Economics HSC topic 3 – Economic Issues

Economic growth

 Economic growth involves an increase in the volume of goods and services that an economy
produces over time. It is measured by the annual rate of change in real Gross Domestic
Product.

𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 (𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟) − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 (𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟)

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑔𝑟𝑜𝑤𝑡ℎ (%) =
𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 (𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟)

 Aggregate demand refers to the total demand for goods and services within the economy. It
includes consumption (c), investment (I), government spending (G) and net exports (X-M)
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
 Aggregate supply refers to the total capacity of an economy, i.e. the potential output when
all factors of production are fully utilised. This includes consumption (c), savings by
households (S), and taxation by the government (T).
𝑌 =𝐶+𝑆+𝑇
 The economy is in equilibrium when the level of aggregate demand and aggregate supply
(national income) are equal.
𝑆+𝑇+𝑀 =𝐼+𝐺+𝑋
𝐿𝑒𝑎𝑘𝑎𝑔𝑒𝑠 = 𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠
 The simple multiplier is the greater than proportional increase in national income resulting
from an increase in aggregate demand.
1
𝐾 = 𝑀𝑃𝑆 → ∆𝑌 = 𝐾 × ∆𝐴𝐷
For example assume in an economy MPS= 0.2 and there is an increase in investment by
$10,000. This expenditure will provide an income of $2000 saved and $8000 spent again.
From this $8000 spent it will also be partially spent and saved having an obvious increase in
national income greater than the initial $10000.

Effects of economic growth

 Living standards: Increased economic growth  increase in real GDP per capita. With a
greater real age households can enjoy a higher level of disposable income.
 Employment: Economic growth creates jobs and potentially ensures everyone who is willing
and able to work find employment.
 Inflation: Increased economic growth leads to higher prices, larger wage claims inflation
 External Stability: Stronger economic growth associated with increased consumer and
business spending thus increasing levels of imports and worsening CAD
 Income Distribution: Although generally it’s assumed that increased economic growth
contributes to higher wages often benefits are concentrated with shareholders, executives.
 Environmental Stability: Increased economic growth often results in damage to the
environment via pollution, depletion of non-renewable resources and local environments.
Sources of economic growth

 Higher incomes results in greater consumption and this economic growth

 Expectations of future price rises , results in greater consumption and thus economic growth
 Low interest rates encourages spending and thus boosting economic growth
 More equitable distribution of income means larger average propensity to consume
 Decreased cost of capital equipment makes investment more attractive
 Expectations of future business prosperity often increases levels of investment
 Increased government spending and/or reduced taxation
 Overseas prosperity and/or weak exchange rate increases export revenue

Aggregate supply can be increased when a higher level of output can be produced for the same cost:

 Workers acquiring new skills

 The adoption of new technology
 Measures to improve efficiency

A major aim of the government’s economic policy is to sustain a high rate of economic growth to
allow national wealth to grow and individuals to experience a higher standard of living. The use of
macroeconomic policies includes:

 Fiscal Policy involves use of governments budget in areas of expenditure (increased AD and
economic growth) and taxation (decreased AD and reduced economic growth)
 Monetary Policy involves the RBA influencing the level of interest rates in the economy
which in turn influences the level of aggregate demand and the rate of economic growth.

Microeconomic policies aim to increase the economy’s sustainable growth rate by increasing
aggregate supply and reducing constraints such as inflationary and current account problems.

 Investment in workforce skills programs and infrastructure

 Boosting productivity, increasing labour force participation and increase international
competitiveness

Unemployment

Labour force consists of all the employed and unemployed persons in the country at any given time.
Those not included in the labour force are children under age of 15, full time non-working students,
those not willing to seek job and retirees.

Participation Rate refers to the percentage of the working age population that are in the labour
force
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒 𝑝𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 (%) = 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 (15+) × 100

Unemployment refers to a situation where individuals want to work but are unable to find a job.

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑠𝑜𝑛𝑠 𝑢𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑

𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 (%) = × 100
𝑇𝑜𝑡𝑎𝑙 𝑙𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
Problems with the method used to measure unemployment:

 Official statistics do not take into account the number of hours people work. Some
employed people with a limited amount of work and want to work more are known as
“underemployed” and are not evident in unemployment statistics.
 By classifying people as either in the labour force or not in the labour force, official
unemployment statistics do not include people who have not been able to find work and
have left the labour force, known as “hidden unemployed”.

