TOPIC

4UNIT 2 AREA OF STUDY 1

Economic activity
Economic activity

OUTCOME 1
On completion of this unit the student should be able to explain the purpose of economic activity,
the distinction between material and non-material living standards and the factors that may affect
levels of economic activity and growth, discuss the costs and benefits of economic growth and
examine the impact of economic activity on living standards using alternative measures.

LEARNING SEQUENCE

4.1 Overview ...............................................................................................................................................................200

4.2 The nature and purpose of economic activity ....................................................................................... 202
4.3 The meaning of material and non-material living standards ............................................................ 205
4.4 The five-sector circular flow model ............................................................................................................ 209
4.5 The business cycle ........................................................................................................................................... 216
4.6 Types of economic indicators ...................................................................................................................... 218
4.7 The relationship between the business cycle and economic indicators ..................................... 221
4.8 BACKGROUND KNOWLEDGE: Overview of factors that may affect Australia’s level
of economic activity ......................................................................................................................................... 223
4.9 Aggregate demand — its meaning, importance and factors affecting its level and
economic activity .............................................................................................................................................. 226
4.10 Aggregate supply — its meaning, importance and factors affecting its level and
economic activity .............................................................................................................................................. 234
4.11 The measurement of economic growth using changes in Gross Domestic Product (GDP) 241
4.12 The potential benefits of economic growth ............................................................................................ 244
4.13 The potential costs of economic growth ................................................................................................. 250
4.14 The limitations associated with using real GDP and real GDP per capita to measure
changes in living standards ...........................................................................................................................258
4.15 Alternative measures of economic activity and living standards ....................................................262
4.16 Review ................................................................................................................................................................... 269
4.1 Overview
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4.1.1 Introduction
In Economics Unit 1, we investigated microeconomics and the operation of individual markets, and the
behaviour of consumers, businesses and governments as economic agents making decisions within those
markets. Now it’s time for some macroeconomics where we look at the bigger picture of the whole economy
that reflects the collective impact of decisions made across the hundreds or individual markets.
Our studies will start with a look economic activity, and the main drivers that influence levels of national
spending, production, employment, and incomes, and see how these factors greatly influence material and non-
material living standards. We will especially focus on economic growth — its measurement and determinants,
and its impacts — both good and bad on our general wellbeing.
Along the way, you will develop important economic skills including the use of models and be able to collect
and analyse data.

200 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.1.2 What you will learn
Key knowledge
Use each of the points from the VCE Economics Study Design below as a heading in your summary notes.
Key knowledge Subtopic

The purpose of economic activity 4.2

The meaning of material and non-material living standards 4.3
The five-sector circular flow model of the economy 4.4
The business cycle 4.5
Types of economic indicators, such as leading, lagging and coincident 4.6
The relationship between the business cycle and economic indicators 4.7
The meaning and importance of aggregate demand and its components 4.9
The factors that may affect the level of aggregate demand and the level of economic activity 4.9
The meaning and importance of aggregate supply 4.10
The factors that may affect the level of aggregate supply and the level of economic activity 4.10
The measurement of economic growth using changes in real Gross Domestic Product (GDP) 4.11
The potential benefits of economic growth, such as growth in material living standards, 4.12
improved non-material living standards, employment opportunities and economic
development
The potential costs of economic growth, including boom and bust economic cycles, 4.13
congestion and pollution, environmental damage, potentially widening inequality and
‘affluenza’
The limitations associated with using real GDP and real GDP per capita to measure changes 4.14
in living standards
Alternative measures of economic activity and living standards 4.15

Key skills
These are the skills you need to demonstrate.
Key skills

Define key economics concepts and terms and use them appropriately
Construct and interpret economic models including the business cycle and the five-sector circular flow
model of the economy
Gather, synthesise and use economic data and information from a wide range of sources to analyse
economic issues
Identify trends, patterns, similarities and differences in economic data and other information
Discuss the potential costs and benefits associated with increasing economic activity

Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Resources
Resourceseses
Digital document Key terms glossary (doc-37948)

TOPIC 4 Economic activity 201

4.2 The nature and purpose of economic activity
KEY KNOWLEDGE
• The purpose of economic activity
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

In each economy, lots of people are involved in producing and selling goods and services that we need in order
to help satisfy our many needs and wants. We call this production process, economic activity.

4.2.1 Definition of economic activity

Economic activity is simply a term used to describe the
process of making or selling goods and services. Each
day, most of us perform two main types of activities,
but for measurement purposes, only some are classed as
economic:
• Economic activities: With the odd exception,
economic activities are those that use scarce
resources to produce and sell goods and services in
exchange for money, to earn income and to make
a living. At the national level, activity involves the
output of primary (rural and mining), secondary
(manufacturing), and tertiary (services) industries.
So, a farmer producing wheat, a teacher taking a
class, a plumber fixing a tap, a doctor operating
on a patient, a check-out person in a supermarket,
a council employee collecting waste, a builder
constructing a house, or the CEO of a company
like Qantas or BHP making decisions — all are
performing economic activities because they are
producing and selling goods and services that are
exchanged for money or income.
• Non-economic activities: In contrast, non-economic
activities are generally not sold for money but are
done for emotional reasons, concern for others, or on
a volunteer basis. Here we might think about cutting
the lawns at home, painting the house, donating
blood at the Red Cross, cleaning up your bedroom, looking after your younger brother, volunteering for the
Salvation Army’s door knock collection, playing basketball for your local team, helping a friend with their
homework or cooking the evening meal. These are classified as non-economic activities, partly because
they are often done to help others and are not designed to earn money. Of course, had you received money
for doing the lawns or tutoring your friend, these non-economic activities might then be seen as economic
in nature.
As we shall detail later, Gross domestic Product (GDP) is a commonly used measure of the total value of a
nation’s output of finished goods and services resulting from all types of economic activities. It is measured over
either a 3-month or 1-year period. As such, GDP excludes the sort of non-economic activities just mentioned,
even though both types of activity can impact our overall living standards. In addition, while some things like
the sale of illegal drugs, crime money, selling on the black market, and undeclared work done for cash, all
represent economic activities and involve the payment of incomes, they are not included in the official GDP data,
because their value is usually unknown.

202 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.2.2 The purpose of economic activity
From our earlier studies, we realise that people (individuals, families, businesses, and governments) have almost
infinite wants, but unfortunately, the resources available to satisfy these wants are relatively limited. This gives
rise to the basic economic problem of relative scarcity. Scarcity forces us to make choices between alternative
uses for our natural, labour and capital resources. Despite our best efforts to use these resources efficiently,
not all wants can be satisfied. There are not enough resources to go round, and this limits the level of economic
activity or production. So, the main purpose of economic activity is to use our available resources efficiently to
produce and sell those goods and services that best help to maximise the general satisfaction of society’s wants
and wellbeing.
In Australia’s predominantly market economy involving the operation of the price system, consumers largely
direct resources into economic activities that are most valued or wanted. In other words, different types of
economic activity or production allow people to earn income that can then be used to help satisfy their many
needs and wants through the consumption of goods and services. This has an important influence on Australian
living standards. Consumption (influencing living standards) is the ultimate purpose or goal of economic
activity. So, up to a point, higher levels of economic activity (production) can allow for higher consumption,
improving most (but not all) aspects of living standards. In contrast, lower levels of economic activity restrict
our incomes and consumption, and can have mostly negative effects on living standards.

FIGURE 4.1 The end purpose of economic activity is to use the incomes generated to help satisfy our needs and
wants through the consumption of goods and services.

1. Economic
activity =
the production and
selling of goods and
services

The purpose
and role of
economic
activity in a
simple economy
3. Consumption = 2. Income =
using income for the reward for
spending on goods producing and selling
and services to help goods and services
satisfy people’s needs and undertaking
and wants economic activities

TOPIC 4 Economic activity 203

4.2 Activities
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4.2 Quick quiz 4.2 Exercise

4.2 Exercise
1. Define the term, economic activity. (1 mark)
2. Examine the figure below. List six economic activities represented in the image. (3 marks)

3. Distinguish economic activity from non-economic activity. (2 marks)

4. Examine the table below. Briefly outlining your reasons, classify each item as to whether it is an economic
activity or a non-economic activity. (5 marks)

204 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Item Classification and reasons
a. You have a job at McDonalds on Saturdays

b. A farmer sells 300 sheep to another farmer in NSW

c. You attend a day event run by Clean Up Australia

Limited

d. Cathy spends 3 hours a day looking after her

mother

e. After John hurt his wrist playing footy, he saw his

doctor and had an x-ray

5. a. Name the measure used by a country to estimate its overall level of economic activity. (1 mark)
b. Outline why it is not possible to accurately measure the total value of all economic activity in a country over
a period. (1 mark)
6. a. Explain the end or ultimate purpose of economic activity. (2 marks)
b. Outline the links between the level of economic activity and material living standards. (2 marks)

Solutions and sample responses are available online.

4.3 The meaning of material and non-material living

standards
KEY KNOWLEDGE
• The meaning of material and non-material living standards
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

4.3.1 Definition and nature of living standards

In all economies, the main purpose of economic activity is to help satisfy society’s needs and unlimited wants
using the limited resources available. The extent to which this satisfaction is successful will have a direct impact
on Australian living standards.
Living standards relate to our general level of wellbeing. As shown in Figure 4.2, there are two main elements
that affect our general or overall living standards:
• Material living standards are affected by the annual average level of income and consumption per person
per year.
• Non-material living standards reflect the quality of daily life.

TOPIC 4 Economic activity 205

 FIGURE 4.2 Factors influencing our overall living standards and our general wellbeing

Overall living standards

Material living standards reflect . . . Non-material living standards reflect . . .

• Income per person The quality of daily life

• Level of consumption of goods and services • Happiness
per person • Life expectancy
• The purchasing power of incomes. • Mental and physical health
• Freedom
• The state of the environment
• Leisure time
• Crime rates
• Literacy rates
• Quality of relationships

FIGURE 4.3 Internationally, every country faces decisions about how to use scarce resources in order to produce
goods, services and incomes. In Malaysia, Borneo rainforests are being cleared to make way for palm oil
plantations. Are there benefits to having a strong economy if it is destroying its environmental base, threatening
future living standards?

206 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.3.2 How changes in the level of economic activity can affect
living standards
As mentioned, changes in the level of economic activity can have both positive and negative effects on living
standards. Sometimes, there are trade-offs (costs or the things we would need to give up when we decide
to use resources in a particular way). For example, more economic activity might improve material living
standards, but at the expense of some aspects of non-material wellbeing. In reverse, lower economic activity
will undermine material living standards although in some ways, non-material, environmental outcomes may
be better.
The effects increased economic activity on living standards
• The effect on material living standards: Up to a point, when the pace of economic activity gets stronger,
this tends to lift material living standards. This is because higher production generally results in increased
jobs and incomes, boosting consumption spending. Of course, if economic activity becomes too strong, this
can cause prices to rise reducing the purchasing power of incomes.
• The effect on non-material living standards: Most (but not all) aspects of non-material welfare,
also benefit from higher levels of economic activity. For example, when production is expanding, and
employment and incomes rise, this helps to reduce stress and social isolation, strengthen people’s mental
and physical health, and improve the quality of relationships. Even so, environmental outcomes are
likely to suffer because of increased pollution, accelerated climate change, and the faster depletion of
non-renewable natural resources.
The effects of decreased economic activity on living standards
• The effect on material living standards: When economic activity falls, this undermines material living
standards because of lower employment, incomes, and consumption.
• The effect on non-material living standards: Lower economic activity that causes higher unemployment
and reduced incomes, tends to undermine the quality of life and most aspects of non-material living
standards. One problem is that if activity is lower and more people are unemployed, this often leads to
social isolation, reduced mental and physical health, unhappiness, possibly higher crime rate, increased
stress, and negative feelings of personal failure. However, a possible upside of lower economic activity is
that there is less pollution and pressure on the environment—things that are beneficial for our wellbeing.

TOPIC 4 Economic activity 207

4.3 Activities
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4.3 Quick quiz 4.3 Exercise

4.3 Exercise
1. Define the term, standard of living. (2 marks)
2. Relatively, Australia has a high standard of living. Explain exactly what this means, referring to various
indicators. (2 marks)
3. Examine the table below. Classify each item as to whether it is something that is likely to increase
or decrease material living standards and/or non-material living standards. Briefly explain your
reasons. (6 marks)

Item Classification of the impact and your reason

a. There was a rise in Australia’s average life
expectancy
b. Average incomes fell during the COVID-19
pandemic
c. Australia’s CO2 emissions fell
d. For your job on weekends, you were paid
$1500 for the year

e. Literacy rates have increased, and crime

rates decreased
f. Julia loses her full-time job at the pizza shop

4. Australia experienced a recession in the first half of 2020. Giving reasons, explain how this would be likely to
affect:
a. Material living standards (2 marks)
b. Non-material living standards. (2 marks)

Solutions and sample responses are available online.

208 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.4 The five-sector circular flow model
KEY KNOWLEDGE
• The five-sector circular flow model of the economy
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

We have recently learnt that people are involved with economic activities so they can earn income, allowing
them to consume goods and services. In turn, this means that they can usually satisfy their most pressing needs
and wants, and enjoy reasonable living standards. To better understand this process, economists use models or
diagrams representing how the economy works and economic activity occurs. In Chapter 1, we introduced a very
basic three-sector circular flow model. This is again shown in Figure 4.4.

FIGURE 4.4 The simple three-sector circular flow model representing Australia’s mixed economy.

