The Market Mechanism

Making Predictions

With the knowledge that you have now gained, you can begin to make some preliminary predictions about how certain changes will affect the economy.  An example will help to make this clear.

Before we begin, let's create a supply and demand diagram for the entire economy.  Although it is possible to work with a graph for just one product, it is also possible to imagine every product in the economy at one time.  When we do this, we call the two lines "aggregate demand" and "aggregate supply".  In this case, the word "aggregate" simply means "total".  In other words, we are looking at the overall demand and the total level of supply for the economy.

Now imagine a situation in which business confidence increases.  When this happens, it is likely that business owners will spend more money.  As a result, investment spending in the economy will increase.  When this happens, aggregate demand will increase.  We might not know exactly which products the business owners will be purchasing, but we can say with some confidence that the spending will occur.  As a result, the aggregate demand curve will shift to the right.

1. The equilibrium point is now higher on the vertical axis. This axis measures changes in price. When we are looking at the Australian economy as a whole, these changes in price are referred to as inflation. In other words, the increase in demand for our products due to higher levels of business confidence may result in some upward pressure on prices – we may see some demand inflation.
2. The equilibrium point is now further to the right on the horizontal axis. This axis measures changes in quantity. When we are looking at the Australian economy as a whole, these changes in quantity refer to our Gross Domestic Product (GDP). Any movement to the right means that we are now producing a higher quantity – in other words we have achieved an increase in GDP.
3. We can also make some observations about employment in this country. As we are producing a higher quantity, and in this case we can see that this higher quantity is not due to improvements in productivity, it is highly probable that we will also see a decrease in the rate of unemployment. This is another very important goal of the Australian economy.

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