Recent trends in unemployment:

Trends in the Australia’s unemployment rate during the last decade have largely been a result of a
severe economic recession in Australia and the global economy during the early 1990s in
combination with structural and microeconomic reform during the time. Many lost their jobs in
declining industries and were unable to obtain new jobs created in emerging industries due to higher
or different skills required. These peaks in unemployment were however only short term. Following
the recession Australia has experienced a steady long term decline in unemployment levels, falling
to its lowest level in 34 years at 3.9% in 2008. This decline in unemployment has majorly been
accredited to Australia’s strong economic performance as the businesses formed during structural
change continue to grow. Those individuals originally left short term unemployed from the less
efficient businesses continue to adjust to the structural changes, by training in these new skill areas.
However, there have been two minor disruptions in this decline. Firstly, the events of the9/11
terrorist attacks 2001 in the US, sent confidence in the Australian economy plummeting and in turn
lead to employers keeping less staff as a more secure financial stance. Australia has also seen the
global financial crisis in 2008 effect the unemployment rate. Economic conditions were put on
slowdown, reducing the demand for labour and thus increasing unemployment in Australia.
Australia’s strong position and fiscal stance during the GFC enabled a relatively quick recovery,
resuming Australia’s downward unemployment trend.

Types of unemployment:

• Structural Unemployment: Occurs because of changes in the structure and composition of

the economy due to the effects of technology and the demand for certain goods and
services.
• Cyclical Unemployment: Occurs because of a downturn in the level of economic activity.
• Frictional Unemployment: Includes individuals unemployed while changing jobs.
• Seasonal Unemployment: Occurs due to the seasonal nature of some work e.g. fruit pickers
• Hidden Unemployment: Refers to individuals who can be considered unemployed but are
not officially defined as unemployed and thus not reflected in unemployment statistics. This
includes individuals who have been discouraged from seeking work and therefore no longer
actively seeking it.
• Underemployment: Refers to people who work less than full time hours per week but would
like to work longer hours.
• Long Term Unemployment: Includes those who have been unemployment for over 12
months.
• Hard-core Unemployment: Refers to individuals whose personal characteristics make them
unsuitable or unacceptable for employment.
Non-accelerating inflation rate of unemployment (NAIRU): This refers to the level of unemployment
at which there is no cyclical unemployment. The theory states that if unemployment falls below this
level inflation will rise rapidly. Above the NAIRU economic growth creates jobs and reduces cyclical
unemployment, but once this has been removed, firms will raise wages in order to attract workers
causing inflationary pressures without significant reductions in unemployment. However, the NAIRU
can be lowered over the long term through policies tat improve the skills of unemployed people or
address constraints on workers ability to participate in workforce e.g. wheelchair accessibility.

Causes of unemployment:

• The level of economic growth: Low Economic Growth  prevention of employment growth
• Macroeconomic policy stance: Fiscal and Monetary stance
• Constraints on economic growth: Constraints such as inflationary pressures and current
account deficit problems restrict economic growth increasing unemployment.
• Rising Participation Rates: Increased short term unemployment as those individuals
originally not included as unemployed that are now actively seeking work add to the levels
of unemployment.
• Structural change: Loss of employment in less efficient industries in the short term. However
in the long term, growth of more efficient industries provides employment for the labour
market.
• Technological Change: Rapid technological advancements new and improved methods of
production may result in capital being a preferred part of the production process over
labour.
• Productivity: High productivity growth in the short term will increase unemployment
because less labour is required but in the long term may lead to higher economic growth
leading to lower rates of unemployment.
• Inadequate levels of training: Mismatch between skills of unemployed and those demanded
by employers. Skill shortages suggest low levels of education and training systems in place
for these areas of labour.
• Rapid increases in labour costs: Any circumstances such as shortages for skilled labour,
excessive wage demands, increase in award wages and rise in additional costs for employing
labour may lead to wage inflation and in the long term economic downturn decline in the
demand for labour.
• Labour Market too highly regulated (employers become discouraged)