Flow 4 = the nation’s flow of finished goods and services produced

Flow 2 = the nation’s flow of all incomes paid

Producer/
Consumer/
business/
household sector
private sector
Flow 1 = the nation’s flow of resources
Flow 3 = the nation’s
flow of total spending
on goods and services
Consumer spending (C) on goods and services

Government/
Government tax (T) public sector Government spending
revenue flows in = a (G) flows out = an
leakage from spending injection of spending

However, while useful, the three-sector model has limitations. It is not all that realistic because it doesn’t allow
for the saving of some household income and international trade between nations, both of which impact the level
of economic activity, employment, incomes and living standards.
To help reduce these shortcomings and better understand the drivers of economic activity, let’s now look at the
improved five-sector circular flow model. It simply builds onto the basic three-sector model by adding two
additional sectors — the financial sector and the international trade or overseas sector.

4.4.1 The five-sector circular flow model of an economy

As evident from Figure 4.5, notice that although this model has two main sectors (the household and business
sectors), along with three lesser sectors (the financial, government and overseas sectors), making five in total.

The consumer or household sector

This consumer or household sector includes around 26 million consumers or spenders, making up Australia’s
entire population. Everyone in the country belongs to this sector. Apart from making decisions about spending,
some households also supply or sell resources to the business sector.
TOPIC 4 Economic activity 209
 FIGURE 4.5 The five-sector circular flow model showing the basic working of the Australian economy

Flow 4: Flow of final goods and services supplied or produced (i.e. GDP)

Flow 2: Flow of incomes to owners selling resources

Household or A MACROECONOMIC CIRCULAR FLOW MODEL Business or producer

consumer sector OF THE AUSTRALIAN ECONOMY sector

Flow 1: Flow of productive natural, capital and labour resources supplied

on Australian production = aggregate

Flow of private consumption spending on final goods and services (C)

Flow 3: Flow of total spending

demand = C + I + G + X – M
Savings Investment
Financial sector spending
(S)
(I)
Income dispensed as ...

Taxes Government
Government sector spending
(T)
(G)

Import Export
spending Overseas sector spending
(M) (X)

Three leakages from Three injections into

domestic spending = S + T + M domestic spending = I + G + X
(these slow AD) (these boost AD)

The producer or business sector

The producer or business sector consists of over 2.2 million trading enterprises (e.g. sole traders, partnerships,
public companies). They supply or sell finished goods or services, using resources purchased from households.
Businesses also make decisions about investment levels, production and how many staff they employ.

The financial sector

The financial sector consists of organisations such as banks, credit unions, building societies, the stock exchange
and life insurance companies. According to this model, these institutions collect or borrow household savings
from some individuals and re-lend them as credit to businesses wanting to expand their operations through
investment spending involving the purchase of new plant and equipment.

The government sector

The government sector includes the activities and decisions of federal, state, and local governments. It collects
various types of tax revenue from those earning income and then uses this to help pay for government spending
on the provision of goods and services for the community (e.g. public roads, health, education, transport
and housing).

The overseas sector

The overseas sector involves spending by Australian residents on imports of goods (e.g. cars and phones) and
services (e.g. international travel), along with spending by people in overseas countries on our exports of goods
(e.g. iron ore and beef) and services (e.g. tourism and education).

210 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
You may have noticed that the five-sector model also has four main flows or streams that link the sectors of
the model:

Flow 1 Resources available

Flow 1 represents the supply of resources (labour, capital and natural resources) over a period of time from the
household sector to the business sector. Ultimately, a nation’s productive capacity, potential output or supply
of goods and services is determined by the volume and efficiency of these productive resources. As mentioned
earlier, it is not possible for countries to produce more than their resources will permit. This limits a nation’s
productive capacity. Hence, the expansion of resources is vital if the supply of goods and services produced in
an economy is to grow between one year and the next.

Flow 2 Total incomes

Flow 2 is the payment of total income over a period of time (e.g. made up of wages, profits, interest and rent)
to those households that have sold resources. As such, it represents the demand by businesses for resources.
The more resources bought by firms each year, the higher the employment rate and the total level of national
income. However, total incomes fall when there are fewer resources wanted or employed by firms. This causes
unemployment to rise.

Flow 3 Total spending

Flow 3 represents aggregate demand (AD) or total annual value of spending on Australian-made goods and
services measured over a period of time. This reflects the spending decisions made by households, businesses,
and governments, both here and overseas. AD is made up of components of expenditure including private
consumption spending (C), plus private investment spending (I), plus government spending (G), plus overseas
spending on Australian exports of goods and services (X), minus Australian spending on imports of goods and
services (M).

AD = C + I + G + X − M

The level of AD is determined by the value of total leakages (i.e. the withdrawal of income consisting of
S + T + M), relative to total injections (i.e. additions to the overall spending stream consisting of I + G + X).
Leakages act like a brake and slow the economy, but injections work like an accelerator and speed up economic
activity or GDP. In this model, total leakages are not always equal to total injections— they can sometimes be
higher or lower. This causes AD to rise or fall. Hence, decisions that raise leakages relative to injections will
slow C, and thus AD. However, decisions that cause leakages to fall relative to injections will tend to accelerate
the level of AD. Only when the total value of injections equals the total value of leakages will AD and the
economy be stable.

Flow 4 Total production

Flow 4 is the annual value ($) of a nation’s production or supply of finished goods and services. The size of
this flow is measured using gross domestic product (GDP) which is commonly used as a general indicator
of the level of economic activity in the Australian economy. Whether the actual GDP of the economy is at its
maximum or potential level, depends on the strength of spending or AD. Sometimes there is unused productive
capacity because spending is too weak.

TOPIC 4 Economic activity 211

It is also important to note that according to this model, the money values of these flows are equal and are
interdependent — so if one changes, all change. That is:

AD or national expenditure (i.e. C + I + G + X – M)

= The national value of goods and services produced (GDP or level of economic activity)
= The national value of resources employed
= The national value of incomes paid (e.g. wages, rent, interest, dividends)

4.4.2 How to use the five-sector circular flow model to explain

changes in economic activity
Over a period of years, the size of the economy changes in a cyclical or wave like manner. Sometimes the level
of economic activity (measured by the value of GDP or flow 4) increases, perhaps causing a boom, while at
other times it shrinks, possibly causing a recession. The five-sector circular flow model shown in Figure 4.5 can
be used to explain these changes:

Using the model to explain an increase in economic activity

How does the model help us to explain the causes of an increase in economic activity (the size of GDP or flow
4)? As we know, individuals, businesses and governments have many needs and wants that they try to satisfy
through spending. In the model, this spending is represented by AD — that is, the total value of all spending
on Australian made goods and services. AD consists of consumer spending (abbreviated as C), plus business
spending on equipment (I), plus government spending (G), plus net export spending (X – M). The model also
shows that the value of AD (C + I + G + X – M) is affected by the total value of leakages made up of savings
(S) plus government taxes (T), plus our spending on imports (M), and by the total value of injections made up of
business investment spending (I), plus government spending (G), plus overseas spending on our exports (X).
When the total value of injections rises relative to total leakages, AD increases (shown as a rise in flow 3 on the
five-sector circular flow model). Here, businesses notice that there is more spending by seeing that their sales
and orders for goods and services are up, and their stocks of unsold items sitting on shelves and in warehouses
are down. As a result, collectively firms will try to lift output, boosting the level of economic activity and GDP
(shown as a rise in flow 4). These steps in thinking are illustrated in Figure 4.6 that only focuses on some of the
key elements of the circular flow model so that we can more clearly see the basic sequence in the explanation.
Stepping further through the five-sector model, higher economic activity (flow 4) then has knock-on effects:
• Higher levels of activity mean that businesses will need to purchase more resources including labour
(shown as a rise in flow 1). This raises the value of incomes paid to those selling resources (shown as a
rise in flow 2) allowing again for more spending (shown as a rise in flow 3), and so on through the circular
flow cycle.
• In addition, it is possible that higher spending might sometimes cause widespread shortages of goods and
services, thereby driving up consumer prices and accelerating the inflation rate and causing a boom.

Using the model to explain a decrease in economic activity

In reverse, the five-sector circular flow shown in Figure 4.5 model can also help to explain a decrease in the
level of economic activity. When the total value of leakages rises relative to total injections, AD slows (shown
as a drop in flow 3). Here, businesses see that there is less spending because their sales and orders for goods
and services are down, and their stocks of unsold items sitting on shelves and in warehouses rise, as new orders
decline. As a result, firms collectively cut production, reducing the level of economic activity and GDP (shown
as a fall in flow 4). This is illustrated in Figure 4.7 where only some of the key elements of the circular flow
model are used to visibly expose the basic sequence or steps in the explanation.

212 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
Stepping further through the five-sector model, declining economic activity also has other knock-on effects:
• Lower levels of economic activity mean that businesses will purchase fewer resources including labour
(shown as flow 1). Incomes paid to those selling resources (shown as a drop in flow 2) will fall, slowing
spending (shown as a drop in flow 3).
• In addition, it is likely that reduced spending will cause inflation to slow as businesses discount or cut their
prices to clear their excess stocks of unsold goods.

FIGURE 4.6 Explaining the causes and effects of higher levels of economic activity in an economy

Flow 1

Businesses employ
more resources including
labour, as they can
increase output

Flow 4 Flow 2

Collectively, producers try There is aFlow 2 the total

rise in
to lift national production, value of incomes paid to
so the total value of those selling resources
economic activity
(GDP) rises

Flow 3
Higher spending or AD
is caused by increased
injections relative to leakages,
leading to general shortages
and lower levels of unsold
stocks of goods and services

FIGURE 4.7 Explaining the causes and effects of lower levels of economic activity in an economy

Flow 1
Businesses employ
fewer resources including
labour, as they reduce output

Flow 4 Flow 2
Collectively, producers There is a drop in the
cut national production so Flowof2incomes paid to
total value
the total value of economic those selling resources
activity (GDP) falls

Flow 3
Lower spending or AD is
caused by increased leakages
relative to injections, leading
to surplus unsold stocks of goods
and services

TOPIC 4 Economic activity 213

This model allows us to better understand the process of economic activity and how resources are used to
generate incomes that ultimately help people to satisfy their many needs and wants. Using this model also assists
us in explaining why economic activity moves up and down in a cyclical or wave-like manner. Additionally,
it allows us to step through the effects of changes in key variables, on domestic macroeconomic conditions
and living standards. Remember that it’s just a matter of moving forward one step at a time, through each of
the flows making up the model. It is a good idea to keep this five-sector model in your mind as we move to
investigate the business cycle of economic activity in the upcoming section.

4.4 Activities
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4.4 Quick quiz 4.4 Exercise

4.4 Exercise
1. Draw and fully label a five-sector circular flow model (preferably from memory) representing Australia’s
economy. (4 marks)
2. Briefly define each of the following terms used in the circular flow model: (11 marks)
a. aggregate demand
b. gross domestic product (GDP)
c. leakages
d. injections
e. household consumption spending
f. business investment spending
g. savings
h. spending on exports
i. spending on imports
j. taxes
k. government spending.
3. Using the five-sector circular flow model:
a. Identify and outline the possible causes of a rise in the level of economic activity, perhaps leading to an
inflationary boom. (2 marks)
b. Identify and outline the possible causes of a fall in the level of economic activity, perhaps leading to a
recession. (2 marks)
4. The five-sector circular flow model is especially useful in understanding the impacts of changes in an
economy. (26 marks)

a. What are the main economic functions of the household sector?

b. What are the main functions of the business sector?

c. What are the main functions of the financial sector?

d. What are the main functions of the government sector?

e. What are the main functions of the overseas sector?

f. Who are the suppliers of resources?

g. Who are the buyers of resources?

214 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 h. How are the suppliers of resources rewarded for their efforts, skills, and risk?

i. Who are the demanders of finished goods and services?

j. How might households dispose of the income they receive?

k. What is the main general determinant of the level of C?

l. What are leakages?

m. How is the impact of leakages different from that of injections?

n. What are savings and why are they regarded as a leakage?

o. What are imports?

p. Define what is meant by AD.

q. What are the immediate determinants of the level of AD?

r. What might cause AD to fall?

s. What are three main macroeconomic effects of a rise in AD by $100 million for an economy that
has unemployed resources or unused productive capacity?

t. What is the immediate effect of a decision by the business sector to increase its production or
supply of goods and services?

u. What is the main cause of an increase in incomes?

v. What may cause some people to receive no income at all?

w. In this model, what is the immediate cause of reduced employment of resources and rising
unemployment in an economy?

x. What are the likely effects on the economy of AD rising faster than the productive capacity of
the country?

y. What is the likely impact on the level of AD of a rise in imports?

z. What are the likely effects of an increase exports?

5. The five-sector circular flow model is especially useful in understanding the impacts of changes in aggregate
demand factors on the economy. (4 marks)
a. According to the model, what is the general cause of a contraction or recession in the level of economic
activity (GDP)?
b. According to the model, what is the general cause of an expansion in the level of economic activity (GDP)?
c. According to the model, what can be said about the values or size of the flows of AD, GDP, and total
incomes in an economy in a given year?
d. What is the name of the flow that measures the general level of economic activity in an economy?

Solutions and sample responses are available online.

TOPIC 4 Economic activity 215

4.5 The business cycle
KEY KNOWLEDGE
• The business cycle
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Look at the news headlines from around the world; most days you quickly realise that it is quite normal for
economies to experience instability in economic activity. Often good times follow bad ones, almost like day
follows night! To help illustrate instability in the level of economic activity, economists use the business cycle
diagram that we introduced earlier in our studies. This is shown in Figure 4.8.

