Year 12 Economics

Mid Semester 1 Revision 2019

1. The
Business The stages:
Cycle

 Changing levels of domestic economic activity can be

illustrated on a business cycle diagram.
 Over the duration of a full cycle (usually between 5 to 8
years) the economy passes through four phases or situations.
 Four Phases:
the recovery (or expansion) phase
the peak (or boom)
the contraction (or downswing)
the trough
1. The recovery/expansion:
  The cycle begins with increasing prosperity and healthy
business activity characterised by increased consumer and
business confidence.
 The upward forces are reinforced by readily available credit
and speculative investment.
 The recovery occurs because of strong growth in total demand
– reflecting higher
o Consumer spending
o Business investment in capital goods
o Government spending
o Exports – imports
 Also occurs because of good sales and falling business stocks.

Within the recovery stage,

 Firms find they need to purchase extra resources including
labour, so unemployment rates fall.
 Inflation tends to rise because during recovery growing
expenditure may cause general shortages of resources and
production
 Strong economic growth

2. The peak
 Eventually the recovery reaches a peak or upper turning point
where economic activity is at its maximum.
 Here economic growth is high,
So is employment of resources (low unemployment rate).
 Also, high levels of incomes and high wages growth
 But a dangerous inflationary boom may result
Interest rates are high, and credit becomes scarcer.

3. The contraction/recession
 Contraction normally follows a peak or boom.
 This occurs because consumer sentiment and business
confidence begin to diminish. We all expect that the
economy will fall
 The government and the RBA introduce restrictive
policies to reduce inflation and this reduces borrowing and
credit
 The economic growth rate slows.
 Firms pull back on production because of a fall in total
demand or increases in unsold stock.
 Unemployment rates start to rise.
 Inflation slows because of over-production and price
discounting.
4. The trough
 The trough represents the lowest point in economic
activity.
  Usually no problem but if negative economic growth
occurs for 2 consecutive quarters it represents a recession.
 Inadequate spending – low consumer spending and
business investment
 Low incomes
 High unemployment
 Low inflation
Example of business cycle investigation:

1. Use the RBA Chart Pack to collect economic growth rate data
for Australia from 1993-2018.
Insert the graph here.

2. Interpret the data and identify the phase of the business cycle
occurring from 2010 to 2012?
= The recovery or expansion phase

3. What economic factors cause this phase of the business cycle?

= Consumer spending, business investment in capital goods,
govt spending and exports-imports

4. How is this phase of the business cycle related to the

achievement of domestic economic objective?
= The economic growth is increased and there's a lot of
spending so increase in inflation, decrease in unemployment.

5. What is the significance of consumer sentiment and business

confidence in this phase?
= The consumer confidence would be higher as the economy
would be increasing
Circular Flow Equilibrium
Model  Equilibrium is a state of economic stability from which there
is no immediate tendency to change.
 In a market economy with D and S dictating change the
economy always moves towards equilibrium
 With ever-changing conditions, the equilibrium is continually
changing. ‘The cat is chasing its tail’
 At equilibrium there may be inflation, a recession, high
unemployment, low standard of living or unfair distribution
of income or wealth.
 Equilibrium is a stable state – not necessarily a desirable one.
Conditions for equilibrium:
 For Equilibrium in a 5-sector CFM:
total of leakages = total of injections

 S+T+M=I+G+X

 So C + S + T + M = C + I + G + X

 i.e. Total Income = Total spending

 And Total Supply = Total Demand

Expansions and contractions in the economy:

 An economic expansion is an increase in economic growth

(economic activity) accompanied by less unemployment and
higher inflation
 An economic contraction is a decrease in economic activity
(economic growth) with a consequent increase in
unemployment and lower inflation
 The economy expands if injections are greater than leakages
 The economy contracts if injections are less than leakages

What happens if the economy expands?