Economic Costs
• Opportunity cost: Resources are not being fully utilised and the economy is operating below
full production capacity. Poor output can lead to lower incomes, expenditure and profits
therefore reducing business growth.
• Lower living standards: Unemployed rely on support payments and don’t contribute to
production process. This leads to those employed and the government needing to fund
greater costs and in turn leads to a reduction in Australia’s living standards.
• Decline in skills: Individuals left unemployed for prolonged periods of time contribute to a
loss of skills amongst workers. Loss of self-esteem preventing future employment
• Costs to government: Lower income levels due to unemployment levels will generate less
revenue and secondly larger payouts are needed to fund the unemployed.
• Lower wage growth: Excess labour supply puts downward pressure on wages.
Social Costs
• Increased inequality: Individuals on lower incomes are majority affected by unemployment.
• Those who suffer from long term unemployment have an increased likelihood of
encountering many social problems such as large levels of debt, family tensions, poor health,
crime, housing problems, hardship and social isolation.
• Unemployment for particular groups: Youth aged 15 - 19, indigenous Australians and
individuals with overseas backgrounds have persistently higher rates of unemployment, indicating
levels of discrimination and unequal employment opportunities.

Policies to reduce unemployment:

• Major strategy is implementation of macroeconomic policy to sustain economic growth and
thus avoiding increases in unemployment
• Microeconomic aims to increase economies efficiency, competitiveness and productivity
• Okun’s Law states that to reduce unemployment, the annual rate of economic growth must
exceed the sum of percentage growth in the productivity plus increases in the size of the
labour force.
• Training programs, wage subsidies, apprenticeships, rewarding work, tougher welfare
regulations

Inflation
Inflation is a sustained increase in the general level of prices in an economy. The best measure of
inflation is the percentage change in the Consumer Price Index (CPI). The CPI summarises the
movement in the prices of a basket of goods and services according to their significance for the
average Australian household.
𝐶𝑃𝐼𝐶𝑌 − 𝐶𝑃𝐼𝑃𝑌
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 (%) = × 100
𝐶𝑃𝐼𝑃𝑌
Headline inflation can be a misleading indicator of ongoing price pressures in the economy because
it includes some goods and services whose price may be highly volatile or may be affected by one-off
factors. The level of underlying inflation however removes theses one-off or volatile price
movements and as a result is less variable than headline inflation.

Recent trends in inflation:

• Before inflationary targeting, quite volatile inflation levels
• Since 1992 RBA targeting inflation between2-3% on average over the economic cycle,
inflation has remained relatively constrained

Causes of inflation:
• Demand-pull inflation- When aggregate demand exceeds the productive capacity prices rise
as consumers compete of limited goods
• Cost-push inflation-Caused by an increase in the costs of the factors of production. When
production costs rise, firms attempt to pass them on to consumers by raising the prices of
their products
• Inflationary Expectations-If individuals expect higher inflation in the future they may
attempt to buy goods and services before price increases, thus driving demand-pull inflation.
• Imported inflation- Causes inflation just as domestic produced goods do. A depreciation of
the Australian dollar will also increase import prices and lead to inflation.

Effects of inflation on economy:

 Distorts economic decision making, reducing consumption and investment
 High economic growth is constrained by inflationary pressures
  Employees seek larger wages in order to compensate for higher prices leading too wage-
price inflationary spiral
 Low-income earners income doesn’t not raise as quickly as prices causing unequal
distribution of income
 Results in contractionary macroeconomic policy reducing economic growth and increasing
unemployment
 Increase price of exports reduces international competitiveness
 Increased consumption on cheap imports worsens CAD
 Attracts financial flows boosting exchange rate

Policies to sustain low inflation:

 Monetary policy since 1993 setting target band of 2-3% inflation on average over the
economic cycle
 Through tightening policy when inflation rises by influencing higher interest rates
 Fiscal policy- if government increases revenue and decreases spending, demand pressures
and thus demand-pull inflation are decreased.
 Microeconomic policies such as reduced protection has lowered price of imports.
 Reforms to labour market attempt to ensure wage increases are linked to productivity
improvements rather than skill shortages
 Government expenditure on infrastructure in coming years necessary to reduce capacity
constrains that increase production costs and contribute to inflation

External Stability

External stability refers to the aim of government economic policy that seeks to promote
sustainability on the external accounts so that Australia can continue to service its financial
obligations to the rest of the world. The components of external stability are maintaining a
sustainable level of net foreign liabilities and current account deficit, as well as avoiding exchange
rate volatility.