FIGURE 4.8 The business cycle diagram illustrating instability in a nation’s level of economic activity

8
Peak or possible Peak or possible
boom boom

6
Slowdown
Ideal level of economic
Slowdown
Annual rate of change in the level of

Recovery activity = domestic

economic stability
4
economic activity (GDP)

2
Recovery Cyclical rate of
change in the level of
economic activity (GDP)
0
Time in years

–2
The trough or possible
recession The trough or possible
recession
–4

Notice that over a period of some years, the pace of economic activity (measured by the quarterly or annual
percentage change in the value of GDP) rises and falls. Over a typical cycle, there are four phases, speeds, or
rates of GDP growth — the peak, slowdown, trough and recovery:
• Phase 1: The peak in the speed of economic activity occurs when GDP is growing at its fastest rate.
Sometimes this is too fast given the economy’s productive capacity, and there will be a boom:
• The peak is caused by strongly rising levels of spending on Australian made goods and services or
increasing levels of AD (C + I + G + X – M).
• The peak results in firms employing more resources so, typically, unemployment rates are very low and
incomes rise. However, if spending grows too fast and outstrips the economy’s productive capacity,
inflation will accelerate. This undermines the purchasing power of incomes and hence material living
standards.
• Phase 2: The slowdown occurs when the speed of the rise in economic activity and GDP lessens to rates
below those in the peak:
• The slowdown is caused by softer rises in sales, spending and AD (C + I + G + X – M).
• The slowdown results in firms cutting jobs, so unemployment rises and inflation slows as firms hold
prices down to try to clear their surplus stocks of unsold goods.

216 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 • Phase 3: The trough is the lower turning point on the business cycle where economic activity and the rate
of GDP growth are at their slowest. If the size of GDP shrinks over two or more consecutive quarters (i.e., a
6-month period), this is called a recession:
• The trough or recession is caused by very weak or falling levels of spending or AD (C + I + G + X – M).
• The trough results in relatively high rates of unemployment as firms cut production, reducing incomes,
purchasing power, and living standards. It is
even possible that there will be deflation
or falling prices as firms discount their prices
to clear excess stocks of goods.
• Phase 4: The recovery in economic activity occurs
when the rate in GDP starts to accelerate:
• The recovery is caused by stronger rises in
spending or AD (C + I + G + X – M).
• The recovery results in firms employing more
staff, lowering unemployment and raising
incomes. It can also mean that inflation starts to
pick up.

As the economy moves through the business cycle and the speed of economic activity changes, so too do the
country’s domestic macroeconomic conditions and living standards — sometimes in a favourable direction, but
at other times, negatively. The ideal level of economic activity is somewhere between the peak and the trough.
This favoured situation is called domestic economic stability. Here, three things are simultaneously achieved:
• There is a strong and sustainable rate of growth in economic activity and GDP (where GDP is rising
steadily, perhaps by an average of around 3 per cent a year).
• There is full employment with low unemployment rates of perhaps 4.0 to 4.5 per cent of the labour force.
This grows incomes.
• There is low inflation where general consumer prices are rising slowly by an average of between 2.0 to
3.0 per cent a year over time. This helps to ensure that incomes keep their purchasing power.
While we aspire to achieve this blissful situation because it is conducive to better living standards, it is seldom
achieved fully.

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4.5 Quick quiz 4.5 Exercise

4.5 Exercise
1. Describe the business cycle. Illustrate this on a fully labelled diagram. (2 marks)
2. Describe the main macroeconomic features or characteristics (i.e. refer to levels of spending, GDP, inflation,
unemployment) of each of the following situations found along the business cycle:
a. expansion
b. peak or boom
c. contraction
d. trough or recession. (4 marks)

TOPIC 4 Economic activity 217

 3. Outline why a recession is mostly bad for the living standards. (1 mark)
4. Outline why a boom can be bad for the living standards of some people. (1 mark)
5. Explain what is meant by the term domestic economic stability. (3 marks)

Solutions and sample responses are available online.

4.6 Types of economic indicators

KEY KNOWLEDGE
• Types of economic indicators, such as leading, lagging and coincident
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

As we know, the level of economic activity is often unstable.

This has knock-on effects on other parts of the economy that,
in turn, impact on our living standards. Economists use a range
of statistical indicators like GDP, unemployment, incomes, and
inflation, to monitor these changes, and to evaluate the success or
otherwise of government policies. Sometimes, they also look for
trends in current data to forecast what lies ahead in the next few
months or years.

4.6.1 The three main types of indicators of economic activity

There are three main types of indicators of economic activity that can shed light on our changing conditions —
lagging, coincident and leading indicators.

Three main types of indicators of economic activity

Coincident
Lagging indicators Leading indicators
indicators

Lagging indicators of economic activity

Lagging indicators of economic activity only tell us the level of activity that occurred some time ago. While
generally more accurate or certain than leading indicators (described shortly), these statistics do not tell us what
the economy is doing right now. They only look backwards to where we were once located. GDP figures fall
into this lagging indicator category, since by the time quarterly production statistics are collected by the ABS,
processed and released, typically three months or so have elapsed. Apart from GDP, other lagging indicators of
changing levels of economic activity might include:
• the unemployment rate (takes time for firms to hire or fire employees after a change in sales and output)
• the inflation rate (the general change in the prices paid for a basket of goods and services takes time to
reflect changes in economic conditions)
• average weekly earnings (wages are sticky and take time to respond to changes in the business cycle)

218 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
Coincident indicators of economic activity
Coincident indicators move very closely with actual changes in the level of economic activity. These allow
us to locate our current position on the business cycle. They are collected and published regularly at shorter
intervals and thus more or less tell us what is happening right now. Examples might include:
• Share prices
• Monthly retail sales
• New car registrations.

Leading indicators of economic activity

Leading indicators can help to predict
where the economy may be heading in the
near future. While not completely reliable,
they can often forecast a change in activity
before it occurs. Indicators in this category
could include:
• consumer confidence index
(measures how optimistic or
pessimistic households feel about
their upcoming employment, income
and spending prospects)
• business confidence (reflects the
level of optimism or pessimism by
firms about their future levels of sales
and profits)
• index of new housing approvals (measures the upcoming intentions of individuals to commence building
activity)
• yield curves or the returns on bonds (can help to predict whether inflation and the economy are expected to
get stronger or weaker in the future).

4.6.2 Looking for patterns in indicators

When examining statistical indicators related to changing economic conditions, economists are on the lookout
for patterns in the data. As illustrated in Figure 4.9, when graphed, these could show long-term, short-term,
seasonal or erratic behaviour.
Long-term trends
The long-term refers to changes in economic activity over perhaps 10 or 20 years, or more. Often it can
represent a straight line of best fit sitting midway between the peaks and troughs on a graph (see graph 1).
Short-term cyclical swings
The short-term cycles in economic activity are the wave-like changes in direction, lasting perhaps between 1–5
years. Typically, these can be seen in data like GDP, unemployment, and inflation rates (see graph 2).
Seasonal patterns
Some data displays a seasonal pattern that occur in the same month or time each year. An example could be the
spike in sales of snow skis in winter each year, toy sales before Christmas, and chocolate at Easter (see graph 3).
Erratic behaviour
Erratic behaviour is where there is no obvious pattern because the data are reacting to one-off events like the
effects of the Olympic Games on the demand for accommodation, or the impact of widespread fires on national
output (see graph 4).

TOPIC 4 Economic activity 219

 FIGURE 4.9 Looking for patterns in statistical indicators

Graph 1 Graph 2
Long-term trends Cyclical behaviour
20 100 Peak
Actual trend
Value of wool sales

GDP ($ billions)
15
Peak
($ billions)

10 50

Trough
5 Long-term average
trend line

0 0
0 10 20 1 2 3 4 5
Years Years

Graph 3 Graph 4
Seasonal behaviour Erratic behaviour
200 100
Melbourne hosts

Hotel occupancy rate (%)

the Olympic
Surfboards sold

games

100
50

0
0 N D J F M A M J J A S O N D 0
Year 1 Year 2 0 1 2 3
Years/months Years

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4.6 Quick quiz 4.6 Exercise

4.6 Exercise
1. Distinguish between lagging and leading indicators of economic activity, giving one example
of each. (2 marks)
2. Classify whether each of the statements about economic indicators in the table below is generally true or
false. Be prepared to defend your responses. (12 marks)

220 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Statement True or false
a. In a recession, the employment rate is high.
b. GDP is a lagging indicator of economic activity.
c. Inflation is high in a boom due to limited spare capacity and
widespread shortages.
d. Booms in economic activity are good for everyone.
e. The unemployment rate can be too low in booms adding to
inflationary pressures.
f. The wild weather and floods in NSW and Queensland in 2022
tended to slow economic activity.
g. St Valentine’s Day in February each year would have a
seasonal impact on chocolate sales and economic activity.
h. Consumer confidence can help reveal the likely direction of
consumer spending and economic activity into the future.
i. New building approvals are a lagging indicator of changes in
economic activity.
j. Leading indicators are usually more accurate than lagging
indicators.
k. Lagging indicators tell us what was happening to economic
activity some time ago.
l. Coincident indicators give a better guide to where the
economy will be in a few months’ time.

Solutions and sample responses are available online.

4.7 The relationship between the business cycle and

economic indicators
KEY KNOWLEDGE
• The relationship between the business cycle and economic indicators
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Mention has already been made that as the economy travels along the business cycle from boom, to slowdown,
recession and recovery, the level of economic activity changes. This alters economic conditions and will be
reflected in various indicators, some of which are summarised in Table 4.1.
Starting with some key indicators in column 1, we see how these change over the business cycle during the
boom, slowdown, recession, and recovery. Column 1 also describes what the ideal statistic may be for an
economy enjoying domestic economic stability. This serves as a benchmark for other conditions.

TOPIC 4 Economic activity 221

 TABLE 4.1 The relationship between the business cycle and key economic indicators
Phase of the business cycle
Common indicator
1 — In a boom 2 — In a slowdown 3 — In a recession 4 — In a recovery
The growth rate in In response to In response to In response In response to
economic activity excessively strong gradually weaker to deficient stronger spending,
reflected in AD and spending/AD and spending/AD and spending/AD, new orders, and
GDP low stocks of reduced orders reduced orders lower stock levels,
(The ideal rate of unsold goods and for goods and and high stocks firms lift output
increase in AD and services, economic services, the of unsold goods and economic
GDP is an average activity/GDP growth in economic and services, output activity/GDP starts
rise of around 3% per eventually becomes activity/GDP is cut and economic to accelerate (e.g.
year). unsustainably rapid starts to slow (e.g. activity/GDP is perhaps a rise of
(e.g. perhaps rising perhaps a rise of negative over at 1–2% per year).
by an average of only 1–2% per least 2 consecutive
5% or more per year). quarters (e.g.
year). perhaps a fall of
-2% per year).
Unemployment rate In response In response to In response In response
(The ideal rate that to very strong slower spending/AD to deficient to stronger
is described as full spending/AD and and lower spending/AD and spending/AD and
employment is an higher production, production, the cuts in production, rising output, the
unemployment rate of the unemployment unemployment rate the unemployment unemployment
around 4.0–4.5% of rate falls to very starts to rise (e.g. rate rises quickly rate gradually
the labour force). low levels causing perhaps with 5% to high levels (e.g. starts to fall (e.g.
labour shortages of the labour force perhaps with 7% or perhaps with 5%
(e.g. perhaps unemployed). more of the labour of the labour force
with only 3% of force unemployed). unemployed).
the labour force
unemployed).
Inflation rate In response to In response to In response In response
(The ideal rate that is excessively strong slower spending/AD to depressed to gradually
seen as low inflation spending/AD that and the gradual spending/AD, firms strengthening levels
is an average rise in is beyond the disappearance are forced to cut of spending/AD
consumer prices of economy’s of shortages of or discount their and falling stocks
between 2–3% per productive goods and services, prices to clear rising of unsold goods,
year). capacity, there inflation starts to stocks of unsold inflation gradually
are widespread slow (e.g. perhaps goods, causing starts to increase
shortages of goods to 3–4% per year). inflation to slow (e.g. perhaps rising
and services, so or become negative by around 2–3% per
consumer prices (e.g. perhaps a rise year).
rise quickly (e.g., of only 1% per year
perhaps 5% per or even -1% per
year or more). year).

222 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.7 Activities
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4.7 Quick quiz 4.7 Exercise

4.7 Exercise
1. Examine the hypothetical data for an economy for four separate financial years. (4 marks)

Year 2020–21 2022–23 2024–25 2026–27

Rate of change in -1.9 3.0 7.1 2.0
economic activity/GDP (%)
Unemployment rate (%) 9.4 4.3 2.8 5.1
Inflation rate (%) -0.9 2.8 6.1 1.9

In terms of the business cycle, classify the most likely type of economic situation in each of the following
years, explaining your reasons:
a. 2020–21
b. 2022–23
c. 2024–25
d. 2026–27.

Solutions and sample responses are available online.

4.8 BACKGROUND KNOWLEDGE: Overview of factors

that may affect Australia’s level of economic activity
BACKGROUND KNOWLEDGE
• An overview of aggregate supply and aggregate demand factors that can affect the level of economic activity
and domestic macroeconomic conditions

There are two main reasons why the level of economic activity may rise or fall. Over the short-term, there are
changes in aggregate demand factors, while in the longer-term, there are changes in aggregate supply factors.
It is also possible for some factors to have an effect on both aggregate demand and aggregate supply.
These big ideas are illustrated in Figure 4.10.
• Aggregate demand factors or conditions influence the total value of spending on a nation’s goods and
services. They can be very changeable especially over the short-term and cause AD to rise or fall:
• Stronger aggregate demand factors cause the value of total spending to accelerate (shown as flow 3 on
the circular flow model), along with the levels of economic activity or GDP (flow 4), employment of
resources (flow 1), the payment of incomes (flow 2), and the inflation rate.

