Trade Off Between Unemployment And Inflation In Australia Impacts Aggregate Demand And Supply Model.

1). Using data from the Australian Bureau of Statistics (ABS)  http://www.abs.gov.au/ collect information on unemployment and inflation rates for Australia over the period 2001 to 2016, inclusive. Employ annual data. Be explicit and define and provide sources for the data obtained.

Plot on a single diagram the relationship between inflation and unemployment, measuring inflation on the vertical axis and unemployment on the horizontal axis. Comment on whether any relationship exists between these variables and any implications of your findings.

2). Employ the aggregate demand and supply model for the Australian economy, to analyse the consequences for real GDP and the general price level of the following scenarios. Confine your analysis to the use of short-run AD/AS curves. In your response clearly state your assumptions and illustrate your answers with diagrams.

(a) India has placed a 30% tariff on chickpea exports from Australia,
(b) The demand for Australian wine in China has substantially increased,
(c) The federal government plans to spend approximately $5 billion on Snowy Hydro 2.0 to generate more electricity power capacity,
(d) The price of oil, a product Australia primarily imports, fall substantially,
(e) An increase in the immigration intake substantially increases the Australian labour force.

Trade-off between unemployment and inflation

1). Among various indicators of macroeconomic performance of a nation unemployment and inflation are the two vital indicators. One indicates the movement of price level and hence, associated with cost of living. Other is an indicator of performance of labor market. Inflation is the measure of percentage increase in the prevailing price level. Both demand and supply side factors are responsible in the movement of price level. Inflation resulted from demand side pressure is known as demand-pull inflation while inflation from increased product cost or supply side shortage is termed as cost-push inflation (Coibion & Gorodnichenko, 2015). In general, there can be observed an association between inflation and unemployment. Inflation and unemployment is often found to move in opposite direction. The trade-off between unemployment and inflation is theoretically modeled with Phillips curve.

In case of Australia Reserve Bank of Australia aims to keep the inflation rate at a targeted level of 2%. The Australian government is also concerned about prevailing unemployment and takes measures to maintain unemployment rate as low as possible. The figure below represents trend in inflation in unemployment rate of Australia for a considerable long period ranging from 2001 to 2016.

                                                            Figure 1: Relation between inflation and unemployment

                                                                                   (Source: abs.gov.au, 2018)

Scatter plot is the most convenient way to graphically explore the relationship between two variables. In the above figure inflation is measured on the vertical axis and the horizontal axis measures unemployment. The points are though highly scattered between range of inflation and unemployment there is in general a negative trend relation between the two indicators. The coefficient of unemployment in the fitted trend equation is obtained as -0.15. This has the implication that with 1 percent fall in unemployment, inflation will increase by 0.15 percent. Therefore, measures taken to reduce unemployment comes with the consequence of some increase in the price level (Owyang, 2015).

Phillips curve

This trade-off between unemployment and inflation can be explained with the help of Phillips curve. Economist A.W. Phillips first tested the relation between unemployment and inflation using the data of United Kingdom for a period extending from 1861 to 1957. The study found that inflation can possibly explained with movement of unemployment level and change in the unemployment rate. The result of the Phillip’s study can be summarized by a simple hypothesis that inflation increases with a fall in unemployment rate and vice-versa. A low unemployment means there is high demand for labor. High demand for labor creates an upward pressure on wages. Labor being one of the crucial factor in production, the rise in cost of wages lead to an increase price of final goods and services (Kumar & Orrenius, 2016). The high unemployment on the other hand signifies low demand for labor. This by reducing wages reduces cost of production and consequently there is a fall in price level and inflation. In Australia a fall in unemployment rate does not increases inflation as RBA always stands to keep the inflation within its targeted level.  

2). a

Real GDP and general price level in an economy is determined from the aggregate demand and aggregate supply model. consumption, investment, government spending and new export are the four important components of aggregate demand, Change in these components lead to a change in aggregate demand. Changing condition in the factor market influence aggregate supply. In the short run the aggregate demand curve slopes downward while aggregate supply curve sloped upward (Baumol & Blinder, 2016).  A tariff imposition by India on Australia chickpea export has the consequence of raising the import cost of Australian chickpeas in India. The increased import prices reduce the demand for chickpea import in India which is reflected in a decline in chickpea export from Australia. Consequently, net export that export less import declines causing aggregate demand (AD) to fall. As shown in figure 2, under this circumstances AD shifts inwards reducing both price level and real GDP.

