Question

Suppose, initially the Australian economy is at full employment (in other words the economy is at the potential GDP). Using AD-AS model, explain how would each of the following events affect the economy both in the immediate and in the long term.

a) A slowdown in China’s economic growth due to the sub-prime crisis in the US.

b) Union wage settlements push the wage rate up.

c) An increase in consumer confidence.

Answer 1

Initially Australian economy is at full employment , economy is at potential GDP . Full employment equilibrium is determined when aggregate demand curve AD1 intersects at aggregate supply curve AS1 at Y* level of potential output and P* level of price. a. Slow down of China's economic growth due to sub -prime crisis in US would highly affect Australian economy. Because China is a biggest trading partner of Australia due to China's strong demand for iron ore, coal, liquefied natural gas etc. Exports to China helped Australia escape from worst effect of global financial crisis many times .Slow economic growth of China reduces their national GDP. It will reduce income level in Chinese economy. fall in income level reduce the demand for the( Australian exports ) importing good from Australia. It would affect the production sector of Australian economy. It will reduce their exports. As a result of decline in production level , investment will also reduce. Fall in investment level rises the unemployment rate due to reduction in labor demand. It will reduce the income level and consumption level in the economy. As a result AD curve and AS curve shifts backward and it will reduce the national output ( real GDP) in Australian economy. b. Union wage settlement push the wage rate up. Higher wage rate rises cost of production of firms. So firm will reduce the production and output level in the economy. It will reduce the aggregate supply of good and services. It will shift the AS curve backward AS1. c. An increase in consumer confidence increase the investment and consumption level in the economy. It will increase the aggregate demand of good and services in the economy due to increase in investment and consumption .It shifts AD curve rightward as AD1. It will increase the price level from P * to P1 and output from Y * to Y1