TOPIC 4 Economic activity 223

 Weaker aggregate demand factors cause total spending to slow (flow 3 on the circular flow model), along
•
with the levels of economic activity or GDP (flow 4), employment of resources (flow 1), the payment of
incomes (flow 2), and the inflation rate.
• Aggregate supply factors influence the economy’s long-run productive capacity and potential level of
GDP. They can change the conditions that alter the ability and/or willingness of producers to supply goods
and services:
• More favourable aggregate supply conditions make producers more willing and/or able to expand
productive capacity and hence increase the potential rate of economic activity.
• Less favourable aggregate supply conditions cause producers to become less willing and/or able to
supply, causing some firms to close, contracting productive capacity and the potential rate of economic
activity.

FIGURE 4.10 Overview of factors affecting Australia’s rate of economic activity

Influences on Australia’s level of economic activity

Aggregate demand factors: Aggregate supply factors:

Aggregate demand factors affect total spending on Aggregate supply factors affect Australia’s productive
Australian-made goods and services (AD = C + I + G + capacity (PPF) or the potential long-term rate of
X – M) over the short-term, determine the actual rate of growth in the level of economic activity. They change
economic activity and the extent to which the nation’s the ability and/or willingness of producers to make or
productive capacity is used. supply goods and services.

Aggregate demand factors may involve changes in ... Aggregate supply factors may involve changes in ...

1. Disposable income 1. The quantity of resources available and how efficiency

2. Levels of consumer confidence these are used
3. Levels of business confidence 2. Production costs including wages, materials, interest
4. Bank interest rates on savings deposits and loans rates on credit, and utility charges
5. The exchange rate for the A$ 3. Business profitability and whether firms expand or close
6. Overseas economic conditions 4. Climatic events
7. Growth rate in population size 5. Pandemic lockdowns and disruptions to supply chains
8. Rates of income tax. 6. Some government economic policies including rates of
company tax, education, and infrastructure projects.

Figure 4.11 (the five-sector circular flow model) shows how these two sets of factors can impact the economy.
Aggregate supply factors especially affect the size of flow 1 (i.e., the quantity and quality of resources available
that in the long-term affect the potential level of production), while aggregate demand factors change the size of
flow 3 (i.e. total value of spending on a nation’s goods and services), the actual value of GDP and the extent to
which productive capacity is used.

224 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 FIGURE 4.11 How changing aggregate supply and demand factors can impact economic activity and
macroeconomic conditions generally

Flow 4 = production (i.e. supply) of goods and services (GDP)

Flow 2 = total incomes paid (demand for resources)

HOUSEHOLD/CONSUMER SECTOR BUSINESS/PRODUCER SECTOR

Flow 1 = supply of resources to businesses

Flow 3 = AD =
C+I+G+X–M
Private consumption spending (C)
Aggregate supply/
Private Private investment Aggregate demand
productive capacity is FINANCIAL SECTOR
saving (S) spending (I) is affected by:
affected by:
• consumer confidence
• quantity and efficiency
• business confidence
of all resources
• disposable income
• profitability Government tax Government
GOVERNMENT SECTOR • interest rates
• production costs (T) spending (G)
• population growth
• wage costs
• tax rates
• cost of credit
• exchange rate for A$
• tax rates on firms Import Export
OVERSEAS SECTOR • overseas economic
• climatic factors spending (M) spending (X)
activity
• participation and strike
• government budget
rates
• commodity prices
• supply chain issues LEAKAGES = INJECTIONS =
• savings levels.
• an ageing population. S+T+M I+G+X
(act as a brake) (act as an accelerator)

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4.8 Quick quiz 4.8 Exercise

4.8 Exercise
1. Identify and explain the two main influences of economic activity. (4 marks)
2. Define the following terms:
a. aggregate supply (1 mark)
b. aggregate demand. (1 mark)

Solutions and sample responses are available online.

TOPIC 4 Economic activity 225

4.9 Aggregate demand — its meaning, importance and
factors affecting its level and economic activity
KEY KNOWLEDGE
• The meaning and importance of aggregate demand and its components
• The factors that may affect the level of aggregate demand and the level of economic activity
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

When we see newspaper headlines about the latest recession or boom, we realise that Australia’s rate of
economic growth can alter quite suddenly. This is often the result of changes of aggregate demand or the
decisions made by households, businesses, and governments about their overall level of spending on Australian-
made goods and services.

4.9.1 The meaning and importance of aggregate demand

Aggregate demand (abbreviated as AD) represents the total value of all spending by households, businesses, and
governments, on finished Australian-made goods and services measured over a period of time. It is made up of
various components or types of spending:
• Private or household consumption spending (C) or outlays on day-to-day purchases PLUS
• Private business investment spending (I) or outlays on physical capital goods PLUS
• Government spending on goods and services (G) for the community PLUS
• Foreign spending on our exports of goods and services (X) MINUS our spending on imports (M).

We can express this as follows: AD = C + I + G + X – M. Thinking of the five-sector circular flow model,
the value of AD can rise or fall due to changes in the total value of leakages (i.e. S + T + M) relative to the
total value of injections (i.e. I + G + X). Over the short-term, changes in the value of AD (think of flow 3)
determine the level of economic activity (think of flow 4 on the circular flow model), inflation, unemployment,
and incomes. They also dictate the extent to which the economy’s productive capacity or potential output is used
(think of the production possibility diagram and the PPF). Clearly, AD is one of the most important variables in
the economy.

226 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.9.2 How aggregate demand factors affect the level of AD and
economic activity
The level of AD (C + I + G + X – M) and economic activity over the short-term is determined by the strength or
weakness of aggregate demand factors or conditions. These might include changes in the following:
• the level of household disposable income
• the level of consumer confidence or pessimism of households about their future employment and income
prospects
• the level of business confidence about their future sales and profits
• the impact of changes in budget taxes and government spending
• the level of interest rates paid to banks by those people borrowing credit to finance their spending
• the value of the Australian dollar when it is swapped or exchanged for other currencies
• general overseas economic activity (e.g. booms or recessions) in countries to whom we export
• the size and growth rate of our population.

Let’s take a closer look at how stronger or weaker aggregate demand factors can affect each of the components
of spending that make up AD (i.e. AD = C + I + G + X – M).

Aggregate demand factors affecting household consumption spending (C):

Private consumption spending (C) by Australian households on food, clothes, electrical goods, entertainment,
and holidays, for example, is the biggest single component of AD. As a result, it can have a huge effect on total
spending. A rise in C for instance would directly stimulate AD (flow 3 on the circular flow model), economic
activity, GDP (flow 4), employment of available resources (flow 1) and incomes (flow 2), while reduced
spending slows economic activity. As summarised in Table 4.2, the value of C can be affected by changes in
several aggregate demand factors:

TABLE 4.2 Aggregate demand factors that can affect the level of private consumption spending and AD
Disposable income Household disposable income per head represents money available for spending
per person, after the payment of tax and the receipt of any government welfare
benefits. A drop in disposable income per head, for example, tends to slow
private consumption, while higher disposable income accelerates consumption
spending and hence AD.
Consumer confidence Consumer confidence is the degree of optimism or pessimism about future
household incomes and employment prospects. Greater optimism leads to
stronger consumption spending and reduced savings, while general pessimism,
slows consumption and increases savings.
Interest rates Interest rates received by households on their bank savings deposits, or those to
be paid on credit borrowed from the banks, affect both the level of savings and
spending. Higher interest rates encourage savings and discourage borrowing to
buy expensive consumer items such as a house or car, while lower interest rates
help to lift consumption spending and discourage savings. This boosts AD.
Rate of population The rate of population growth (i.e. the excess of births over deaths and
growth immigration levels) influences consumption spending. For instance, a slower
growth in population tends to slow consumption and AD.
Government Government budgetary policies affect the levels of tax, government spending
budgetary policies and other outlays. Cuts in personal income tax rates, for example, can help to
increase disposable income, and hence consumption spending and AD.

TOPIC 4 Economic activity 227

Aggregate demand factors affecting private investment spending (I)
Businesses make spending decisions that affect AD and the level of economic activity. For instance, as an
injection on the circular flow model, higher level of private investment spending (I) by businesses on new plant
and equipment such as computers, factory buildings and trucks, would tend to increase AD, economic activity,
GDP, employment and incomes, while reductions have the reverse effect. As shown in Table 4.3, the level of I
can reflect the influence of changes in various aggregate demand conditions.

TABLE 4.3 Aggregate demand factors that can affect the level of private business investment spending and AD
Business confidence The level of business confidence or optimism signals firm's expectations about the
level of future sales and profits. Business pessimism leads to reduced investment
spending on new plant and equipment, while optimism leads to increased
investment spending and AD.
Interest rates Interest rates charged by banks on loans to firms can alter levels of private
investment spending. Higher interest rates tend to discourage investment spending
on new equipment because it becomes dearer for firms to borrow and repay credit,
while lower rates help to encourage investment spending and AD.
Company tax rates Company tax rates affect the after-tax profits of businesses. Lower tax rates for
businesses help to lift after-tax profits and hence encourage new investment
spending designed to expand operations. Rises in tax rates have the opposite effect
and slow AD.

Aggregate demand factors affecting government spending (G)

Australian government spending (G) and other outlays on the provision of goods and services for
the community (e.g. health, transport, education, defence and childcare) represents an injection on the circular
flow model that can alter the level of AD. For example, increases in the value of G in the budget tends to boost
AD, economic activity, GDP, employment, and incomes, while cuts in G slow AD. Table 4.4 shows that the level
of G can be affected by a range of aggregate demand conditions:

TABLE 4.4 Aggregate demand factors that can affect the level of government spending and AD
The level of The level of G often increases when the unemployment rate rises because through
unemployment this approach, the government can help lift AD and reduce the severity of a
recession. In reverse, during inflationary booms, the government may slow its
spending to help stabilise AD and the economy.
The level of inflation The level of G often decreases or slows when inflation is rising because this helps
the government restrain AD and reduce shortages of goods and services that cause
inflationary pressures.
The speed of The level of G often rises faster when population growth is more rapid following
population growth a rise in the birth rate or an increased level of immigration. This is because more
community services are needed.
Concern about the If the government spends more than it receives in taxes, it will have to borrow
level of government money. This adds to its level of public debt. Concern about high debt levels can
debt act to help slow the level of government spending.

228 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
Aggregate demand factors affecting export spending (X)
Decisions made by overseas consumers also affect
Australia’s AD and level of economic activity. If there is
an increase in export spending (X) abroad on Australian
made goods and services (e.g. cotton, wool, minerals,
manufactured items and travel) as an injection on the
circular flow model, this would tend to increase AD,
economic activity, GDP, employment and incomes. In
reverse, a decrease in the value of our X sales abroad or
injections would have the reverse effects. Table 4.5 shows
that changing aggregate demand conditions can influence
whether the value of overseas spending on our X rises or falls:

TABLE 4.5 Aggregate demand factors that can affect the level of overseas spending on our exports and AD
The exchange rate or the The exchange rate or the value of the A$ when swapped or converted into other
value of the A$ currencies affects the value of our exports. A rising A$ tends to slow our exports
because they become dearer to people overseas, while a fall in the A$ makes
our exports cheaper, leading to an increase in sales and hence AD.
Overseas economic Changes in overseas economic conditions, involving booms, recessions, and
conditions pandemics can change the value of our exports. For instance, a recession or
slowdown abroad among our major trading partners like China, Japan or the US,
slows overseas spending on our exports, while a boom overseas tends to raise
the value of foreign spending on Australian exports.
Natural disasters Natural disasters and severe weather events in Australia alter our capacity to
export. Floods, drought and fires reduce exports of agricultural and mining
products.

Aggregate demand factors affecting import spending (M)

Spending decisions made by local consumers affect AD and the level of economic activity. The level of import
spending (M) by Australians (e.g. on oil, computers, business equipment and overseas holidays) represents
a leakage on the circular flow. When we spend more on imports, this tends to slow AD, economic activity,
GDP, employment and incomes. In contrast, a fall in imports lifts AD. The value of import spending can reflect
changes in aggregate demand conditions, as seen in Table 4.6.

TABLE 4.6 Aggregate demand factors that can affect our level of spending on imports from abroad and AD
The exchange rate or the A fall in the exchange rate for the A$ tends to make imports dearer and less
value of the A$ attractive for Australians to purchase, lifting AD while a rise in the A$ tends to
make imports cheaper and more attractive for local consumers, slowing AD.
Local economic activity If there is stronger consumer and business confidence and high levels of
economic activity locally, this often results in more spending on imports where
leakages slow AD. In reverse, weaker conditions and recession here in Australia
usually mean lower spending on imports.
Consumer and business Greater household and business optimism locally usually result in more
confidence spending on imports, slowing AD, while pessimism tends to lower our spending
on imports of goods and services, boosting AD.
Our inflation rate relative to For instance, higher inflation rates at home make overseas goods and services
that overseas relatively more attractive, increasing imports and leakages, slowing AD.
The exchange rate for the Changes in the exchange rate for the A$ against the value of other currencies
A$ will affect the price or cost to us of imports of goods and services. A fall in
the A$, for example, tends to make imports dearer, slowing their relative
attractiveness. This boosts AD, while a rise in the A$ encourages us to buy
more imports and travel abroad, slowing AD and economic activity.

TOPIC 4 Economic activity 229

4.9.3 How changing aggregate demand factors can determine the
level of economic activity and macroeconomic conditions
As we have seen, generally stronger or weaker aggregate demand factors cause instability in spending, bringing
about changes in the level of economic activity and other domestic macroeconomic conditions.

The effects of stronger aggregate demand conditions on the economy

Over the short-term, generally stronger aggregate demand conditions will stimulate spending or AD, because of
falls in the value of leakages (lower S + T + M) relative to injections (I + G + X). Because the size of the four
flows making up the circular flow model are equal in value and interdependent, GDP, employment of resources
and incomes will all need to increase to help maintain equality. However, if the economy is already operating
at or near its productive capacity (close to the PPF on the production possibility diagram), stronger AD can
sometimes mean that spending will outstrip national production or aggregate supply. Normally, this would cause
widespread shortages of goods and services, leading to increased inflation and boom conditions in the business
cycle. Using the circular flow model to guide your thinking, Figure 4.12 provides a step-by-step explanation of
the effects of generally stronger aggregate demand conditions that can cause booms.