  This is not open ended. As income increases so will leakages
that are linked to income (S, T, M)
 The economy will continue to expand until leakages grow to
be equal to injections (I, G, X)
 At that point the economy would be in equilibrium and no
further expansion would occur

Low economic growth:

 In the CFM low economic growth (small increases in
production) occurs when injections barely exceed leakages.
 The greater the difference between injections and leakages the
higher the economic growth achieved
 Increase injections (I, G, X) and decrease leakages (S, T, M)
to increase economic growth
Demand inflation explained:
 In the CFM demand inflation occurs because of excessive
spending i.e. I+G+X > S+T+M.
 Curb inflation by decreasing injections and increasing
leakages.
Unemployment explained:
 In the CFM unemployment can be explained by low
production caused by insufficient spending.
 Reduce unemployment by increasing injections relative to
leakages.
Keynesian Model Elementary theory:
 Keynesian theory tells us that the value of output (production,
GDP, National Income, Y) will vary with changes in
aggregate demand (total demand, total spending, C+I+G+X-
M).

 PO is the Potential Output (i.e. the full employment level of

income).
 It is the level of production where resources are fully utilised.
It is where the cyclical unemployment is zero.
 Above the PO there will be demand inflation, below PO there
will be cyclical unemployment.
 The aggregate supply (total supply) curve is at 45˚ and is
fixed as supply conditions are assumed constant over the short
term – the time frame of Keynesian economics.
Aggregate demand (total demand):
• Total D = C+I+G+X-M
• Consumption
• Investment
• Government spending
• Exports – Imports
• Consumption is induced spending – it varies with Income (Y).
• It is a function of income. See the Consumption Function
below.
• C = a +bY a is a constant; b is the MPC; Y is the
national income or GDP
• e.g. C = 30 + 0.8 Y
Autonomous spending:
• Autonomous spending refers to those elements of aggregate
demand that don’t change as Income changes e.g. I, G, X
• Any change in autonomous spending will have a multiplier
effect on equilibrium income Y.
• In a 3-sector Keynesian model (with H, B, and F/S) the
Investment multiplier is = 1/(1-MPC)
 • If C = 30 + 0.8 Y then MPC = 0.8
• The 3-sector Keynesian Multiplier = 1/(1-0.8) = 5
• This means for every $1 increase in Investment Eqm
Y will increase by $5
5-sector multiplier:
• The multiplier is the numerical link between a change in
autonomous spending and the resultant change in equilibrium
income (Eqm Y).
• If the given 5-sector Keynesian multiplier = 4 and the total
increase in I,G,X is $30 mill, then the increase in Eqm Y will
be
• ∆ Eqm Y = ∆ autonomous spending x Multiplier
= $30 mill x 4
= $120 mill
Inflationary/deflationary gap:
• A Deflationary Gap exists when Eqm Y is less than the
Potential Output PO (also known as the full employment level
of income). Deflationary Gap = PO – Eqm Y
• Cyclical Unemployment will exist and will increase the
further Eqm Y is below the PO. Cyclical unemployment
emerges because of insufficient demand or spending.
• A Deflationary Gap will exist because the Total D (Agg D) is
insufficient to push equilibrium up to the Potential Output.

• An Inflationary Gap exists when Eqm Y exceeds the Potential

Output. Inflationary Gap = Eqm Y - PO
• Demand–Pull inflation will exist and will increase as Eqm Y
moves further above the PO. Beyond the PO the value of
production will only increase because of increased prices
(inflation) as the maximum amount that can be produced is
that at the PO.
An Inflationary Gap will arise because Total Demand is
excessive.
Limitations of Keynesian Model:
• The Keynesian model is a short-term model and as such
assumes a lot of variables remain constant. In reality even in
the short run many of these variables will change sufficiently
to affect the multiplier effect and projected effects on
economic growth, unemployment, and inflation.
• The model concentrates on aggregate expenditure and does
not address changes in aggregate supply. An extension of
Keynes’ model into this area is needed to better manage the
economy and achieve economic objectives.
Building the
Keynesian Model

