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ISSUES
TOPIC FOCUS
This topic focuses on the nature, causes and consequences of the economic issues and problems that
can confront contemporary economies as applied to the Australian economy. The issues examined
include economic growth; unemployment; inflation; external stability; the distribution of income and
wealth; and environmental sustainability. Students should learn to examine the following economic
3
issues and apply the following economic skills in Topic 3 of the HSC course:
ECONOMIC ISSUES
• Examine the arguments for and against increasing economic growth rates;
TOPIC THREE
income; and
• Examine the economic issues associated with the goal of ecologically sustainable
development.
ECONOMIC SKILLS
• Identify and analyse problems facing contemporary and hypothetical economies;
• Calculate the unemployment rate and the participation rate using labour force statistics;
• Interpret a Lorenz curve and a Gini co-efficient for the distribution of income in an economy;
The major economic issues in Australia involve Australia’s economic performance in terms
of outcomes for economic growth, unemployment, inflation, the balance of payments and the
exchange rate. Other important issues include trends in the distribution of income and wealth
in Australian society, and Australia’s approach to the management of the environment and its
commitment to a policy of ecologically sustainable development (ESD).
Chapter 7
Economic Growth
Economic growth refers to an increase in a country’s productive capacity as measured by changes in
its real GDP over time. Real GDP refers to the national output of goods and services adjusted for
changes in inflation over time. Increases in the rate of economic growth provide the means by which a
country can raise its level of income and standard of living. Macroeconomic theory involves the study
of aggregate economic behaviour (or economic activity in the economy as a whole), and is used to
analyse the main components of economic growth and GDP. Changes in the rate of economic growth
are measured by changes in real GDP, which can produce business or trade cycles in market economies.
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
G0 = autonomous government expenditure
Y C S I MPC MPS
Figure 7.1: The Equilibrium Level of National Income in the Three Sector Model
Expenditure AS = Y = C + S
C + I = 100 + 0.5Y
C = 50 + 0.5Y
Panel A
100
50
o
0 45 Y
100 200
S and 1
S = -50 + 0.5Y
Panel B
50 I = 50
0 100 200 Y
Ye Ye1
–50
The 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. The aggregate supply function
(AS) is represented by the 45˚ line in Figure 7.1, which is a locus of points where Y = E = O. The
equilibrium 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):
Therefore the equilibrium level of income or Ye1 = 200
Alternatively, the equilibrium level of national income can also be determined by using the leakages and
injections 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)
Therefore the equilibrium level of income or Ye1 = 200
Without the addition of the finance sector (and the injection of investment to offset the leakage of
saving), 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)
In the three sector model of the circular flow of income, the multiplier can be derived by substituting
the consumption and investment equations into the national income identity as shown in equation (1).
(1) Y = C + I (2) Y = 1 x C0 + 10
Y = C0 + cY + I0 1 - c 1
Y - cY = C0 + I0
Y (1 - c) = C0 + I0
(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 effect on the equilibrium level of national income equal to the size of the multiplier,
times the initial change in autonomous consumption or investment spending. The value of the simple
expenditure multiplier (k) in equation (3) is equal to one over one minus the MPC (c), or one over the
MPS (s). The 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 ∆Y
In 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 function
from I to I1 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. The 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)
Therefore Ye1 = 250
Expenditure AS
C + I1 = 125 + 0.5Y I
C + I = 100 +- 0.5Y
Panel A
C + I 2 = 75 + 0.5Y - I
125
100
75
o
0 45
Y
150 200 250
S and I
S = –50 + 0.5Y
Panel B
75 I1 = 75
I = 50 I
50
25 I2 = 25 - I
0 Y
150 200 250
–50
Y Y
A rise in autonomous investment of 25 by firms (due to improved profit expectations or a fall in the
cost of capital) has increased national income by 50. Since (k) is greater than one, any change in an
autonomous 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. The new equilibrium level of national income is now lower at 150, determined by
the 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
The size of the simple multiplier co-efficient is influenced by the relative sizes of the MPC and MPS.
The larger the MPC or the smaller the MPS, the larger the value of the multiplier. The smaller the
MPC or the larger the MPS, the smaller the value of the multiplier (see Table 7.2). This is because
consumption is an injection into the circular flow of income whereas saving is a leakage from income.
Table 7.2: The Relationship Between the MPC, MPS and the Multiplier
REVIEW QUESTIONS
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?
6. Graph the consumption and savings functions C = 100 + 0.6Y and S = -100 + 0.4Y.
(ii) If autonomous investment of 150 occurred, graph the new C + I function
of AD = 250 + 0.6Y.
Table 7.3: Measures of GDP and other Selected Aggregates for Australia ($m)
% real GDP
0
99-0 00-1 01-2 02-3 03-4 04-5 05-6 06-7 07-8 08-9 09-10 10-11 11-12 12-13
Sources: ABS (2012), Australian Economic Indicators, Catalogue 1350.0, July and Budget Paper No. 1, 2012-13.