FIGURE 4.12 How generally stronger aggregate demand factors can increase Australia’s economic activity and impact
other domestic macroeconomic conditions

Lower
Stronger aggregate Increased
Stronger AD: Increased inflation: unemployment and And so on,
demand factors: production:
higher incomes:

Stronger demand- Stronger aggregate When AD rises, sales When AD and sales When AD increases through the circular
side conditions can demand conditions and new orders increase, business and businesses flow model.
include … mean an increase in increase. However, firms will try to need to lift
• higher consumer the total value of the stocks of unsold expand GDP (flow 4), production, firms will
confidence components goods may fall, and to replace their generally attempt to
• increased business making up AD or widespread falling stocks. buy or employ more
confidence spending on shortages can This accelerates the resources including
• rising overseas Australian-made sometimes develop rate of economic labour (flow 1).
economic activity goods and services if there is no unused growth, providing This causes
• weaker A$ — AD increases productive capacity there is some spare unemployment to fall
• lower interest rates (flow 3). available. This could or unused productive and total incomes
• cuts in taxes lead to increased capacity available. to rise (flow 2).
• increases in inflation.
government
spending.

The effects of weaker aggregate demand conditions on the economy

By contrast, generally weaker aggregate demand conditions will slow spending and AD reflecting rising
leakages and/or lower injections. To restore equilibrium between the four flows in the model, GDP
slows creating more spare capacity. Unemployment of resources would rise, and incomes fall. Additionally, with
slowing economic activity, inflation is likely to fall. This is because firms are likely to discount their prices to
clear unwanted stock caused by the drop in sales. Using the circular flow model to help guide your thoughts,
Figure 4.13 provides a step-by-step explanation of the impacts of generally weaker aggregate demand conditions
and activity that can possibly lead to a recession.

230 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 FIGURE 4.13 How generally weaker aggregate demand conditions can slow Australia’s rate of economic activity and
impact other macroeconomic conditions

Increased
Weaker aggregate Lower economic And so on,
Weaker AD: Lower inflation: unemployment and
demand factors: activity:
lower incomes:

Weaker aggregate Weaker aggregate When AD drops, When AD and sales When AD decreases through the circular
demand conditions demand conditions sales and new decrease, business and businesses flow model.
can include … mean a decrease in orders fall. Stocks firms will reduce need to cut their
• Lower consumer the total value of the of unsold goods their output to avoid output, firms will
confidence components making and services start to excess stock levels. employ fewer
• Reduced business up AD or spending increase. With rising GDP (flow 4) falls. resources including
confidence on Australian-made stock levels, This slows the rate labour (flow 1).
• Falling overseas goods and services sometimes a glut of economic growth. Unemployment
economic activity — AD (flow 3) slows. or market surplus If GDP falls over two rises and so total
• Rising A$ develops, so firms or more consecutive incomes fall (flow 2).
• Higher interest often cut or quarters (6 months),
rates discount their this is called a
• Rises in taxes prices. This slows recession.
• Decreased inflation.
government
spending.

4.9 Activities
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4.9 Quick quiz 4.9 Exercise

4.9 Exercise
1. ‘The level of aggregate demand helps to determine the rate of economic growth and the extent to which
the economy’s productive capacity is actually used.’ Define what is meant by the term aggregate
demand (AD). (2 marks)
2. Explain what is meant by aggregate demand factors. Define each of the following aggregate demand factors
and explain how each could affect the level of AD:
a. consumer confidence
b. business confidence
c. disposable income
d. the exchange rate for the A$
e. interest rates
f. overseas economic activity. (6 marks)
3. Use the five-sector circular flow model of the economy to help predict (in a logical and step-by-step way), the
likely cyclical effects of the ten economic events listed in the table that follows:
a. AD
b. inflation or generally rising prices
c. economic activity measured by GDP
d. employment or unemployment of resources
e. incomes and material living standards.

TOPIC 4 Economic activity 231

 Start each answer with a brief definition of the italicised term (see the Economics dictionary), and then step
through your explanation. In answering the question, remember that many of the listed events change the size
of leakages, injections and hence AD (i.e. the size of flow number 3). In turn, this alters sales, orders and
unsold stocks of goods and services, perhaps affecting inflation. And so, the next flow in order to be affected
is the level of production or GDP (i.e. flow number 4), then the level of resources purchased and perhaps the
unemployment rate (i.e. flow number 1), and finally the total level of incomes paid to households (i.e. flow
number 2).
The order or sequence of your step-by-step explanation here is important. Try not to get sidetracked by
changes in things about which we may be very unsure. To help with this aspect and to guide your response,
read the sample answer provided at the end of the table below. As a shorthand approach here, you may also
use official abbreviations, horizontal arrows (indicating ‘leads to’), and vertical arrows (meaning ‘increase’ or
‘decrease’). Notice how the explanation works its way around the circular flow model in a
forward direction. (20 marks)

Explanation of the likely macroeconomic

Aggregate demand factor or event effects of the aggregate demand event
a. Consumer confidence falls.
b. Household disposable income per person falls.
c. There is a slowdown overseas in China’s rate of
economic growth.
d. The exchange rate for the A$ rises or appreciates
against other currencies.
e. Interest rates fall and remain low on bank credit that is
borrowed by business firms.
f. More free trade agreements are signed, abolishing
tariffs on imported goods and opening up new export
markets.
g. A decision was made to stage the World Soccer
Cup in Melbourne, attracting overseas tourists, and
involving increased investment in new facilities.
h. You decide to spend your week’s wages on a big night
out in Melbourne and reduce your level of savings by
$250.
i. The government pays health workers a special one-off
bonus of $200
j. Australian households recently increased their savings
ratio (i.e. the percentage of income not spent).

SAMPLE ANSWER
Predict the likely economic effects on Australia’s economy of a large fall in business confidence

Definition: Business confidence relates to the general level of business optimism or pessimism about
their future sales and profits. This affects businesses’ investment decisions.
Step-by-step explanation: If there was a collapse in business confidence, firms would be pessimistic
and feel that their future sales and profits will fall → ↓ investment spending (I) or injections by firms
on new plant and equipment since there would be no need to expand their capacity → ↓ AD or total
spending on Australian-made goods and services (flow 3) → ↓ sales of goods and higher stocks perhaps
leading to price discounting and lower inflation → ↓ production by Australian firms, hence slowing
the rate of growth in national output or GDP produced (flow 4) → ↓ amount of resources needed by
Australian firms (flow 1) → ↓ employment and increasing unemployment → ↓ total incomes paid to
Australian households (flow 2) and perhaps lower material living standards.

232 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4. Examine the following graph showing changes in Australia’s index of consumer confidence where the base
reading of 100 points indicates a neutral situation (i.e. the number of optimists equal the number of
pessimists). An index of less than 100 points shows overall pessimism about the future, while one above 100
points shows general optimism.

Consumer sentiment*
Average since 1980 = 100
Index Index

100 100

85 85

70 70
2010 2014 2018 2022
* Average of the ANZ-Roy Morgan and Westpac-Melbourne Institute
consumer sentiment measure of respondents’ perceptions of their
personal finances relative to the previous year; ANZ-Roy Morgan
index rescaled to have the same average as the Westpac-Melbourne
Institute index since 1996.
Source: RBA Chart Pack, https://www.rba.gov.au/chart-pack/household-
sector.html.

a. Referring to the graph data, describe the change in consumer confidence between
2021 and 2022. (2 marks)
b. Other things remaining equal, outline the macroeconomic effects of the change in consumer confidence
between 2021 and mid-2022 on each of the following (remember to step your explanation in the correct
order or sequence, following the flows around the circular flow model):
• AD (and selected components)
• Economic activity
• Inflation
• Unemployment and incomes. (4 marks)
5. Examine the graph below showing changes in overseas economic activity amongst Australia’s major export
markets and globally. (4 marks)
GDP growth – World
Year-ended
% %

10 10
Major trading partners*

5 5

World**
0 0

–5 –5

–10 –10
2005 2009 2013 2017 2021
* Weighted using Australian export shares.
** PPP-weighted; accounts for 85 per cent of world GDP.
Source: RBA Chart Pack, https://www.rba.gov.au/chart-pack/world-economy.html.

TOPIC 4 Economic activity 233

 a. Referring to the graph data, describe the change in overseas economic activity between 2019 and 2020
and 2021–22. (2 marks)
b. For each of the following, outline the likely macroeconomic effects for Australia of the change in economic
activity amongst our major trading partners during 2020 and 2021–22 (remember to step your explanation in
the correct sequence following the circular flow model): (4 marks)
• AD (and a selected component)
• Economic activity
• Inflation
• Unemployment and incomes.

Solutions and sample responses are available online.

4.10 Aggregate supply — its meaning, importance and

factors affecting its level and economic activity
KEY KNOWLEDGE
• The meaning and importance of aggregate supply
• The factors that may affect the level of aggregate supply and the level of economic activity
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

The demand for goods and services can only be satisfied if producers are able and willing to match this with
adequate levels of supply or production. However, we know that because people’s wants are unlimited and the
quantity and or quality of resources available is inadequate, there are restrictions or limits to how many goods
and services can be supplied.

4.10.1 The meaning and importance of aggregate supply

Aggregate supply (abbreviated AS) represents
the total volume of goods and services that all
producers in the country can make available
over a period of time. It strongly relates to the
nation’s productive capacity or the potential
level of national output and is designed to help
satisfy the demand for goods and services.
You might remember that this is shown on the
production possibility diagram as the PPF.
The level of aggregate supply reflects the
impact on producers of aggregate supply
conditions or factors. These can include:
• the quantity or efficiency of natural, labour
and capital resources available for production
• business production costs, profitability and whether firms close down, open up, or expand
• climatic events
• pandemic lockdowns, wars and disruptions to supply chains
• various government economic policies including rates of company tax, education and training, and
improvements in infrastructure.
By affecting the availability of resources, production costs, and business profits, aggregate supply factors can
greatly affect the country’s productive capacity, potential level of economic activity or GDP, and other domestic
macroeconomic conditions.

234 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.10.2 How aggregate supply factors affect the level of AS and
economic activity
Over the longer-term, aggregate supply conditions determine Australia’s productive capacity and the potential
level of AS. These factors usually do this by affecting the quantity and quality of natural, labour and capital
resources available, production costs of firms, and business profitability. In turn, aggregate supply factors
influence the willingness and ability of producers to supply goods and services. We will now take a look at a
few of these factors. As a starter, Table 4.7 summarises just a few aggregate supply factors that can affect
economic activity.

TABLE 4.7 Some aggregate supply factors that can affect productive capacity and the potential level of
economic activity
Demographics and the population’s age structure: The size of the population
and its age distribution affect the size and growth of the nation’s labour force.
Population can grow because of the excess of births over deaths and because
of net migration. For example, immigration can increase the number and skills of
the labour force available. In contrast, Australia’s ageing population (where there
is a rising proportion of the population in older age groups and retiring) is causing
The labour resources labour shortages that limit the expansion of our productive capacity and the level of
available (Provide mental aggregate supply.
talents and physical Education, skills, and labour productivity: High labour efficiency or productivity
power) allows for a greater level of output per worker. This is often measured by the annual
percentage change in GDP per hour worked. Many factors affect labour efficiency,
including the levels of education, training, skills, and innovativeness. Here, there is
an important role for government spending. This might include the use of financial
incentives (free and subsidised education and training courses) that could help to
grow our productive capacity, potential GDP, and AS.
Investment levels: The quantity and quality of capital resources is increased through
high levels of private and government investment in new plant and equipment.
Increased investment can also come from foreign capital inflow used to set up or
finance new firms. These grow productive capacity and AS.
Interest rates: Interest rates are the cost of borrowing credit used by firms to
The capital resources purchase new, more efficient plant and equipment. Borrowing credit can help
available (Investment in expand productive capacity and perhaps grow business profitability. Lower interest
new or better plant and rates tend to increase investment in new equipment, while higher interest rates deter
equipment) investment, slowing the growth in productive capacity and AS.
Outlays on technology and R&D: The use of new technology like robotics in
various industries such as manufacturing, warehousing, and medicine, along with
investments in research and development (R&D), can help increase the volume and
efficiency of capital resources, adding to productive capacity and AS.
Mineral exploration: Exploration can help us find new deposits of minerals. This can
increase the quantity of resources available, and hence grow productive capacity,
AS, and the potential level of GDP.
Land management: Lifting the productivity of land and the sustainability of mining
The natural resources and farming practices, can help grow Australia’s productive capacity and our
available potential level of GDP. In reverse, poor management will eventually see capacity
(Productive inputs found in shrink.
nature) Climate change and severe weather events: Increased carbon emissions,
global warming and severe weather events are limiting the growth in productive
capacity and AS. Floods, drought, and fires have destroyed some businesses and
infrastructure. To grow capacity, it is now essential that we have policies in place
designed to reduce global warming, perhaps by putting a price on carbon emissions
(e.g. a tax or the introduction of a carbon emissions trading scheme).
(continued)

TOPIC 4 Economic activity 235

 TABLE 4.7 Some aggregate supply factors that can affect productive capacity and the potential level of
economic activity (continued)
Wage costs and labour productivity: Businesses won’t exist if they can’t make
a profit. High wages costs, as in Australia, combined with relatively low worker
productivity can be a disincentive for business expansion because they reduce
after-tax profits and cause business closures, limiting the growth of productive
capacity, potential GDP, and AS.
The level of production
Rates of taxation: Rates of company tax affect after-tax profits and hence alter
costs and after-tax
the willingness and ability of firms to expand. Currently, higher rates of tax in
profits for businesses
Australia, compared with many countries, act as a disincentive, make local firms
(These affect business
less internationally competitive, drive firms to relocate overseas and hence restrict
expansion and survival.)
the growth in Australia’s productive capacity, potential GDP, and AS.
Government outlays on infrastructure: Infrastructure includes roads, rail, shipping
ports, airports, water and power supply, and telecommunications. It is used
by businesses to produce other goods and services. If there is congestion and
inadequate provision of infrastructure, production costs are higher, businesses are
less internationally competitive and profitable, and capacity is more limited. This
restricts AS and the potential level of GDP.

