ECO10004: ECONOMIC PRINCIPLES

WEEK 10_TUTORIAL QUESTIONS

The key concepts covered in this topic are as follows:

− Business Cycle, Contraction (Recession) & Expansion (Growth) (Tutorial Question 1).
− Aggregate Demand & Aggregate Supply model (Tutorial Question 2, 3 & 4).
− Demand-pull inflation (Tutorial Question 2).
− Cost-push inflation (aka Stagflation) (Tutorial Question 3).
− Actual GDP vs. Potential GDP (Tutorial Question 4).
− The economy’s transition from the short run to the long run (Self-study questions).
− Unemployment rate & Inflation rate during the business cycle (Self-study questions).
− Business Cycle & Leading Indicators (Self-study questions).
− The virus recession (aka the COVID-19 recession) (Self-study questions).

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Question 1)

a. In your own words, clearly explain what the “business cycle” means (Page 478 of the textbook)

=> Business cycle is consists of alternating periods of eonomic expansion and economic contraction
relative to long-term trend rate of economic growth.

-> The level of economic activity, as measures by Real GDP (aka output), will keep fluctuatig throughout
the business cycle.

b. The Reserve Bank of Australia (RBA) offers the following visual illustration of the business
cycle. See diagram below

Source: RBA – In Education – Recession Explained

Now think about the Australian economy has fared over the past 30 years.
Has the Australian economy gone through alternating periods of expansion and contraction as
regularly as depicted in the diagram above?

Answer:

- Autralian economy went through 29 straingth years (1991 – 2019), without a technical rêcsion (Real
GDP falling for two consecutive quarters).

- The impressive streak only came to an end because of COVID.

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=> The economy did not suffer from alternating periods of expansion and contraction as regularly as
depicted in the RBA’s diagram.

- Factors contributing to the economic success between 1991 and 2019 include:

 Active counter-cyclical economic management by the federal government (fiscal policy) and the
reserve bank (monetary policy).

 Provision of unemployment benefits and other transfers payment acts as automatic stabilisers
during economic downturn.

 Australia was fairly lucky to dodge a recession caused by GFC in 2007/08.

 The 1991 recession, painful as it was, helped stamp out high inflation. Inflation has been low and
steady since, which provides a stable foundation for economic growth.

=> The Australian economy since the 1960s tends to enjoy extended periods of economic growth, with
few recessions. The economy just slumped into a severe one as recent as previous year (2020).

c. The Australian economy slumped into a recession in 2020, the first recession after almost 30
years of uninterrupted economic growth. During a recession, what will typically happen to:

− Real GDP: decrease

=> Recession is defined as real GDP falling for 2 consecutive quarters
− Total Output: decrease
=> Measured by real GDP = C + I + G + NX
− Aggregate Income: decrease
=> Measured by real GDP = C + I + G + NX
− Unemployment rate: increase
=> Total Out decrease – production falls – lay off workers
− Household consumption: decrease
=> Income falls – rising uncertainty, cuts down consumption
− Business investment: decrease
=> Uncertain economic outlook, borrow might be cheap but Investment (I) will likely fall

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Question 2) This question focuses on the mining boom in Australia.

The recent mining boom in Australia was considered the second biggest resource boom ever in the
country’s history, behind only the gold rush of the 19 th century. The boom started in 2003, reaching its
peak between 2011 and 2013. During those years, the mining sector grew dramatically thanks to the
massive demand for iron ore and thermal coal from China.

a. Clearly explain how the shock above (i.e., the mining boom) would affect aggregate demand (AD)
and aggregate supply (AS) (both short-run and long-run) in the Australian economy.

- Massive demand for iron ore and thermal coal from China suggests a dramatic increase in X, thus, NX
for Australia.

- Mining companies committed large investment (I) on new machinery and equipment during those peak
years of the mining boom.

- Since AD = C + I + G + NX, this is a positive demand shock, and the AD curve will shift right.