 Current account deficit: the best way of assessing external stability is too look at
sustainability of external accounts, in particular CAD. Measuring Australia’s current account
deficit as a percentage of GDP enables trends to be seen over time and allows accurate
comparison between countries.
 Net foreign debt: Total stock of loans owed by Australians to foreigners, minus the total
stock of loans owed by foreigners to Australians. Measuring Australia’s net foreign debt as a
percentage of GDP enables us to track levels of change in it over time and whether it is
getting more difficult for the economy to service the debt. ‘
 Net foreign liabilities: equal to Australia’s financial obligations to the rest of the world minus
the rest of the world’s financial obligations to Australia.
(Net foreign debt + Net foreign equity)
 Terms of trade: Calculating the ratio of the price of exports to the price of imports is often
an important factor contributing to balance on goods and services
 Exchange rate: Volatility in the value of the Australian dollar can affect the balance of
payments by impacting on international competitiveness and the size and servicing costs of
foreign debt.
Since the balance on goods and services is a major contribution to the deficit on the current account,
levels of international competitiveness affects the level of this deficit.
Recent trends:
 Sustained high current account deficit: Although previously blamed on trade problem
relating to BOGs, the CAD is now generally considered to be a structural issue related to net
primary income account, resulting from a savings and investment gap. This is due to small
population on large land with extensive natural resources
 Net foreign liabilities: Australia’s foreign debt as a percentage of GDP along ide net foreign
liabilities has increased dramatically during the period of globalisation but has recently come
to stabilise on a still increasing slope. This reflects rising export revenue, mining profits and
high Australian dollar enabling Australia to service its large foreign borrowings.
 Debt servicing ratio is a figure that indicates the proportion of export revenue that must be
spent on interest payments on foreign debt. A country is better able to service its foreign
debt when it is earning a high level of export revenue
 Since floated exchange rate, experienced high volatility but has generally helped economy.
E.g. depreciation of dollar during crises improved competitiveness and appreciation of dollar
due to resources boom cushions Australia from inflationary impact of soaring prices.

Effects of increasing CAD are increasing level of foreign debt and the government trying to lower
level of economic activity. There are however opposing views on the effects of increasing foreign
debt:

 Debt servicing, debt trap scenario, increased vulnerability to external shocks

 Development opportunities, investment, private companies make up majority of external
debt

Policies to improve external stability:

The government may use microeconomic policy to improve the balance on goods and services.
Reductions in protection force inefficient import-competing firms to restructure or close, which
frees up resources which can be used in more efficient areas of the economy. Whilst this may
worsen the current account balance in the short term, in the long term, resources will flow to areas
in which Australia has a comparative advantage, raising the level of exports and improving the
current account balance. The government may use fiscal policy to raise the level of national savings
and reduce Australia’s reliance on overseas financing for investment. The policy of fiscal
consolidation (running balanced or surplus budgets on average over the economic cycle) would
reduce the government’s drain on national savings. The policy of compulsory superannuation also
raises the level of private savings in the economy. This should reduce overseas borrowing, slowing
the growth of foreign liabilities and reducing the net primary income deficit.

Distribution of income and wealth

Income inequality refers to the degree to which income is unevenly

distributed among people in the economy. The Lorenz curve is a
graphical representation of income distribution, plotting the
cumulative increase in population against the cumulative increase in
income. The Gini coefficient is a single statistic that summarises the
distribution of income across the population. It is calculated as the
ratio of the area between the actual Lorenz curve and the line of
inequality (A) and the total area under the line of equality (A+B).
 𝐴
𝐺𝑖𝑛𝑖 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 =
𝐴+𝐵

The coefficient ranges between zero when all incomes are equal and one when a single household
receives all the income.

Sources of income:

 Wages from sale of labour make up the main source of income at about 60%
 Rent from land 10%
 Earnings from capital such as superannuation or income from shares. Profit from sale of
entrepreneurial skills 20%

Transfer payments such as social security or welfare 10% (Transfer payments are payments made by
the government to assist people with basic costs of living)

Sources of wealth:

 Property
 Superannuation

Trends in the distribution of income and wealth:

 Gender-Although the relative wage of females to males is becoming more equal, on average
women earn a lower income indicating discrimination.
 Age-Incomes low in early years of lime due to lack of experience, less education and training.
This is also the case for older people whose income decline as employees seek new staff and
individuals move to rely on pension.
 Occupation-Jobs that require higher levels of education, training and experience such as
executive positions enjoy higher incomes than those that do not.
 Ethnic background-In general, those born overseas tend to receive greater incomes from
English speaking countries while those from non-English speaking countries receive
significantly lower income levels reflecting insufficient ability to work in many jobs that
require communication.
 Family structure-Couples with no children earn the greatest, while with children earn less.
Single persons earn less than couples but earn more than single parents