                                                                                 Figure 2: Impact of import tariff in AD-AS model

Impact of key factors on Aggregate Demand and Aggregate Supply Model

                                                                                          (Source: as created by Author)

b). An increase in demand for Australian wine in China market increases export of wine from Australia to China. The external demand of wine increases aggregate demand in Australia through an increase in trade balance (Maurice & Thomas, 2015).  As net export increases the aggregate demand curve shifts to the right. The scenario can be modeled with help of the following figure

                                                                                    Figure 3: Impact of increase in Wine demand

                                                                                            (Source: as created by Author)

E₁ denotes the stable macroeconomic equilibrium obtained from the point where aggregate demand and aggregate supply meets. An increase in net export because of China’s demand for Australian wine moves the aggregate demand curve outward to AD₂. At the new equilibrium, real GDP increases along with an increase in price level.

c).Government spending is one major component of aggregate demand. An increase in government spending has a positive contribution on aggregate demand. The economic expansion through increase in government spending increases output and price level (De Vroey, 2016). The plan of Federal government to invest $5 billion in Snowy Hydro 2.0 to expand to generate more electricity power capacity thus increases aggregate demand through increases in public spending or investment. The resulted increase in aggregate demand makes a parallel shift in aggregate demand to the right. The economy now reaches to a new equilibrium at a higher price and output level.

Government spending

                                                                              Figure 4: Impact of increase in government spending

                                                                                            (Source: as created by Author)

d). Oil is used as one primary input in many industries. A fall in price of oil reduces the overall import cost of Australia. Given the imported oil demand, a fall in price positively influences trade balance with an increase in aggregate demand. The industries using oil as a primary input now faces a lower price of oil and hence a lower cost of production. The fall in oil price thus increases aggregate supply through output expansion by business. The simultaneous change in aggregate demand and aggregate supply though have a clear impact of raising real GDP but the impact on price level remain indeterminate (Sadat, 2017). It depends on the assumption about magnitude of change in aggregate demand and aggregate supply.

                                                                                      Figure 5: AS changes more than AD

                                                                                             (Source: as created by Author)

                                                                                           Figure 6: AS changes less than AD

Net exports

                                                                                              (Source: as created by Author)

                                                                           Figure 7: Equal proportionate change in AD and AS

                                                                                           (Source: as created by Author)

e). The immigrant labor force when added with domestic labor force increases the supply of labor in the economy. The excess supply of labor reduces equilibrium wage in the labor market. As the cost of production reduces along with an increased supply of labors aggregate supply in the economy increases (Baumol & Blinder, 2016). The increase in aggregate supply is shown from the rightward shift of the aggregate supply curve to AS1. At new equilibrium the economy achieves a higher real GDP corresponding to a lower level of price.

                                                                                            Figure 8: Impact of immigration

                                                                                             (Source: as created by Author)

References: 

6202.0 - Labour Force, Australia, Mar 2018. (2018). Retrieved from https://www.abs.gov.au/ausstats/[email protected]/mf/6202.0?opendocument&ref=HPKI

Baumol, W. J., & Blinder, A. S. (2016). Principles of Macroeconomics. Cengage Learning.

Coibion, O., & Gorodnichenko, Y. (2015). Is the Phillips curve alive and well after all? Inflation expectations and the missing disinflation. American Economic Journal: Macroeconomics, 7(1), 197-232.

De Vroey, M. (2016). A history of macroeconomics from Keynes to Lucas and beyond. Cambridge University Press.

Kumar, A., & Orrenius, P. M. (2016). A closer look at the Phillips curve using state-level data. Journal of Macroeconomics, 47, 84-102.

Maurice, S. C., & Thomas, C. (2015). Managerial Economics. McGraw-Hill Higher Education.

Owyang, M. (2015). Has the Phillips Curve Relationship Broken Down. St. Louis Fed On the Economy.

Sadat, S. D. (2017). Rethinking Macroeconomics: An Introduction. International Journal of Economics, Management and Accounting, 25(3), 635-639.