Topic 2: Macroeconomic indicators and government policy
Explain the factors that influence aggregate demand and aggregate supply in the Australian economy, and how each affects real GDP, employment and inflation
A focused QCE Economics Unit 2 answer on the determinants of AD and AS. Identifies the eight main AD factors and the six main AS factors, traces cause-and-effect chains to real GDP, employment and inflation, and applies the framework to recent Australian conditions.
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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:
- Explains the business cycle (AD shifts).
- Explains long-run growth (LRAS shifts).
- Frames the inflation-unemployment trade-off (the Phillips curve is implicit in the model).
- 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.
Exam-style practice questions
Practice questions written in the style of QCAA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
2023 QCAA4 marksAssume the graph represents a recent event experienced by the Australian economy that required economic management. [The graph shows the short-run aggregate supply curve shifting left from SRAS1 to SRAS2, raising the price level from P1 to P2 and lowering real GDP from YFE to Y2.] Explain a likely cause and short-term effect of the event.Show worked answer →
This was Question 12 (4 marks) of the 2023 external assessment. The diagram shows a leftward shift of short-run aggregate supply (SRAS1 to SRAS2), so you must identify a negative (adverse) supply shock.
Likely cause (2 marks). Identify an event that raises the economy-wide cost of production and contracts short-run aggregate supply, for example a sharp rise in oil and energy prices, higher imported input costs from a depreciating dollar, or a supply chain disruption [1 mark]. Explain that higher per-unit production costs reduce the quantity firms are willing to supply at each price level, shifting SRAS to the left [1 mark].
Short-term effect (2 marks). Read the new equilibrium from the diagram: the price level rises from P1 to P2 [1 mark] while real GDP falls from the full-employment level YFE to Y2 [1 mark]. This combination of higher inflation and falling output (a contraction below full employment) is cost-push inflation, the classic stagflation outcome that makes demand-side management difficult.
Markers reward correctly reading the leftward SRAS shift and linking the cause to both effects shown.
2021 QCAA12 marksAnalyse Sources 1 to 3 in the stimulus book to explain the impact of electricity prices on small and medium-sized businesses over the years 2014 to 2019. Draw a short-term AD/AS diagram in the space provided to support your explanation.Show worked answer →
This was Question 11 (12 marks) of the 2021 external assessment, marked across a diagram, a trends section and an effects section.
- Diagram (3 marks)
- Draw a short-run AD/AS diagram with an accurate title and axis labels (price level against real GDP) [2 marks]. Because higher electricity costs raise production costs, shift aggregate supply to the left (AS1 to AS2) and link the shift to your explanation [1 mark]. The new equilibrium shows a higher price level (P2) and lower real GDP (Q2).
- Trends from the data (up to 5 marks)
- Identify the rising trend in energy prices across 2009 to 2019 and quantify it (prices more than doubled, including a roughly 30 index point jump in one quarter of 2014). Quantify the milder rise in CPI and wages (about 37 index points). Infer that energy is a non-discretionary cost for businesses, and calculate a figure to make meaning.
- Effect on SMEs (up to 4 marks)
- Explain that as electricity costs rise, small and medium-sized businesses cannot supply the same quantity at the same price, so some reduce output or exit, lowering employment. Support this with the stimulus data (SMEs employ almost 70 per cent of the workforce and add about 60 per cent of value).