The benefits 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 be
pursued as an end in itself but as a process of assisting the Australian economy to achieve higher living
standards 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 of
economic growth is the damage caused to the natural environment through pollution, deforestation
and land degradation. More natural resources are needed to sustain higher rates of economic
growth and this may lead to the depletion of non renewable and renewable resources, pollution of
the atmosphere, land degradation, and a consequent decline in environmental quality in a country.
• Economic growth is a vehicle for great technological and structural changes in production, which
can lead to some structural unemployment of labour. Governments need to fund retraining
schemes 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 benefits of growth do not ‘trickle down’ to low and middle income groups, but
are concentrated in high income groups. Progressive taxation can be used by governments to
redistribute incomes and finance social security and welfare payments to lower income earners.
• Excessive rates of economic growth can lead to demand pull and cost push inflation as resources
become scarce in relation to the increased demand for goods and services. Economic growth might
therefore conflict with the objective of price stability. It can also conflict with full employment as
technical progress may lead to structural unemployment. The other conflict that can arise is with
the goal of external balance. As the economy increases its demand for imported goods, this can lead
to an increase in the current account deficit and the level of net foreign debt to finance the deficit.
Price Level
AD AS AS 1
P
P1
AD
AS AS1
0 Real GDP or
Ye Ye1 national income
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 (Ye to Ye1) and a lower price level (P to P1), since more output is available at a
lower price level. An increase in aggregate supply could be sourced from higher productivity (i.e. more
output being produced from a given level of inputs) or from more resources being used to increase
output. This could come about from business firms using more efficient work practices and the latest
technology to raise labour and capital productivity. Education and training of labour could also increase
skills and raise labour productivity. It could also come about from the use of more resources such as
higher rates of immigration of skilled labour to increase the size of the workforce and more investment
in resource projects (such as oil, gas, coal and iron ore) to increase resource availability.
Government policies called microeconomic reforms are important mechanisms for improving the
efficiency of resource allocation in the economy in the long term. These policies include the reduction
in tariffs 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 in
financial, labour and product markets. These reforms along with changes in markets, have led to
changes in the structure of the economy (i.e. structural change) to make it more productive, efficient
and competitive. The three types of potential efficiency gains from microeconomic reform policies and
market induced structural change are the following:
• Technical or productive efficiency refers to firms producing output using the least cost combination
of resources. This means producing the maximum output at the minimum average cost. This is
known as achieving technical optimum in microeconomic theory.
• Allocative efficiency involves firms charging prices which reflect the marginal cost of production so
that resources are allocated in such a way as to reflect consumer preferences for goods and services.
• Dynamic efficiency refers to firms adapting to changing economic circumstances (such as changes
in demand and technology) by using the latest cost reducing technology to meet changing consumer
preferences. This is also known as inter-temporal efficiency as firms respond to changes in domestic
and global markets over time by producing output at minimum cost.
One of the main sources of the growth in growth in GDP per capita in Australia between 1990 and
2001 was the improvement in labour productivity. Australia’s annual labour productivity growth was
2.2% between 1990 and 2001, which was higher than in most other OECD countries. However annual
productivity growth fell to about 1% between 2001 and 2012 as capacity constraints emerged. These
included a shortage of some forms of skilled labour (such as professionals and tradespersons) and the
need for increased investment in infrastructure such as transport, communications and education.
Figure 7.5 shows the trend in Australian labour productivity (as measured by GDP per hour worked)
between 2000 and 2012. Key influences 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 their
application 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 encouraging
innovation in industry. However Australia only spends 1.6% of its GDP on R & D compared to
an 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, including
electronic commerce and accessing global markets.
• Labour quality is linked strongly to the levels of education and training at school, as well as
vocational and tertiary levels of education. Improvements in education and training have become
a major focus of government policy as a means of raising the quality of the Australian labourforce.
Unemployment falls because higher spending creates new job opportunities e.g. an economic
upswing occurred in 2009-10, with real GDP rising by 2.3% and the unemployment rate falling
from 5.8% to 5.1%, due to a recovery in domestic and global economic activity after the Global
Financial Crisis. This recovery continued in 2010-11 (despite the impact of natural disasters) with
economic growth of 2.25% and a fall in the unemployment rate to 4.9% of the workforce.
• The peak or boom of the business cycle is the upper turning point, where the economy has grown
to its capacity and income, employment and output are at a maximum. Aggregate demand exceeds
aggregate supply causing over full employment of resources. Inflation may arise because resources
are scarce and their prices are bid up by competing users. Between 2003 and 2004, the Australian
economy boomed with real GDP growth averaging over 4%, and unemployment fell to below 5%,
but inflationary pressures increased, with the CPI rising to 3.2% by 2005. These boom conditions
continued between 2006 and 2008 as Australian growth was supported by the expansionary effect
of a rising terms of trade and strong growth in domestic demand. Real GDP growth averaged over
3% between 2006 and 2008 and levels of capacity utilisation in the economy peaked.
