Question

Using appropriate diagrams, explain the likely impact of drought on macroeconomic equilibrium in Australia. Use evidence drawn from media reports to illustrate your answer. How might government policy response to drought will modify the macroeconomic impact of the drought?

Answer 1

A drought can reduce major crops in the country. This would reduce the inputs required for production and in total we can expect the production to fall. Hence the macroeconomic impact of a drought would be to shift the aggregate supply curve leftwards, thus, reducing the aggregate supply. This brings in a hike in the rate of inflation and reduces real GDP below its potential level. Hence growth rate of real GDP would fall and inflation rate would rise.

Government will find it difficult to bring the economy back to its original long run equilibrium. If fiscal or monetary expansion is done, then it would stimulate spending and shift AD to the right, but this would raise the rate of inflation further. However, real GDP would rise and return to its full employment level. If fiscal or monetary contraction is done to tackle inflation, then it would discourage spending and shift AD to the left. This would reduce the rate of inflation but then, real GDP would fall beyond its full employment level. Hence it depends on the motive of the government, if it is willing to bring growth at the cost of further inflation