 Below P.O is cyclical u/e and above is demand inflation

 Where these two lines cross, represent the equilibrium level of

income.
 The equilibrium level of income is which the economy moves.
In this scenario, it is stable and is less than the P.O
 Therefore, in this instance, the EQM is in the unemployment
zone – there will be cyclical unemployment at that
equilibrium level.
 We can see a shift in aggregate demand, which has increased
by 10.
 As a result in an increase in autonomous spending
(investment, govt. spending or exports)
 We can also see that the equilibrium has increased by 50 and
has shifted closer to the P.O as a result of increased demand
or increased spending.
 This highlights the functions of Keynesian model: the changes
in demand determine the level of equilibrium and the
achievement of economic goals.
 An increase in aggregate demand is a result of increases in
autonomous spending (I, G, X), which cause an increase in
EQM and a multiplier effect.
 Increase in demand and autonomous spending of 10 caused an
increase in eqm of 50.
 When we’re changing demand, it increases eqm and
production, not just by the amount of increase in demand but
by a multiple of it.
 Calculation of the Keynesian multiplier:
1. Start with consumption equation: the MPC is in front of
the Y
1
2. The multiplier is 1−𝑀𝑃𝐶 therefore, in this instance the
multiplier is 5.
 What does multiplier of 5 mean:
 If autonomous spending (I,G,X) increase by 1, the eqm will
increase by 5.
 If we multiply the chance in autonomous spending by the
multiplier, we’ll get the change in eqm. E.g if the autonomous
spending (I,G,X) increased by 30, and the multiplier is 8, the
equilibrium would increase by 240 (30x80=240). Therefore,
we multiply the change in autonomous spending by the
multiplier to find out change in equilibrium level of income or
production.
 Any changes in autonomous spending, changes aggregate
demand and this changes equilibrium (EQM Y), income or
production
 The change in EQM Y relative to P.O will affect cyclical
unemployment and demand inflation.
 If eqm moves closer to P.O, that’ll reduce cyclical U/E. If the
eqm shifts from being below the P.O to being above the P.O,
will be that cyclical will increase to 0 as the economy moves
 towards that P.O. Once that level of income exceeds the P.O,
demand inflation will exist and will become greater the
further above the P.O, EQM moves.
Keynesian Model
3-Sector P.O.(f.e.Y) Eqm C function Change in Change in
Y I EqmY
16 000 12 C=150+0.8Y 100 2500
000
6 000 7 000 C=100+0.9Y -200 5000
9 000 8 500 C=600+0.75Y 150 4100
28 000 26 C=1293+0.7Y 600 27998
000

For each of the situations in the table above:

1. Show this information on a Keynesian Income/Expenditure graph.
2. Calculate the multiplier.
3. Calculate the effect on Eqm Y of the change in autonomous
spending.
What is the new Eqm Y?
4. What effect will this change in Eqm Y have on inflation and
unemployment?

Mult Effect New Effect on Effect on u/e

Eqm Y Eqm Y Inflation
5 +500 12 500 No inflation Decrease u/e
10 -2000 5 000 Decrease Increase u/e
inflation to zero
4 +600 9 100 Increase inflation Decrease u/e to
zero
3.3333 +2000 28 000 Inflation remains Decrease u/e to
zero zero

Steps of Keynesian 3-sector:

1. Diagram
2. Multiplier
3. change in Autonomous spending
4. Change in EQM
5. The new eqm
6. The updated new diagram
7. The effects on demand, inflation and cyclical u/e
Keynesian 5-
Sector Multiplier
Fantasia 1

another version:
Fantasia 2

Practest 2
Agg D – Agg S Aggregate demand – aggregate supply model:
Model Ppt

With the aid of Aggregate D and Aggregate S curves in the model

explain why unemployment might exist:
 Unemployment exists because the equilibrium real income
(real GDP) is below that required to achieve full employment.
 As long as equilibrium is below P.O. cyclical unemployment
will exist
What changes on the model would reduce unemployment? Verify
using a diagram?
 Unemployment would be reduced if Agg D increases moving
Eqm closer to the P.O.
 Unemployment would be reduced if cost of resource/cost of
production were less, causing a partial shift in Agg S, moving
Eqm closer to P.O.

What adjustments in what factors would bring this reduction in

unemployment about?

 The partial shift in the Agg S curve occurs because of

decreases in:
 Price of materials
 Wages
 Price of imported
 Materials
 Energy prices
 Govt costs and charges
With the aid of Aggregate D and Aggregate S curves in the model
explain why high inflation might exist.
 Demand inflation will exist if the Agg D is greater than that
required to achieve Eqm the P.O
What changes on the model would reduce inflation? Verify using
a diagram?
 Demand inflation would be reduced if Add D decreased
towards that minimum level required to achieve P.O. level of
real GDP.