• The downswing of the business cycle is characterised by falling output and employment and the
emergence of excess capacity. Spending falls in a recession and unemployment of labour rises, as
aggregate demand is insufficient 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 the
technology boom. Growth slowed again from 3.9% in 2001-02 to 3% in 2002-03, as the drought
and lower world economic growth impacted on Australia.
A further slowdown in economic growth occurred in 2008-09 as the global economy experienced
the GFC, which was the worst recession since the Great Depression of the 1930s. According to the
IMF 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. This represents
the government’s use of counter cyclical or stabilisation policies to ‘smooth out’ fluctuations in the
business cycle, and is known as ‘lopping the peaks and filling the troughs’. In a trough or recession
the government could use expansionary monetary and/or fiscal policies to support growth in aggregate
demand and reduce unemployment. In a peak or boom the government could use contractionary
monetary and/or fiscal policies to reduce the growth of aggregate demand to contain inflation.
REVIEW QUESTIONS
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:
1 $1,000m 100
2 $1,200m 104
3. Distinguish between the value added, expenditure and incomes received methods of calculating
the value of total production.
4. Refer to Table 7.3 and describe the trends in measures of Australian GDP between 2009-10 and
2010-11. How is the rate of growth in real GDP measured?
5. Refer to Figure 7.3 and describe the trend in Australia’s rate of economic growth between
1999-00 and 2011-12.
6. Outline the main sources of economic growth in Australia. Refer to the data in Table 7.4
in your answer.
7. Discuss the main benefits 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 efficiency, productivity and technology can increase aggregate
supply and economic growth in the long run.
10. Explain the main features of each stage of the business cycle. Refer to Figure 7.6
in your answer.
11. Explain how the government can use counter cyclical or stabilisation policies to smooth out
fluctuations 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 fiscal stimulus to support aggregate
demand 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.
C = 80 + 0.8Y
o
0 45 Income
Ye Ye 1
Refer to diagram above of the determination of the equilibrium level of national income in a
hypothetical economy and answer the questions below. Marks
3. What is the change in the equilibrium level of national income from Ye to Ye1? (2)
4. State the formula for the multiplier and calculate the value of the multiplier if the MPC is 0.8. (2)
5. Explain TWO costs and TWO benefits for this economy in achieving a higher rate of
economic growth. (4)
In the economic downturn growth slowed to 1.3% in 2008-09 and is expected to remain below
trend at 2% in 2009-10. However growth is forecast to pick up in 2010-11 and 2011-12 and the
economy is expected to return to around its full employment level of output.”
Explain the main sources of economic growth and the use of fiscal and monetary policy stimulus
to support economic growth in Australia during a recession.
CHAPTER SUMMARY
ECONOMIC GROWTH
1. Economic growth refers to an increase in a country’s productive capacity as measured by changes
in real GDP over time. Economic growth results from using more resources or increasing the
productivity 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 firms (I), net government
spending (G) and net exports (X - M).
4. The simple expenditure multiplier in a three sector model of the economy is the extent to which an
initial change in autonomous consumption or autonomous investment spending is multiplied to give
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 or
GDP at current prices adjusted for changes in the price level or rate of inflation. In 2010-11 real
GDP in Australia was valued at $1,317,914m and the Australian economy grew by 1.9% in real
terms between 2009-10 and 2010-11.
6. The main sources of economic growth in Australia in 2010-11 were consumption spending (C)
accounting for 55.7% of GDP; investment spending (I) which accounted for around 21.7% of GDP;
government spending which accounted for around 24.5% of GDP; and inventories (or unsold
stocks) which added 0.2% to economic growth. Net exports add to economic growth when they
are positive (i.e. the value of exports exceeds imports) and detract from economic growth when
they are negative (i.e. the value of exports is less than imports) e.g. -2.3% in 2010-11.
7. Some of the main benefits of economic growth include rising real incomes and living standards as
well 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 used
to finance 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 deterioration
in the natural environment due to higher pollution and over exploitation of resources. Economic
growth can also cause inflation if the rate of growth is too rapid and resources become scarce. A
widening in the inequality of the distribution of income can also be associated with the process of
economic growth as not all members of society may share equally in the ‘growth dividend’.
9. Economic growth can be sourced from increases in productivity, efficiency and technological
advancements. These can increase aggregate supply or productive capacity in an economy in the
long 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 phases
of the business cycle are the trough or recession; the upswing or upper turning point; the peak or
boom; and the downswing of the cycle. The government can use counter cyclical policies such
as monetary and fiscal policies to stabilise fluctuations in the business cycle. If successful, these
stabilisation policies will minimise inflation in inflationary booms of the cycle, and the rate of
unemployment in recessions or deflationary periods of the cycle. Microeconomic policies can be
used in the longer term to improve the efficiency of the economy’s allocation of resources.