax collections for the government which can be usedto nance social welfare to alleviate poverty, as well as developing infrastructure in the economy.

8. Some of the costs associated with unsustainable economic growth may include a deteriorationin the natural environment due to higher pollution and over exploitation of natural resources.Economic growth can also cause inflation if the rate of growth exceeds productive capacity. Awidening in the inequality of the distribution of income can also be associated with the process ofeconomic growth as not all members of society may share equally in the ‘growth dividend’.

9. Economic growth can be sourced from increases in productivity, efciency and technologicaladvancements. These can increase aggregate supply or productive capacity in an economy in thelong term and sustain higher rates of economic growth.

10. The business cycle refers to changes in the level of real economic activity over time. The phasesof the business cycle are the trough or recession; the upswing or upper turning point; the peak orboom; and the downswing of the cycle. The government can use counter cyclical policies suchas monetary and scal policies to stabilise uctuations in the business cycle. If successful, thesestabilisation policies will minimise inflation during inflationary booms of the cycle, and the rate ofunemployment during recessions or deflationary periods of the cycle. Microeconomic policies canbe used in the longer term to improve the efciency of the economy’s allocation of resources.

190 Chapter 7: Economic Growth © Tim Riley Publications Pty Ltd

CHAPTER SUMMARY

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