Some aggregate supply factors that affect producers and influence productive capacity
Ultimately, a country can’t produce more than the available natural, labour and capital resources permit. Having
access to more resources would potentially allow for higher levels of national output, whereas reduced access
would cut productive capacity and the potential level of GDP. In addition, unless costs are low and profits are
reasonable, businesses will close, limiting AS.

4.10.3 How changing aggregate supply factors can determine the

level of economic activity and macroeconomic conditions
Especially over the shortterm we saw that a nation’s level of economic activity (and therefore its material living
standards), largely reflect cyclical changes in the level of aggregate demand. However, over the longer term,
it is impossible to keep on expanding the level of economic activity and GDP simply by spending more. The
economy would soon hit its capacity limits and AD would exceed AS, leading to inflation. At this point, further
increases in national production would depend on new, more favourable aggregate supply conditions to grow
the economy’s productive capacity. However, sometimes there are less favourable aggregate supply conditions
limiting AS and the potential level of GDP.
Realising that aggregate supply conditions can become more favourable or less favourable, let’s see how they
work to affect productive capacity, AS, and the potential level of GDP, along with their impact on other domestic
macroeconomic conditions:
• More favourable aggregate supply conditions involve producers having access to extra resources, lower
production costs and stronger business profits. This acts as an incentive to make firms more willing and/or
able to expand their productive capacity. In this situation, the potential rate of economic activity, GDP,
employment, and incomes can readily increase, without adding to inflation. This thinking is summarised
in Figure 4.14.
• Less favourable aggregate supply conditions like reduced access to resources, supply chain issues, higher
costs, or lower profits, act as a disincentive. They cause producers to become less willing and/or able to
produce, contracting productive capacity, the potential rate of economic activity, employment, and incomes,
and adding to inflationary pressures. This is shown in Figure 4.15.

236 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
FIGURE 4.14 How generally more favourable aggregate supply conditions can increase the potential rate of
economic activity and improve domestic macroeconomic conditions

More favourable Increased potential level of Lower unemployment and

Reduced inflation:
aggregate supply factors: economic activity or GDP: higher incomes over time:

More favourable aggregate More favourable aggregate Over the longer-term, More favourable aggregate
supply conditions can supply conditions cause favourable aggregate supply conditions are
include … businesses to be more supply conditions cause usually associated with
• Increased quantity and willing and/or able to businesses to become more lower production costs and
quality of resources produce and grow their willing and/or able to better business profitability.
available productive capacity/AS, produce goods and This means that goods and
• Lower production costs expanding the potential services. They are keener services can be sold
including wages, level of economic activity to expand their output profitably by firms at lower
materials and GDP. because it is more prices, slowing the
• Increased productivity or profitable, and they are inflation rate.
efficiency in production hence less likely to close
• Increased business down or move overseas.
profitability This means, staff are less
• Favourable climatic events likely to lose their jobs and
• Government policies like more likely to earn higher
lower tax rates, better incomes, and have greater
infrastructure, and employment opportunities.
improved education and
skills.

FIGURE 4.15 How less favourable aggregate supply conditions can decrease Australia’s potential rate of
economic activity and weaken domestic macroeconomic conditions

Decreased potential level

Less favourable Higher unemployment
of economic activity or Increased inflation:
aggregate supply factors: and lower incomes:
production:

Less favourable aggregate Less favourable aggregate Over the longer-term, less Less favourable aggregate
supply conditions include … supply conditions cause favourable aggregate supply conditions are
• A decrease in the quantity businesses to be less supply conditions cause usually associated with
and quality of resources willing and/or able to businesses to become less higher production costs
available produce or expand their willing and/or able to and reduced business
• Higher production costs productive capacity/AS, produce goods and profitability. This means
including wages, decreasing the potential services. They are that to protect their profits,
materials level of economic activity discouraged from businesses try to pass on
• Decreased productivity or and GDP. expanding their output their higher costs to
efficiency in production because it is less profitable. consumers in the form of
• Decreased business As a result, some firms will higher prices. This
profitability close down or move increases the inflation rate.
• Severe climatic events overseas. This means staff
• The failure of some are likely to lose their jobs,
government policies to earn lower incomes and
adequately cut tax rates, have fewer employment
and improve infrastructure, opportunities.
and education and
training.

TOPIC 4 Economic activity 237

 FIGURE 4.16 As a result of severe weather events including cyclones, floods, fires
and droughts over the last five years to 2023, there was the loss of life, personal
suffering, property damages to homes, destruction of tourism, farming and mining
industries, and huge damage to infrastructure like roads and rail systems. This
limited productive capacity and AS, and reduced Australia’s potential rate of
economic growth.

4.10 Activities
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4.10 Quick quiz 4.10 Exercise

4.10 Exercise
1. Define the following terms:
a. aggregate supply (1 mark)
b. aggregate supply factors (1 mark)
c. productive capacity. (1 mark)
2. Giving examples, distinguish more favourable aggregate supply factors from less favourable aggregate
supply factors. (3 marks)

238 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
3. a. For each of the following events listed in the table below, explain how the aggregate supply factor or event
could affect Australia’s productive capacity, AS, and our potential long-term level of economic activity
and GDP. (12 marks)

Explain the way in which the event

affects productive capacity, AS and
Event potential GDP.
i. Efficiency among Australian workers and the
productivity of other resources fall to even lower
levels

ii. New oil and gas discoveries are made in SA to rival

those of the North-West Shelf

iii. Genetically modified (GM) sheep double wool

production per sheep per hectare

iv. Severe floods occurred in eastern states during

2019 and 2022

v. Business and government expenditure on new

capital equipment and buildings reaches an all-time
high

vi. Lockdowns and supply chain issues caused by the

COVID-19 pandemic between 2020 and 2022

vii. Bass Strait oil and gas reserves run out

viii. Soils in the Murray River region become salinated

and useless

ix. Mining in Kakadu causes environmental damage

and discourages tourism in the region

x. New technology leads to higher efficiency and lower

electricity costs

xi. Australia’s population rises to 28 million people

xii. A compulsory carbon emissions trading scheme

(ETS) is introduced to make polluters pay for carbon
emissions

b. Identify and outline how any two of the following could help to increase productive capacity
and AS. (2 marks)
I. Lower rates of company tax
II. Increased education spending
III. Promoting stronger competition in markets
IV. Building new infrastructure.

TOPIC 4 Economic activity 239

 4. Examine the graph below showing monthly changes in the number of business bankruptcies in Australia.

500

463 466
449
450
431 435
423 419

400

354 353
350

325
313

300

260
250
Jul 2021 Oct 2021 Jan 2022 Apr 2022
Source: Trading Economics, https://tradingeconomics.com/australia/bankruptcies.

a. Referring to the graph, describe the monthly change in the number of business bankruptcies in Australia
over the period shown. (2 marks)
b. Identify and describe three aggregate supply factors that could contribute to these changes in the level of
business bankruptcies. (3 marks)
c. Explain how the change in business bankruptcies would affect the levels of AS, Australia’s potential level of
economic activity and GDP, unemployment and potential incomes. (4 marks)

Solutions and sample responses are available online.

240 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.11 The measurement of economic growth using
changes in Gross Domestic Product (GDP)
KEY KNOWLEDGE
• The measurement of economic growth using changes in real Gross Domestic Product (GDP)
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Economic growth exists when a country’s economy gets bigger as a result of increasing economic activity. It
occurs when there is a rise in the total volume of goods and services produced by a nation between one year and
the next. This means that there are more goods and services being produced and made available for consumers,
helping to increase some aspects of living standards.

4.11.1 Measuring a country’s rate of economic growth using real GDP

The most common measure of economic growth is the percentage change in the quarterly (i.e. every 3 months)
or annual value of gross domestic product (abbreviated as GDP) or, more precisely, real or chain gross
domestic product. In the case of the latter, GDP statistics attempt to estimate the total annual value of goods and
services produced or sold by a nation. However, to make one year’s GDP results comparable with another’s, the
exaggeration of the value of production caused by the effects of inflation (i.e. generally rising prices paid for
goods and services) or deflation (i.e. generally falling prices for goods and services) is removed statistically so
we can compare like with like. The resulting measure produced by the Australian Bureau of Statistics (ABS)
shows changes in the real or actual volume of goods and services produced and is hence called chain volume
GDP. When looking at how the size of the economy has changed, it’s really volume changes rather than price
changes that we seek to measure.
Thinking back to the five-sector circular flow model of the economy (see subtopic 4.4), you may recall that
mention was made of the equality in the dollar values of total spending (called aggregate demand or flow 3),
national production of goods and services (called GDP or flow 4), and total incomes from the sale of resources
(flow 2). This means that Australia’s GDP can be calculated by the ABS using the three methods shown
in Figure 4.17.

TOPIC 4 Economic activity 241

 FIGURE 4.17 Three ways of calculating GDP to determine if there has been economic growth

1 - GDP method ($): 2 - Income method ($): 3 - Spending method ($):

The measurement of total output The measurement of total The measurement of total
or GDP (i.e. add up the total incomes (i.e. add up the total spending or AD (add up the
value added to the production value of all types of incomes values of the different
of all final goods and services). received from selling different components of expenditure on a
resources including wages, rent, nation’s output or AD consisting
interest, profits). of C + I + G + X - M).

Hence, if Australia’s total annual value of spending in a year was $2000 billion, then both GDP and total
incomes would also equal $2000 billion. All three methods of calculation provide almost identical results,
although there are small differences due to inaccuracies and other limitations of data.
Figure 4.18 shows changes in Australia’s GDP presented in two ways (notice that the left- and right-hand scales
on the vertical axis are not measured in the same units).
• Quarterly rate or percentage change in GDP (LHS): The graph columns show the quarterly percentage
change in the value of GDP using the left-hand scale. This tells us the speed of change in production
against the previous period.
• Quarterly level or value of GDP (RHS): The blue columns show the quarterly value of chain volume GDP
(measured in billions of dollars) using the right-hand scale. This tells us the total dollar value of output in
each quarter since March 2014.

FIGURE 4.18 Changes in Australia’s quarterly chain volume GDP shown in both percentage and dollar terms

Gross domestic product, chain volume measures, seasonally adjusted

4 540

520
2
500
0
480
$b
%

–2 460

440
–4
420
–6
400

–8 380
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22

Quarterly growth Levels (RHS)

Source: ABS, National income, expenditure and product, see https://www.abs.gov.au/statistics/economy/national-accounts/au
stralian-national-accounts-national-income-expenditure-and-product/latest-release.

242 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
As can be seen, the growth in Australia’s GDP has been quite unstable between one quarter and the next,
especially over the last two to three years. This volatility reflects changing aggregate demand and aggregate
supply factors, and the effects of COVID-19 lockdowns and recent disruptions to domestic and international
supply chains.

4.11.2 Limitations of using GDP as a measure of economic growth

Chain volume GDP is only an estimation of the total real value of national output or economic activity. Its
measurement is complex and involves huge quantities of data from lots of sources. It is therefore not surprising
that after the initial release of figures, the statistics are often revised with corrections. Even then, you should be
aware of at least two main limitations:
• Some production is not counted in GDP: Some non-marketed goods and services (items produced but
not sold normally through the market) are excluded from the GDP figures, often because they are too hard
to measure. For example:
• Do-it-yourself home production such as painting, housework, parenting and gardening are not included.
• Production involved in the cash economy, such as work that is paid as cash in hand and not declared to
the tax office, is excluded from GDP.
• Production in the black economy (e.g. the production and sale of illegal drugs) is not included in GDP.
• The value of goods and services produced by unpaid volunteers is not counted as part of GDP.
This makes GDP an underestimation of the change in the real level of national output.
• The value of some production must be imputed or ‘guesstimated’. Because of the lack of an alternative,
the ABS is forced to ‘guesstimate’ or impute the value of some types of goods and services that are
produced but not sold or marketed in the normal way. The inclusion of these items in GDP data may lead
to inaccuracies. For example:
• The value of farm production that is consumed on the farm and not sold is estimated and then included
as part of GDP.
• The annual value of accommodation provided by houses occupied by their owners is also estimated and
added to GDP.

TOPIC 4 Economic activity 243

4.11 Activities
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4.11 Quick quiz 4.11 Exercise

4.11 Exercise
1. a. Outline the three ways the annual value of Australia’s GDP can be measured by the ABS. (3 marks)
b. Outline two weaknesses that limit the accuracy of using real GDP as a measure of
economic growth. (2 marks)
2. Examine the table below showing the hypothetical data for an economy. Selecting only the relevant items
from the table, calculate the value of GDP ($ billions) using the AD or total spending method. Show how you
calculated the answer. (2 marks)

Item from the circular flow model Value ($ billions)

Household consumption $1600
Saving $100
Business investment $200
Government taxes $50
Government spending $40
Export spending $10
Import spending $5

Solutions and sample responses are available online.

4.12 The potential benefits of economic growth

KEY KNOWLEDGE
• The potential benefits of economic growth, such as growth in material living standards, improved
non-material living standards, employment opportunities and economic development
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

It is difficult to deny that economic growth (higher levels of national production) has helped most Australians
to enjoy better material living standards and has probably even improved some aspects of our non-material
wellbeing. These benefits are summarised in Figure 4.19.
Given these potential benefits, its no wonder that the Australian government promotes the goal of full
employment or the fastest rise in GDP that is possible (perhaps an average increase of around 3 per cent a year)
without causing serious inflation or jeaopardising the achievement of other important government economic and
environmental goals.