 Demand inflation would be reduced if there is a total shift in

Agg S to the right which results in a lower-price (lower
inflation) equilibrium.

What adjustments in what factors would bring about this

reduction in inflation?
With the aid of Aggregate D and Aggregate S curves in the
model explain how the goal of sustainable economic growth might
be addressed
Economic growth (increase in real GDP) can be achieved by:
 an increase in Agg D
 a partial shift in the Agg S by reducing production costs
 a full shift in Agg S by increasing the availability and
productivity of resources

What adjustments in what factors would bring about the increase

in real GDP to boost economic growth?
 Fig 1 Changes in factors which increase Agg D (see above)
 Fig 2 Changes in factors which lower production costs eg.
decrease in:
 Price of materials
 Wages
 Price of imported Materials
 Energy prices
 Govt costs and charges
  Fig 3 Changes in factors which increase the amount of
resources and their productivity
 Increased efficiency of labour
 New technology
More labour and raw materials

 This is the aggregate demand – aggregate supply model.

 It explores the effects of changes in a wide range of demand-
side and supply side factors over various time frames.
Aggregate demand:
• Aggregate Demand = spending on real GDP
= C + I + G + X-M

• An increase in C, I, G, (X-M) will cause the Aggregate

Demand curve to shift to the right.

• Aggregate Demand will shift to the right with the

following changes:
Aggregate supply:
• Aggregate Supply is the quantity produced or real GDP
• Agg S increases up to the potential output.
• No further increase in real production is possible.
• Only price rises follow.

• A decrease in the cost of resources such as wages or imported

fuel causes this type of partial shift in Agg S
• The aggregate supply curve is not fixed as supply conditions
are assumed variable over the medium term – the time frame
of the Agg D – Agg S model.

• This total shift in Agg S could be caused by an increase in the

availability and productivity of resources which extends
production possibilities and raises the potential output.
 • Firms will supply more, will produce more as a result of
anything which reduces their costs and increases their ability
and willingness to produce.
• Overall Aggregate Supply will shift to the right in some form
with the following changes:

Equilibrium Income/GDP:
• Equibrium income is where Agg S = Agg D
• In this particular case equilibrium income is less than the
potential output so cyclical unemployment would exist.

• In this case an excessive increase in aggregate demand moves

the economy to an equilibrium position where the potential
output is achieved.
• But too much demand puts upward force on prices causing
high demand inflation
 •
Here an increase in supply extends potential output, provides
economic growth and reduces inflation
• It also provides the opportunity to increase Agg D to create
further growth and employment without inflating prices

• The PO (potential output), what the economy is capable of

producing, will increase over time as the Agg S curve shifts to
the right. It is not fixed as it was in the Keynesian model.
• This has implications for the emergence of cyclical
unemployment and demand inflation. Demand inflation is less
likely and cyclical unemployment is more likely as the Agg S
and PO move to the right.
• At the same time the equilibrium level of production is
increasing causing economic growth.
• The cyclical unemployment can be absorbed by increasing
Agg D
It’s a Wrap:
• The model accounts for both demand and supply factors.
• Demand - Supply theory tells us that the value of output
(production, GDP, National Income, Y) will vary with
changes in Aggregate Demand (total demand, total spending,
C+I+G+X-M) and Aggregate Supply.
• The model provides an insight into the causes of
unemployment, high or low inflation and low economic
growth.
• It provides a wide range of options to increase (or decrease)
aggregate demand and aggregate supply to bring about a
balanced response to economic problems not only in the short
 term but in the longer term drawing on both macro and micro
policy.
The Multiplier:
• Agg D (C+I+G+X-M) will move as in the Keynesian Model.
• Autonomous spending items (I,G,X) will still have a
multiplier effect;
However, with the Agg S curve moving around it is much more
difficult to predict the effects of changes in autonomous spending
Macroeconomic Management Options:
• The Aggregate D – Aggregate S model broadens the options
available for managing the economy and better achieving
economic goals
• Whereas the short term Keynesian model is limited to
changes in the elements of demand (C,I,G,X-M) to bring
about improved economic conditions,
• the longer term Agg D – Agg S model can look at
manipulating both demand and supply conditions to change
the equilibrium and to move the economy in a desired
direction.