Explain the factors that influence aggregate demand and aggregate supply in the Australian economy, and how each affects real GDP, employment and inflation

What this dot point is asking

QCAA wants you to identify the factors that influence AD and AS, explain the cause-and-effect chain from each to real GDP, employment and inflation, and apply the framework to current Australian conditions. Expect short and extended response.

The answer

The AD/AS framework

Aggregate demand (AD) is the total demand for goods and services at each price level:

Aggregate supply (AS) is the total production of goods and services. The short-run AS curve slopes upward; the long-run AS curve is vertical at potential output.

A rightward shift in AD raises real GDP and the price level. A rightward shift in LRAS raises potential output (real GDP) without inflation.

Factors that influence aggregate demand

1. Consumer confidence

Higher confidence raises C. Measured by the Westpac-Melbourne Institute Consumer Sentiment Index.

2. Business confidence

Higher confidence raises I. Measured by the NAB Business Confidence Index.

3. Interest rates

The cash rate flows through to retail rates. Higher rates reduce C and I and dampen AD. The 2022-24 RBA tightening cycle is the textbook current example.

4. Disposable income

After-tax household income. Affected by wages, taxes (the 2024 Stage 3 cuts raised disposable income), and transfer payments.

5. The exchange rate

AUD depreciation raises export competitiveness and makes imports more expensive (supports AD). AUD appreciation does the opposite.

6. Government economic activity

Federal, state and local spending. The 2020-21 COVID-19 stimulus was the largest fiscal expansion in peacetime history.

7. Overseas economic conditions

Demand from trading partners. Australia's exports are sensitive to Chinese GDP (32 percent of exports), Japanese, Korean and ASEAN demand.

8. Population growth

Net overseas migration of around 500,000 in 2023-24 supported AD through housing and retail demand.

Factors that influence aggregate supply

1. Productivity. Output per unit of input. Multifactor productivity has averaged 0.5 percent per year over the last decade in Australia, well below the 1.5 percent of the 1990s.

2. Costs of production.

• Wages. Wage Price Index growth above productivity growth raises unit labour costs and shifts SRAS left.
• Energy. Wholesale electricity and gas prices spiked in 2022, raising production costs across the economy.
• Other inputs. Building materials, transport, freight, financial services.

3. Tax and regulation. Higher business taxes and stricter regulation shift AS left. Microeconomic reform (National Competition Policy 1995-2005) shifted AS right.

4. Labour force size and quality.

• Migration. Net overseas migration expands the labour force.
• Participation. Female participation has risen from 50 percent (1980) to 63 percent (2024).
• Skills. Free TAFE, university CSP, apprenticeship support.

5. Capital stock. Investment in machinery, infrastructure, R&D.

6. Natural resources. Mineral and energy endowment.

Cause-and-effect chains

QCAA marking guides reward explicit chains. Examples:

Cash rate rise → lower inflation.

"RBA raises the cash rate → banks raise mortgage and business loan rates → households reduce consumption (especially durables) and firms cut investment → AD shifts left → real GDP growth slows → capacity utilisation eases → wage growth and inflation slow."

Migration surge → AD up, AS up.

"Net overseas migration of 500,000 → larger consumer base raises C and housing demand (AD right) → larger labour force expands productive capacity (LRAS right) → real GDP rises; some upward price pressure in housing offset by easing wage growth."

AUD depreciation → higher inflation.

"AUD falls → import prices rise in AUD terms → tradables inflation rises → through input costs, services inflation rises → headline CPI rises with a lag of 2 to 4 quarters."

Application: 2022-24 inflation episode

A textbook case of multiple shocks acting together.

AD pressures (2021-22):

• Cash rate at 0.10 percent (record low).
• $250 billion of fiscal stimulus during COVID-19.
• $300 billion of pent-up household savings.
• Tight labour market (unemployment 3.5 percent).

Supply shocks (2022):

• Wholesale electricity prices doubled (Russian invasion of Ukraine).
• Global shipping and supply chain disruption.
• Wage growth rising from 2 percent to 4 percent.

AUD depreciation: from USD 0.78 (early 2021) to USD 0.62 (late 2024).

Net effect. Headline CPI peaked at 7.8 percent (Q4 2022). Trimmed mean at 6.9 percent.

Policy response:

• RBA cash rate from 0.10 percent to 4.35 percent (May 2022 to Nov 2023).
• 2023-24 federal Budget tightened the structural balance.
• Migration surge (500,000) eased labour market tightness.

By late 2024, headline CPI was around 2.4 percent and trimmed mean 3.2 percent. The disinflation has been slower than initially expected, particularly on the underlying measure.

Effects on the three macroeconomic indicators

Real GDP

A rightward shift in AD raises real GDP in the short run; a rightward shift in LRAS raises real GDP in the long run.

Employment

Higher real GDP growth typically lowers unemployment (Okun's Law: a 1 pp rise in GDP growth above trend lowers unemployment by around 0.5 pp).

Inflation

AD shifts above potential output raise the price level. LRAS shifts raise real GDP without raising the price level.

Why the AD/AS framework matters

The AD/AS framework is the central tool for QCE Economics macroeconomic analysis. It:

1. Explains the business cycle (AD shifts).
2. Explains long-run growth (LRAS shifts).
3. Frames the inflation-unemployment trade-off (the Phillips curve is implicit in the model).
4. Identifies the appropriate policy response (AD policies for cyclical, AS policies for structural).

Common QCE traps

Confusing AD factors with AS factors

Interest rates, confidence and disposable income are AD. Productivity, costs and labour force are AS.

Drawing AD shifts without identifying which component changed

Specify C, I, G or X-M.

Forgetting LRAS shifts

Long-run growth requires LRAS to shift right. AD shifts alone produce only inflation in the long run.

Treating AD and AS as if they only affect inflation

They affect all three indicators: GDP, unemployment and inflation.