244 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 FIGURE 4.19 Summary of the main benefits of strong economic growth

The potential benefits of strong

rates of economic growth

Improves government
Creates new employment Increases personal incomes, Improves some
finances by lifting tax
opportunities and lowers purchasing power and aspects of non-material
revenues and reducing
unemployment material living standards living standards
welfare outlays

4.12.1 Strong economic growth creates new employment

opportunities and lowers unemployment
Strong economic growth and rises in real GDP create extra jobs, helping to keep unemployment rates at lower
levels. Indeed, one of the Australian government’s important aims is to achieve the goal of full employment.
This is defined as the lowest rate of unemployment, perhaps at around 4.0 to 4.5 per cent of the labour force, that
does not cause inflation to accelerate.
As illustrated in Figure 4.20, one benefit of strong economic or GDP growth of at least 2 to 3 per cent a year is
that it usually helps to lower Australia’s unemployment rate (e.g. during 2017–19 and 2021–22). This is because
when there is economic growth, firms usually need to hire or employ more staff to lift their production levels.
By contrast, weaker rates of economic growth, below 2 per cent, mean that cyclical unemployment soon rises.
For example, during the COVID-19-induced recession in 2020, annual GDP growth was 0 per cent. This caused
monthly unemployment to peak at 7.4 per cent (the actual figure was over 11 per cent but was artificially kept
down by the government’s JobKeeper wage subsidy scheme so people remained employed).

FIGURE 4.20 The close relationship between Australia’s rate of economic growth and the rate of unemployment

The relationship between Australia’s annual rate of economic growth (percentage

change in real GDP) and the unemployment rate (percentage of the labour force)
8
Rate of
Rate of GDP growth and unemployment

7.1
economic
7 growth (year
5.9 5.7 ended June,
6 5.4 percentage
5.2
4.9 change in Chain
5 volume GDP,
reference year
4 2019-20)
3.5
2.7 2.9 3.3*
3 Unemployment
2.3 rate (percentage
2.1
2 of labour force
1.5
at June)
1
0
0
2015–16 2016–17 2017–18 2018–19 2019–20 2020–21 2021–22 2022–23 2023–24

*12 months to March 2022

Source: Data derived from ABS, Labour force, https://www.abs.gov.au/statistics/labour/employment-and-unemployment/
labour-force-australia/latest-release; National income, see https://www.abs.gov.au/statistics/economy/national-accounts/
australian-system-national-accounts/latest-release.

TOPIC 4 Economic activity 245

4.12.2 Strong economic growth increases personal incomes and
material living standards
In general, income is earned by those who sell resources to the business sector and take part in the production
of goods and services. The more people produce and sell thereby growing GDP, the more income is earnt. One
measure of material living standards is real GDP per capita. Its level is very closely related to average incomes
per head and can be calculated as follows:

Average real GDP (income) per head ($) = real value of GDP ($) -:- population size
For example: If GDP equaled $1000 and the population size was 100, then average GDP (income) per
capita would equal $10 (i.e. $1000 -:- by 100).

When economic growth is strong, and GDP is rising at a faster rate than the rate of increase in our population
size, average per capita incomes and consumption levels increase. This is because to lift production, firms
employ more resources including labour. As a result, wages and total incomes rise.
However, when GDP growth is negative or increases very slowly, average per capita incomes fall. This is the
result of firms cutting production due to a lack of spending. They employ fewer resources, unemployment rates
climb, and more people end up on meagre welfare benefits of perhaps $300–400 per week, rather than perhaps
receive average weekly wages of around $1740 per week when employed. Clearly, their consumption levels and
living standards will fall dramatically.
Figure 4.21 shows the change in average real GDP (income) per capita. Notice that:

FIGURE 4.21 Strong economic growth at rates higher than rises in Australia’s population increase average per
capita production and incomes, while slower growth rates tend to reduce average per capital production and
incomes and therefore material living standards.

Australia’s average real GDP per capita (A$)

84 000

82 000
Average real GDP per capita (A$)

80 000
78713
78322 78245
78 000 77335 77518
76870
75909
76 000 75388
74690
74109
74 000
72440
71659 71436 71686
72 000
A rise in real GDP per capita means that because more goods and
services have been produced, more incomes are generated
70 000 allowing for greater purchasing are generated and material
living standards
68 000

66 000
2007–08

2008–09

2009–10

2010–11

2011–12

2012–13

2013–14

2014–15

2015–16

2016–17

2017–18

2018–18

2019–20

2020–21

2021–22

2022–23

2023–24

2024–25

Source: Data derived from ABS, National income, expenditure and product, Table 1, Key national aggregates, see https://www.abs.
gov.au/statistics/economy/national-accounts/australian-system-national-accounts/latest-release.

246 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 • overall, average real GDP per capita has increased substantially over the period leading to higher incomes,
consumption and material living standards
• the rise in average GDP per capita was faster in some years (e.g. 2011–12) than in others
• that there were only two years where average real GDP failed to record an increase on the previous
year’s level — 2008–09 (the global financial crisis) and 2019–20 (the COVID-19 recession), lowering
consumption and living standards.
Overseas experience has also impressively demonstrated
why strong economic growth is so important. As shown in
Figure 4.22, the spectacular rise in the average rate of
global economic growth, from 4.3 per cent in 1960–2000
to 6 per cent in 2000–10, saw a dramatic reduction in
extreme poverty (people surviving on less than US$1.90
per day) by over one billion people in the 25 years
between 1990 and 2015. An article in the Economist
claimed that two-thirds of this reduction can be credited to
strong global economic growth, with government policies
to reduce income inequality accounting for the remaining
one-third. For many people, economic growth has meant
increased life expectancy, better healthcare, and improved
education and literacy — elements essential for better living standards.

FIGURE 4.22 Strong global economic growth has helped to reduce levels of extreme poverty.

The number of people living in extreme poverty — including projections to 2030

1.9 billion people lived in extreme poverty in 1990 (36% of the world population)
1.9 billion

South Asia
1.5 billion

1 billion
730 million in 2015 (9.9% of
East Asia and Pacific the world population)

650 million in 2018

500 million
479 million in 2018

Sub-Saharan Africa

1990 1995 2000 2005 2010 2015 2020 2025 2030

Projection by the World Bank

Middle East and North Africa Latin America and the Caribbean
Other high income Europe and Central Asia

TOPIC 4 Economic activity 247

4.12.3 Strong economic growth improves the government’s finances
and its capacity to provide services and welfare
Another benefit of a strongly growing economy is that there should be an increase in average incomes, with
fewer people unemployed. This also means that there will normally be a rise in the amount of revenue collected
by the federal government from personal income and other types of tax (such as that collected from company
profits, and from the goods and services tax), along with reduced numbers receiving unemployment benefits.
This strengthens the government’s finances and budget position and is ultimately beneficial for our material
living standards. For example:
• The extra government revenue generated from strong economic growth can be used by the government to
better help the neediest individuals in our society through the payment of more generous cash welfare
benefits (e.g. to the unemployed, families, sick, aged and veterans), allowing these people to enjoy
reasonable living standards. There is more cash to go round for those needing help, and the welfare system
is financially more sustainable, without adding further to government debt.
• The extra tax money collected when economic growth is strong can also be used by the government to
provide better quality, cheap or free community services through the public sector (e.g. public health,
education, transport and housing).
By contrast, if economic growth is weak, supporting the incomes of the neediest individuals or providing
community services becomes even less affordable for the government, and living standards tend to fall.

4.12.4 Strong economic growth can improve non-material

living standards
Economic growth can sometimes help improve our non-material living standards and the quality of our
daily lives.
First, think for a moment about the massive non-material benefits Australians enjoy, largely thanks to decades of
quite strong economic growth.
• By sacrificing some income not needed for satisfying pressing needs, individuals have the possibility of
gaining more leisure time and reducing their hours of work.
• We have an increased ability to enrich our lives and minds through the broadening experiences gained from
international travel.
• We have the resources and capacity to tackle environmental problems that currently reduce our wellbeing.
• There is the opportunity to extend life expectancy and improve our quality of life through improved health
possibilities, care, and nutrition.
• Society can use technology and innovation to eliminate many physically demanding or boring jobs that
reduce work satisfaction.
• There is an improved capacity to allocate resources towards the arts, education, music, and drama —
experiences that can enrich our lives and expand our possibilities.
Second, strong economic growth normally tends to reduce
the number of persons unemployed and those in poverty.
For instance, in May 2022 when economic activity was
strong, there were only 548 100 unemployed, whereas
in July 2020 at the end of the recession, the number was
1 009 000, due to COVID-19 lockdowns and supply chain
issues. Sadly, studies reveal some of the devastating effects
of unemployment on the non-material living wellbeing of
individuals and society generally. For instance:
• Both the physical and mental health outcomes of the
unemployed are far worse than the outcomes
of those with paid jobs.

248 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 • More unemployed individuals experience feelings of failure, social isolation, and lack of self-worth.
• Unemployment causes family financial and other stress, breakups, and unhappiness.
• Both the ABS and the NSW Bureau of Crime Statistics have reported higher youth crime rates among
Australia’s long-term unemployed, those who leave school early, and people on low incomes and
in poverty.
These problems that undermineour non-material living standards tend to be less severe when there is stronger
economic growth and jobs are easier to find.

4.12 Activities
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4.12 Quick quiz 4.12 Exercise

4.12 Exercise
1. Before answering the questions that follow, examine the figure below showing the annual percentage change
in Australia’s rate of economic growth using real GDP.

Rate of economic growth (year ended June, percentage change in chain volume GDP,
reference year 2019–20)
Annual percentage change in the value of

5
4.5
4
chain volume GDP

3.5 3.3*
2.9
3 2.7
2.5 2.3
2.1
2
1.5
1.5
1
0.5
0.0
0
2015–16 2016–17 2017–18 2018–19 2019–20 2020–21 2021–22 2022–23 2023–24

* 12 months to March 2022

Source: Data derived from ABS, National income, see https://www.abs.gov.au/statistics/economy/national-accounts/
australian-system-national-accounts/latest-release.

a. Explain the general type of relationship that exists between Australia’s rate of economic growth,
the rate of unemployment, the level of average income per person and average material
living standards. (3 marks)
b. Referring to the figure in question 1, predict the years when Australia’s unemployment rate was probably
relatively low and average incomes relatively high. Justify your selection. (2 marks)

TOPIC 4 Economic activity 249

 c. Explain how a lower unemployment rate would be likely to affect society’s non-material living
standards. (2 marks)
d. Given a slower rate of economic growth in 2019–20, explain how you would expect this to affect the
Australian government’s financial situation and its ability to provide better services like transport,
education and welfare systems. (2 marks)
2. Again, referring to the figure in question 1:
a. Explain the general type of relationship that exists between Australia’s rate of economic growth and
the state of the Australian government’s financial position or budget (i.e. the difference in value between
total taxes and government outlays). (2 marks)
b. Referring to the figure in question 1, predict the years when the financial position of the Australian
government is likely to be relatively stronger. Justify your selection. (2 marks)
3. Sometimes, rapid economic growth can lead to an improvement in society’s non-material living
standards. Identify and outline two ways this might happen. (2 marks)

Solutions and sample responses are available online.

4.13 The potential costs of economic growth

KEY KNOWLEDGE
• The potential costs of economic growth, including boom and bust economic cycles, congestion and
pollution, environmental damage, potentially widening inequality and ‘affluenza’
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Few people, especially those in low-income countries, deny the

benefits of strong economic growth for general improvements
in living standards. Worldwide, and in the space of just two
decades, growth has lifted perhaps 1 billion people out of severe
poverty by helping to generate jobs, raise incomes, and allow
for a greater satisfaction of basic needs (like food, clean water,
accommodation, clothing and medical services) and even some
wants. However, the question that we must now ask is — at what
costs have we pursued economic growth? The main ideas are
summarised in Figure 4.23.

FIGURE 4.23 Some potential costs of economic growth

Potential costs of rapid economic growth

Environmental costs:
Social costs:
Increased CO2 emissions and
Reduced leisure time
Economic costs: climate change
Under-parenting of children
Higher rates of structural unemployment Deterioration of common access
Economic growth without appropriate
Possible rise in the inflation rate resources
government policies can lead to more
Slower future rates of economic growth Depletion of non-renewable
social inequality
natural resources
Increased stress and health issues
Increased noise and congestion

250 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.13.1 The economic costs of economic growth
While strong economic growth brings benefits, especially in the short-term, it also creates economic problems
and comes with at least three important costs.
• Rapid economic growth is unsustainable and will limit future economic growth
Given the world’s finite resources, strong economic growth today is likely to limit the future rate of
economic growth. This is because increasing GDP normally requires access to additional natural and
other resources. Unfortunately, our natural resources like clean water and air are limited. In addition,
as a consequence of using up non-renewable natural resources like minerals to fuel greater production
for the current generation, this is reducing the capacity of future generations and an ever-growing global
population to enjoy economic prosperity. This raises the question — how long will the world’s natural
resources last? While estimates exist for many key minerals, the answer is uncertain. It depends on
assumptions including new discoveries of mineral wealth, our ability to substitute one mineral or energy
resource for another by using fresh technology, the rate of population growth, and our ability to move
towards a circular economy (i.e. instead of extracting minerals and producing goods with a short life
expectancy to consume and then throw away, raw materials can be recycled and reused, slowing the
demand and depletion of some resources).
• Excessively strong economic growth can accelerate inflation
When economic growth is driven by strong rises in spending or AD, and the economy is close to its
productive capacity or on its PPF, it is common to see a rise in the prices paid for consumer goods and
services. Here, inflation is due to the onset of widespread shortages where demand or spending exceeds
supply or production. In turn, higher inflation has a negative effect. It reduces the purchasing power of
money, eroding consumption and hence material living standards.
• Economic growth can add to structural unemployment
Usually, rapid economic growth causes a fall in cyclical unemployment (i.e. unemployment that exists in
a recession due to a lack of spending or AD) because as businesses seek to expand production, they need
to purchase extra resources including labour. However, sometimes economic growth involves structural
changes to the way firms produce and sell goods and services and the type of things that are made in the
economy. When firms change their production methods and use new technology to become more efficient
(such as using robots on an assembly line, ATMs for banking, automated warehouses, online shopping
and so on), especially in the short-term, this can cause some workers to lose their jobs, resulting in higher
structural unemployment even though these changes can accelerate economic growth in the longer-term.
Additionally, in seeking to be more internationally competitive and expand, some firms undertake cost-
cutting measures. This can involve closing down less efficient and unprofitable business operations, or even
relocating the whole business to low-wage countries (e.g. Bonds underwear, Brinton’s carpets and aircraft
servicing moved to China, and customer call centres shifted to India). While adding to global economic
growth, this too can cause structural unemployment at home.

