According to the AD/AS model, in the short-run governments can increase demand by increasing government spending, lowering taxes, or increasing the money supply. This should increase output in the short-run while also increasing prices. In the long run, however, the model predicts that the economy will not increase output as effective employment is already at a market equilibrium level, so the increase in demand will simply be inflationary. Indeed, a reported unemployment rate of 5.1% in combination with a historically high 64.5% workforce participation rate indicates that there is little slack in the Australian labor market, particularly for highly skilled positions. In addition, businesses report high capacity utilization levels and are expecting inventory-to-sales ratios to decrease. Given such constraints on long-run output, we then take a look at the components of AD and AS to consider how the pulling of different levers might impact the economy in a sustainable manner.
Aggregate Supply, or the total output of an economy, is a function of Labor (L), Capital (K), and Materials (M). Businessmen and women, the employers of these resources, make decisions on when to increase or decrease their use of these resources based on their projections of future demand for goods and services. Aggregate Demand is in turn a function of total Consumption (C), Business Investments (I), Government Spending (G), and Net Exports (NX).
Aggregate Demand (AD) = C + Ip + G + NX
Aggregate Supply (AS) = f(Lt,Kt,Mt )
The equilibrium level where the two intersect is determined by levels of prices, which then determines the overall level of demand and supply. Looking only at the most recent data, the Australian economy appears to be in good shape. According to the Australian Bureau of Statistics (ABS), while consumption, housing expenditures, private investment, and government spending are trending down or are expected to be lower in 2006, the import/export balance of trade is expected to improve and GDP growth in 2005 and in 2006 are expected to be healthy (see figure 1), thanks largely to high commodity prices. The Australian economy is steady, but the AS curve is nearly vertical, and the expected increases in GDP next year are based largely on high commodity prices. The economy, therefore, is beset by expectations of higher prices, and perhaps, the spectre of higher inflation. So the question now becomes, which lever(s) shall we pull to create an environment for future growth
Fig. 1. Contributions to GDP growth, Australian Bureau of Statistics 2005.
Analyzing Components of Aggregate Demand
Consumption (C) has been a very important driver of the domestic economy, helping to pull Australia through the Asian financial crisis of the late 1990s, weak global growth in 2001-2002, and the drought of 2003. Consumption is however a function of disposable income, the savings rate, and the desire to preserve and protect wealth. While gains in wages might serve to feed consumption, such gains, in the absence of