By Hendrarto Sutarto, 2241709
ECON5103: Business Economic
Tutor: DR. Hazel Bateman
Assignment 2
Session 1, 1999

This paper is to answer the discussion questions of Week 11 Tutorial topic: Aggregate Supply and Aggregate Demand (AS-AD). Several scenario simulations that may influence Australia’s economy are to be discussed. Also, there are some questions of why government might want to take action to influence the economy, and the types of action that might be taken to anticipate possible scenario in the simulation above.

To examine the effect of such simulations on real GDP and price level change, the AS-AD model was required as an analysis tool.

A severe recession in the Japanese economy lower Japanese demands of goods and services to other countries. As a result, the decreasing Japanese market demand significantly reduce Australia’s export market, because Japan is a major Australia’s export market.

In the short run, in the AS-AD model, the decline of Australia’s export is represented as a leftward shift of AD curve toward AD’ (see Figure 1). AD’ intersects SAS on the new short run equilibrium point; E2.

Figure 1: A leftward shift on AD curve due to a demand collapse in Japanese market.

After E2 is attained, both the price level and the real GDP output level equilibrium become lower than the original equilibrium (E1). The price level is now on P*SR, and the real GDP output level is on Real GDP SR level (see Figure 1); below than full employment real GDP level.

In conclusion, in the short run, there will be both falling prices and falling output of real GDP which lead to an increase in unemployment rate.

Figure 2: Long-Run Adjustment of SAS curves in response to a collapse of export market.

To reduce long term unemployment gap, despite of labor supply excess, it may be difficult to push money wages downward, for example, due to government policy over money wages. Thus, the long run equilibrium itself tends to stay on E2, which means prolonging of lower output level of real GDP and also lower prices level of Australian goods and services.

However, a severely longer economic recession may lead wages fall. Falling wages drive production costs lower. Hence, this will lead SAS toward SAS’, until the new equilibrium E3 is reached (see Figure 2). If E3 can be reached, the unemployment level will back to its natural rate, but the price will get the lowest level than any previous equilibrium.

To overcome short run economic recession and to decrease unemployment, government can control the economy using both fiscal and monetary policy to force AD’ back to AD (see Figure 1):

• Fiscal policy actions:
  • Increase government spending
  • Increase transfer payment
  • Reduce taxes of goods & services both to increase aggregate demand and to push supply costs (SAS) slightly lower.
• Monetary policy actions:
  • Decrease interest rate to encourage people spending and investment
  • Increase money volume in the circulation to keep interest rate lower

High expectation to huge profits in the near future attracts the firms to expand through more investment. More investment generate more demand of any goods and services which, in the AS-AD model, is represented as a rightward shift of the AD curves; AD curves become AD’ (see Figure 3).

Figure 3: Rightward shift on AD curve due to a high expectation to huge profits in the near future.

Then, AD’ intersect SAS on the new equilibrium point E2. The new equilibrium point E2 has a greater level of real GDP and price than E1 has. The level of real GDP is now on Real GDP SR, while the level of price is now on P*SR (see Figure 3).

In conclusion, in the short run, a higher profit expectation results the economy into an increasing price level and also increasing output (real GDP) which drives the economy into higher level of inflation.

Figure 4: Long-Run Adjustment of SAS curves in response to high expectation to huge profits in the future.

In the short run, expectation to higher profits attracts firms to produce more than the economy at full-employment capacity available. As a result, there will be higher prices level, and higher output level which raise inflation rate.

If this situation happens in a relatively long time, this may lead an upward push of wages level, because the workers demand higher wages to their firms to adjust their losing purchasing power. As wages rise, the production costs will also rise, which depicted as movement of SAS toward SAS’ (see Figure 4).

When SAS’ is being reached, the level of equilibrium is becoming E3, which has a greater price level than any previous price levels, and has an output level closer (or equal) with original full employment real GDP level.

To control inflation rate at a certain level and to keep the prices down in the short run, government may use some elements of both contractionary fiscal and monetary policy to force AD’ back to AD.

• Fiscal policy actions:
  • Decrease government spending and transfer payments
  • Increase taxes of goods & services to decrease aggregate demand
• Monetary policy actions:
  • Increase interest rate to reduce excess spending and investment, and/or
  • Decrease money volume in the circulation to keep interest rate at a certain level.

A broad wages increase in the economy lead to higher overall production costs. The increased production costs results to a higher price level at overall levels of real GDP. A higher price level, in the AS-AD model, is represented as an upward shift of SAS curve toward SAS’.

Figure 5: An upward shift of SAS curve due to higher money wages received by workers.

After SAS’ is get, there is a new equilibrium point on E2. E2 has a higher price level due to higher production costs. But, because of the higher prices which contribute to decreasing demands, the firms are now forced to lower the output. As a result, there will be a situation in which overall production level output is below the full employment output that available in the economy.

In conclusion, in the short run, the real GDP level will be falling below full employment output level, while the price level will be rising higher than previous full employment price level.

In the long run, the E2 equilibrium has the higher overall price and unemployment level in the country. If government policy over money wages does not allow falling wages, then, the unemployment gap will be exist, which means there potentially will be prolonging higher unemployment rate.

To overcome high unemployment rate, government should take action to increase the aggregate demand of the country. To do so, government can use expansionary fiscal and/or monetary policy to drive AD curve towards AD’ (see Figure 6), as follows:

• By raising government spending, transfer payment and/or by reducing taxes, people are encouraged to spend more which lead AD curve moves toward AD’.

Figure 6: An attempt to lower unemployment by expanding aggregate demand.

• By increasing money supply or reducing interest rates, the firms are encouraged to spend more for businesses expansion. So, the aggregate demand will be affected to move rightward. Then, the unemployment gap may be reduced.

However, both monetary and fiscal expansionary policy will contribute to higher and higher price level in the long run. If government prefers to avoid these situation, it would be better to introduce wages policy to prevent the raise of SAS curve to be SAS’ before the wages rise.