=> The mining boom is a positive demand shock. Aggregate demand increases and the AD curve shifts
right.

b. Draw an appropriate AD – AS graph to illustrate the impacts of this shock. Assume that the
Australian economy was originally at the long-run equilibrium.

Price level

LRAS

SRAS1

B
P2

P1
A
AD2
AD1

Real GDP
0
Y1 = Yp Y2

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c. State clearly the impacts of this shock on the key macroeconomic variables (i.e., Price level, Real
GDP & the Unemployment rate). What type of inflation would occur as a result of this shock?

- Real GDP has increased (Y2 > Y1), economy is booming

- Real GDP rising means production climbing up => Firms will hire more workers => Unemployment
rate will fall.

- Price level (P2 > P1) has increased, which means inflation: Y2 > Yp => inflationary preassure

- Because inflation is caused by an increase in AD, this is called “demand-pull inflation”.

Question 3) This question focuses on the 1970s oil crisis.

During the 1970s, developed economies around the world (Australia included) were brought to their
knees by a severe oil crisis.

In October 1973, oil exporting countries, led by Saudi Arabia, announced a global oil embargo. Oil price
soon skyrocketed, surging from $3 per barrel to almost $12 per barrel. The dramatic increase in oil price
continued throughout the 1970s, with price reaching $40 per barrel in 1979.

Given how critical oil and other types of fuel were as inputs to production, this crisis heaped crippling
impacts on major economies around the world.

a. Clearly explain how the shock above (i.e., the oil crisis) would affect aggregate demand and
aggregate supply (both short-run and long-run) in the Australian economy.

- Oil is an important input in the production process of many industries.

- The price of oil tends to correlate with the prices of other energy products (e.g. fuel).

- Oil price crisis means the cost of production for firms rise through the roof.

- This reduced firms' ability to produce, SRAS curve must shift left.

- This is an example of a negative (adverse) supply shock.

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b. Draw an appropriate AD – AS graph to illustrate the impacts of this shock. Assume that the
Australian economy was originally at the long-run equilibrium.

Price Level
LRAS
SRAS2

SRAS1

B
P2
P1
A

AD

Real GDP
Y2 Y1 = Yp

c. State clearly the impacts of this shock on the key macroeconomic variables (i.e., Price level, Real
GDP & the Unemployment rate). What type of inflation would occur as a result of this shock?

- Real GDP has decreased (Y2<Y1), economy is in recession

- Real GDP is tumbling means firms slashing production => Unemployment rate will rise.

- Price level (P2>P1) has increased, which means inflation: Y2 < Yp stagflation pressure => Firms will
lay off more workers

- Because inflation is caused by a decrease in AS, which raised cost of production, this is called “cost-
push inflation”.

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Question 4) Suppose the Australian economy is currently characterised by the following graph:

a. Is the current equilibrium point (point 1) desirable for the Australian economy? At point 1, is the
Australian economy facing an unemployment problem or an inflation problem? Clearly explain.

 The current equilibrium point (point 1) is not desirable:

- Actual GDP (Y,) is being lower than potential GDP (Yp).

- Resources, especially labour, are not being put to full use.

 The Australian economy is not yet reaching its full potential

→ As a result, it is highly likely that the economy is facing an unemployment problem.

There might be an inflation problem too (stagflation): depends on initial state (AD or AS shock)

b. What needs to happen so that the Australian economy can achieve full employment? Clearly
explain.

For the economy to achieve full employment, actual GDP must grow further to equal potential GDP.
There are two ways to achieve this:

• Boost Aggregate Demand (AD) so that AD curve shifts right.

=> by increasing any of the four components: C, I, G, or NX

• Boost Aggregate Supply in the short run (SRAS) so that the SRAS curve shifts right.

=> Any policy that helps reduce the cost of production for firms can do the trick: tax cuts to boost short-
run aggregate supply (higher income encourage work)

=> However, it must be noted that this approach is more challenging, less certain, and highly
unpredictable: tax cuts have the greatest impacts on AD while the effects on AS are fairly subdued.

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