Answer the following question ensuring that you apply economic principles or theory related to understanding the health of the economy and the need for government intervention to inform your analysis and support your decisions. Communicate your ideas with correct grammar, spelling and writing style and support your answer with diagrams and examples as necessary.
Using appropriate diagrams, explain the likely impact of drought on macroeconomic equilibrium in Australia. Use evidence drawn from media reports to illustrate you answer. How might government policy response to the drought modify the macroeconomic impact of the drought?
This assessment task will assess the following learning outcome/s:
Lack of rainfall is one of the biggest threat for the agricultural sector. The phenomenon of below average rainfall for a considerably long period is called drought. This a natural disaster having a negative effect on people, business and the society. The intensity of impact of drought depends on severity of drought. Based on the severity of drought the effect might be either local or economy wide (Kiem & Austin, 2013) Objective of this essay is to evaluate impact of drought on Australian economy. Additionally, the paper also examines the likely impact on government policy intervention on economic outcome during drought.
Aggregate demand and aggregate supply model
The two forces determining macroeconomic equilibrium an economy are aggregate demand and aggregate supply. Aggregate demand is the sum of demand of all the produced final product and services in the economy. It is represented as a sum of expenditure on consumption, investment, government spending and net export. Aggregate supply represents the availability of total product and services in an economy (Heijdra, 2017). The economy attains a stable equilibrium where the aggregate demand is same as aggregate supply. The macroeconomic equilibrium determines real GDP and price level of the economy. The aggregate demand and aggregate supply model of macroeconomic equilibrium is described in the following figure.
Figure 1: Macroeconomic equilibrium
Figure 1 portraits macroeconomic equilibrium with the aid of aggregate demand and aggregate supply. AD1 shows the aggregate demand curve and SRAS shows the short run aggregate supply curve. LRAS is the long run aggregate supply curve (Mankiw, 2014) The interaction of aggregate demand and aggregate supply attains equilibrium corresponding to the point E. At the equilibrium point, price level is P* and GDP is Y*.
An economy is in equilibrium unless some external forces changes either aggregate demand or aggregate supply. Sudden shocks causes demand or supply to change shifting the economic equilibrium. Natural calamities like drought destroy economic resources and hamper production. The sector most vulnerable to drought is the agricultural sector. A certain amount of rainfall is required to complete a crop cycle. Lack of sufficient amount of water damages crops and reduces productivity. As agricultural output constitutes part of the aggregate output, there is a significance contractionary impact on aggregate supply. Not only output of agricultural sector but also output of other sectors get hampered due to drought. One such example is production of energy. The dry condition hampers production of both hydroelectric and thermal energy. Lack of energy again reduces productivity of sectors highly dependent on energy sector. Australian economy thus likely to experience an overall negative supply shock due to drought. As aggregate supply contracts, the supply curve goes inward causing national output to decline. Because of an economy wide shortage, there is an upward pressure on price level.
Figure 2: Adjustment to macroeconomic equilibrium after drought
The negative supply shock causes an inward shift of the aggregate supply curve inward to SRAS1 (Argy, 2013) Consequently, the equilibrium shifts upward along the aggregate demand curve to E1. Corresponding to the new equilibrium, GDP falls to Y1 and price level increases to P1.
The Australian economy already faced such consequences of drought. In the year 2002, Australia suffered a drought. The drought severely affected different states and territories of Australia. The economy experienced a deficiency of rainfall for a prolonged period of 11 months. Due to drought, there is a significant decline in grain production in the affected areas. Gross Domestic Product in the agricultural sector fell by 24.3 percent. The decline in domestic production causes a significant decline in agricultural export resulting in a decline in rural income (Qureshi, Hanjra & Ward, 2013). Along with this direct and indirect employment related to agricultural sector contracted by a significant extent. The resulted decline in food production following drought led to an increases in food price which has a significant influence on overall consumer price index. The food prices during this time rose by approximately 4.5 percent. Reserve Bank of Australia estimated that the ongoing drought in Australia, would hamper the economic growth largely costing the economy approximately $12 billion (sbs.com.au., 2018) The Governor of Reserve Bank expressed the concern for an extended drought in terms of significant impact on economic growth and prices of food. The worst effect of drought has been realized by farmer living in states like NSW, northern Victoria and southern Queensland.
In order to overcome economic contraction government intervention is necessary to support the farmers and other affected sectors. The drought policies in Australia have been evolved gradually (Bennett, 2019) The twentieth century came with a significant expansion of irrigation and interior that is drought-proof. During 1970, government introduced a scheme of financial assistance to farmers in times of drought by the policy known as “National Disaster Relief and Recovery Arrangement”. In order to extend help to the farmers, a new scheme named “National Drought Policy” was introduced. The Farm Management Deposit scheme aims to offer farmers loans at a subsidized rate. Increase in government spending to support the drought –stricken economy in forms of resilience packages is a part of expansionary fiscal policy (Kendall, 2013) Expansionary fiscal policy in the economy targets to expands economic activity by stimulating aggregate demand. Government spending being an important component of aggregate demand, an increase in government expenditure leads to an aggregate demand. The expansion of demand in the economy helps to recover real GDP and price level. The potential impact of government policy intervention is shown below.
Figure 3: Impact of government intervention on economic outcome
Drought is a natural disaster affecting the overall economy and life of people. In context of macroeconomic equilibrium, drought brings a negative supply shock to the economy. With a decline in production in agriculture and other sectors of the economy the aggregate output contracts. Shortage in aggregate supply, pushes up price level with major contribution coming from an increase in food price. Australia had already experienced such economic contraction during the drought of 2002-03. The ongoing drought is likely to cost nearly $12 billion to the economy. Government intervention in forms of different drought resilience policies aim to help farmer and recover economic output.
Argy, V. (2013). International macroeconomics: theory and policy. Routledge.
Bennett, E. (2019). Policy and politicians are failing our environment and our future. Retrieved from https://www.smh.com.au/environment/conservation/policy-and-politicians-are-failing-our-environment-and-our-future-20190111-p50qt8.html
Heijdra, B. J. (2017). Foundations of modern macroeconomics. Oxford university press.
Kendall, M. (2013). Drought and its role in shaping water policy in Australia. In Drought in Arid and Semi-Arid Regions(pp. 451-467). Springer, Dordrecht.
Kiem, A. S., & Austin, E. K. (2013). Drought and the future of rural communities: opportunities and challenges for climate change adaptation in regional Victoria, Australia. Global Environmental Change, 23(5), 1307-1316.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.
Qureshi, M. E., Hanjra, M. A., & Ward, J. (2013). Impact of water scarcity in Australia on global food security in an era of climate change. Food Policy, 38, 136-145.
sbs.com.au. (2018). Drought could cost economy up to $12b. Retrieved from https://www.sbs.com.au/news/drought-could-cost-economy-up-to-12b
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