Benefits of inequality:

 Encourages education and training

 Encourages the workforce to work longer and harder
 Makes workforce more mobile
 Encourages entrepreneurs to accept risks more readily
 Creates potential for higher savings and capital formation
Costs of inequality:

 Reduces overall utility

 Can reduce economic growth
 Creates conspicuous consumption
 Creates poverty and social problems-reducing participation and skills of labour force
 Increases the cost of welfare
 Social class divisions (social)
 Increased poverty (social)

Policies to manage inequality:

Fiscal policy is used to improve the distribution of income and wealth. The progressive income tax
system and welfare system aim to redistribute income from higher income earners to lower income
earners, thus reducing income inequality. Also, the government policy of compulsory
superannuation reduces wealth inequality by encouraging low income earners to save for
retirement. Monetary policy has a temporary impact upon the distribution of income. For example,
expansionary monetary policy tends to improve the distribution of income. Lower income earners
tend to be borrowers who pay interest and high income earners tend to be savers who receive
interest, so lower interest rates would redistribute income from high income earners to low income
earners. Finally, microeconomic policy tends to worsen the distribution of income in the short run,
as structural change often leads to structural unemployment, often amongst low income earners.

Environmental Sustainability

Ecologically sustainable development involves conserving and enhancing the community’s resources
so that ecological processes and quality of life are maintained. It is a level of economic activity which
is compatible with the long term preservation of the environment, rather than merely the maximum
level of growth possible in the short term.

Private costs includes the costs to producers that must be paid for in the production process

Social costs are additional costs impacting on society created by the production process but are not
paid for by the producer e.g. pollution

Externalities are positive and negative outcomes of an economic activity whose cost is not reflected
in the operation of the price mechanism.

Market Failure occurs when the price mechanism takes into account private benefits and costs of
production, but fails to take into account indirect social costs.

Public goods are:

 non-excludable(cannot exclude consumers from enjoying benefit of that good)

 non-rival (consumption of good does not reduce quantity of the good available for other
consumers)

Private goods have the opposite characteristics of a public good

Free rider refers to groups or individuals who benefit from a good or service without contributing to
the cost of supplying. This has the effect of private markets either not providing or under-providing
public goods, since private firms would not be able to charge consumers for enjoying the benefit of
that good.

Merit goods are goods and services that provide positive externalities.

Tragedy of the commons refers to a situation where the failure of the market to assign costs to
individuals leads to an overuse of resources such as the natural environment, which has no single
owner.

Major environmental issues:

 Preserving natural environments: In the long run the economy cannot continue growing i f
the environment is degraded. Environmental damage affects human health through higher
levels of air and water pollution, and restricts the availability of resources. Thus we must
take aim to take active measures which preserve the environment, avoiding the social an
economic problems associated with its degradation.
 Climate Change: The emission for carbon dioxide gas produced in the burning of fossil fuels
is known to be a major contribution to climate change. Because of the world wides reliance
on fossil fuels, there is a link between economic growth and increased carbon emissions. If
this issue is not properly addressed it global warming could have severe effects on the world
including extreme, unpredictable weather, increased skin cancer rates and flooding.
 Depletion of natural resources: Renewable resources can naturally regenerate themselves in
a relatively short period of time making them an important resource for solving the
economic vs environmental problem. Non-renewable resources are those natural resources
that are limited in supply because the can only be replenished over a long period of time or
not at all e.g. fossil fuels

Policies to achieve environmental sustainability:

The government can correct market failure by banning the production of a product with high social
costs, for example – banning leaded petrol. The government could also impose a tax on the product
to include an approximation of the social costs on top of the private costs of the product, thereby
discouraging use and ‘internalising the externalities’. An example of this would be the government
imposing a tax on cigarettes. The government could also subsidise products which have social
benefits which are not taken into account by the price mechanism, thereby reducing their price and
increasing their quantity, such as through providing grants to assist the development of ‘green’
industries. The government may also directly provide goods that the private sector may be unwilling
to provide, such as a public transport system or public hospitals.