Macroeconomic Activity

Using the Market Mechanism to Make Predictions

If you understand everything that has been covered so far, then you now have at your disposal a very valuable tool for making predictions about what will happen in the Australian economy. We will explore this with an example.

Imagine for a moment that the US economy moved out of recession, as it did in the second half of 2003 and the early months of 2004. What might the consequences for the Australian economy be? To assess this, first ask yourself whether this is a demand factor or a supply side factor. We can easily see that as the US economy moves into a stage of higher economic activity, they will buy more of our exports. This will be reflected in a higher value for X in the aggregate demand formula [AD=C+I+G1+G2+(X-M)]. Therefore it follows that this is a demand side factor.

The next thing we need to establish is, will this change cause an increase or a decrease in aggregate demand? We have already established that this will lead to a higher value for our exports. In other words, aggregate demand in Australia will increase. We can represent this on a supply and demand graph as follows:

Based on this, what can we conclude about the Australian economy?

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 a return to economic prosperity by a major trading partner of ours may result in some upward pressure on prices – we may see some demand inflation.
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. This is one of the major reasons that the US economy is so important to the long term prosperity of the Australian economy.
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.
Other conclusions can also be made. The increase in exports may mean that we are able to improve our balance on current account (if we assume that the increase in exports is not off-set by an increase in imports at the same time). The increase in employment may lead to an improved performance in income distribution.

In other words, by using these graphs we can assess the impact of any change to the economy on each of the economic goals that you will study in Unit 3.

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