TOPIC 4 Economic activity 251

4.13.2 The environmental costs of economic growth
Economic growth can accelerate environmental problems including climate change and the deterioration in the
quality of common access goods (i.e. those things we all share and depend on, like the air we breathe, oceans,
wild fish stocks, climate, native forests, rivers, and ecosystems). In addition, economic growth, urban expansion,
increased urban noise, and overcrowding also go hand in hand with increasing GDP.
Economic growth causes a deterioration of common
access resources
Common access resources are needed for survival. They
are seen as free and non-excludable (that is, anyone can
use them without paying for them), so without proper
safeguards imposed by nations (e.g. environmental pollution
controls, or putting a price or cost on pollution to make it
less attractive), these resources are often over-exploited for
personal gain or profit. Abuse by individuals can deprive
others of consumption. The atmosphere is a common access
resource. So, when pollution is released into the air (or
waterways) as a result of production, consumption and waste
disposal, this creates negative externalities or costs for
third parties who are usually not directly involved with the
particular economic activity — costs associated with rising
sea levels, the destruction of island and coastal communities,
severe weather events, health issues, the loss of life and,
over time, reduced levels of GDP growth and economic
prosperity.
Economic growth accelerates climate change undermining
living standards
Much research now shows a close connection between rises in global GDP levels and climate change. This
connection exists because the production or goods and services, and their consumption and disposal, generate
greenhouse gasses that are released into the atmosphere. These cause global warming with far reaching negative
externalities or costs, now and into the future.
• Severe climatic events: Global warming is leading to more frequent and severe weather events including
cyclones, storm surges, droughts, extreme temperatures, bushfires, and floods.
• Rising sea levels: Global warming is melting the polar
caps, significantly increasing sea levels. This causes
coastal erosion, damages property, and threatens
coastal and island communities, adding to levels of
climate-induced migration.
• Climate change slows economic growth and GDP: For
most countries, climate change is a less favourable
aggregate supply factor that will continue to slow
economic growth, GDP, incomes and living standards.
For example, one estimate of the global cost of climate
disasters for 2020 put the loss at $272 billion! Another
report concluded that climate change would shave 11–
14 per cent off global GDP by 2050, compared with no
climate change. Modelling used in Figure 4.24 shows
the expected impact on counties’ GDPs of climate
change by 2100.

252 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 FIGURE 4.24 Projected change in GDP by 2100 from global warming against no climate change — losers
and winners

Change in GDP per capita

by 2100 compared to a
world without climate change

–100% 0% 200%

Source: Nature, see https://www.nature.com/articles/nature15725. Reprinted in World Economic Forum, What are the consequences
of climate change? See https://www.weforum.org/agenda/2015/11/what-are-the-economic-consequences-of-climate-change/.

While northern countries stand to gain, most (including Australia) are likely to suffer. Of particular note is that
those likely to suffer most are often low-income nations that have contributed least to emissions and climate
change. They are the third party paying a disproportionate share of the costs.
For Australia, apart from the significant loss of life and personal suffering, we think of the huge financial costs
of recent fires, floods and droughts over the last five years resulting in reduced yields, repairs to infrastructure,
houses and businesses, and insurance payouts. For us, these disasters are expected to rise in severity and
frequency at an annual cost estimated to be around $129 billion by the year 2100.
The main takeaway here is that the impacts of accelerating climate change dramatically reduce the material and
non-material gains or benefits derived from economic growth, and that it is time to take substantial action on
climate change and realise that it can not be business as usual.
• Food insecurity: Economic growth that has
accelerated climate change has also tended to slow
crop yields, despite advances in agriculture. With the
number of mouths to feed in the world still rising,
moving forward, food security has become an even
more significant issue. Volatile and generally higher
commodity prices are likely to mean that in some
years there will be less to eat, making life even
more precarious. In addition, water security is a real
problem in some countries. As highlighted by some
commentators, it is not a huge stretch to imagine that
issues related to food and water security could lead to
wars and threats to world peace.
• Degraded ecosystems: Climate change due to economic growth has undermined the sustainability and
quality of ecosystems. It has led to the loss of biodiversity needed to maintain functions like providing
oxygen, clean water, pollination, and pest controls that are needed for survival.
• Health impacts: Climate change is negatively impacting global health. There are deaths because of
heatwaves and air pollution (estimated by the WHO to be around 7 million per year). In addition, there are
changed patterns of disease spread (e.g. malaria and dengue fever).

TOPIC 4 Economic activity 253

4.13.3 The social costs of economic growth
Economic growth can accelerate social problems.
• Economic growth can reduce leisure time available
Economic growth can reduce the number of hours of leisure. This is because over the last 30 years,
Australian workers have seen an overall rise in actual hours worked by those employed full-time to
between 38 and 40 per week. With low wages and high costs of living, some are forced to have multiple
jobs to make ends meet. As a result, there has been a reduction in the number of hours left for recreation
and leisure, even though some people have taken a cut in income to reduce their time at work.
• Economic growth can reduce health
Economic growth can be associated with increased levels of stress and health issues brought on by
sedentary work, and pressures to lift workplace productivity and cut costs. There are also health issues
associated with the consumption of fast food for a busy lifestyle, along with the negative impacts of air and
noise pollution, and traffic congestion.
• Economic growth can harm families
Economic growth has been linked with a range of problems that
degrade family life. Perhaps the most common one is under-
parenting due to mums and dads working longer hours to earn even
more income. This means that they spend less time raising, loving,
and guiding their children. Some young people are left unsupervised
and to their own devices. Some wander the community, find
themselves in unsafe situations, or are exposed to crime and drugs.
These can lead to further social problems.
• Economic growth and a failure of government policy can lead to
more inequality
While economic growth has been good for many, the benefits of
increased output and incomes are usually not shared or distributed
equally. Some groups in society have benefited more than others
and, in most countries, there has been an increase in inequality between the rich and poor. This does not
necessarily mean that economic growth causes increased inequality — it is more complicated than this. In
fact, weak economic growth that leads to higher unemployment and lower incomes would almost certainly
make inequality even worse. The growing inequality in income and wealth that we now see is partly the
result of the government’s failure to adopt appropriate policies to ensure that the benefits of growing
national output and income are shared more evenly.
In Australia, for example, with rising revenue gained for economic growth, governments have cut tax
rates, and allow generous tax breaks that are most beneficial for higher income earners. While tax cuts
might incentivise effort, the policy has made the tax system less steeply progressive, allowing for greater
inequality. In addition, tax cuts have also reduced the government’s ability to pay for adequate welfare,
education, health, and public housing that are needed to help slow the rise in inequality.
• Affluenza — can money buy happiness?
Economic growth has created jobs, raised incomes, boosted consumption, and allowed most people to
enjoy generally better living standards. But does all of this necessarily lead to greater happiness? Some (but
not all) research suggests that only up to a point, where essential needs are met without uncertainty, does
earning extra money add to society’s happiness. Beyond this, there may be a trade-off.
Affluenza is mostly a problem for some in high-income countries. The term describes a social condition
that comes about from an individual’s obsession and single-minded pursuit of wealth and material things.
They fail to understand that their actions may hurt others and damage relationships, possibly leading to
depression and anxiety. People with this problem focus on work and believe that their self-image is linked
directly with their financial reputation and ability to display their success. This strong focus on material
values prevents them from gaining enjoyment from the broader non-material aspects of life such as love,
family, and recreational pursuits, ultimately leaving many feeling unfulfilled and unhappy. In some cases,
they try to buy happiness through destructive, risk-taking actions, including substance abuse.

254 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.13 Activities
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4.13 Quick quiz 4.13 Exercise

4.13 Exercise
1. a. Growth in GDP can potentially bring economic and social costs. Complete the table below by explaining
how economic growth might cause each of the impacts noted. (6 marks)

Explain how the growth in GDP might

Potential economic and social costs of economic growth cause the cost noted.
a. Increased inequality of incomes
b. Affluenza
c. Unemployment
d. Higher rate of inflation
e. Lower future rates of economic growth
f. Lower future incomes and material living standards

b. Some of our non-renewable natural resources are running out because of economic growth and a finite
planet. Depending partly on the decisions we make as consumers, future generations will probably have
reduced access to some resources. Classify each of the products in the table below as to whether they are
produced using mainly renewable (R) or non-renewable (NR) natural resources. (10 marks)

Type of product Classification of resources (R or NR)

a. A nylon shirt
b. A coffee table made from plantation pine
c. Petrol (crude oil)
d. Gas made from corn or sugar cane
e. Solar or wind power
f. A woolen jumper
g. Steel framing for a house
h. A plastic ruler
i. Cement
j. Sardines from the Atlantic Ocean

c. Over the past 1000 years, global production and population have both increased. Initially until the
early-1800s, this was relatively slow. However, in the subsequent 200 years, the process accelerated
dramatically and, when graphed, their level has risen exponentially at a faster and faster rate. In some
circles, this has caused alarm because the world’s resources are limited and in the long-term, growth in
production is unsustainable.

TOPIC 4 Economic activity 255

 Here is an old French riddle about exponential growth and environmental threats that you might like to
solve — when will the lily plant cover just half the pond? (1 mark)
Imagine you own a beautiful fish pond (representing the supply of the world’s resources) on
which a water lily is growing (representing the world’s demand for resources). This lily plant
doubles in size each day. If the lily is allowed to grow unchecked, it will completely cover the
whole pond in exactly 30 days, choking off all other forms of life in the water. For a long time, the
lily plant seems small and harmless, and so you decide not to worry about cutting it back until it
covers half the pond. Identify the day on which this occurs. The answer = day ………

d. Economic growth comes at a cost:

i. Define the term, negative externalities associated with economic growth, and outline how they can
affect living standards. (2 marks)
ii. Increased economic activity and growth can result in negative externalities. Describe the negative
externality that is likely to be the result of the economic activities listed in the table below. (10 marks)

Describe the negative

Type of activity externality and who pays the cost.
a. Increased wood chipping in the Otways and north-east
Victoria
b. Setting up a new paper mill in Burnie, Tasmania
c. The construction of a new tunnel near Westgate in
Melbourne
d. The opening of Sydney’s new airport in the west
e. A passenger smoking a cigar on a flight to Perth
f. Leaving an electric light on all day in your bedroom
g. Driving instead of walking to the corner shop
h. Off-road four-wheel driving and trail motorbike riding
i. Disposing of household rat poison down the sewer
j. Holding a wild and noisy party at your house on Saturday
night

iii. Climate change is an example of a negative externality associated with economic growth. Explain
how economic growth accelerates climate change and increases the incidence of severe weather
events. (2 marks)
iv. Explain how climate change and severe weather events can affect the material and non-material living
standards of Australians and people living in other parts of the world. (4 marks)
v. Define common access resources. Give examples of these resources. (2 marks)

256 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 e. Economic growth has also been associated with a reduction in some aspects of non-material living
standards, including the amount of leisure time. Examine the figure below, which is a comparison of hours
of work in selected countries as an influence on the amount of leisure time.

Where do employees work longer than 9 to 5?

% of employees working more than 50 hours per
week on average in selected countries*

Turkey 43.3%

Mexico 28.8%

South Korea 27.1%

Japan 22.6%

Australia 13.7%

United Kingdom 12.3%

United States 11.4%

Brazil 10.7%

France 8.7%

Spain 5.9%

Germany 5.6%

Russia 0.2%

*Latest available year

Source: Adapted from Measuring the Standard of Living, Tutor2u; Statista Charts.

For some people, growing national production and income have meant longer hours of work.
i. List the two countries that work the longest hours on average, and the two that work the shortest
hours. (2 marks)
ii. Identify and outline three ways long hours of work could reduce our non-material living
standards. (3 marks)

Solutions and sample responses are available online.

TOPIC 4 Economic activity 257

4.14 The limitations associated with using real GDP
and real GDP per capita to measure changes in
living standards
KEY KNOWLEDGE
• The limitations associated with using real GDP and real GDP per capita to measure changes in living
standards
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Living standards reflect the population’s overall level of wellbeing and is influenced by two aspects:
• Material living standards reflect the average level of income and consumption per person per year.
• Non-material living standards consider other factors not directly related to income that affect the quality of
life such as levels of happiness, freedom, pollution, crime, congestion, leisure time and relationships.
There is a temptation by some to use various GDP measures to indicate overall living standards. After all,
GDP is closely related to incomes and purchasing power. However, we are about to find out exactly what these
measures do and don’t tell us about society’s wellbeing.

4.14.1 Limitations of simply using real GDP as a measure of material

living standards
Some people mistakenly assume that the
FIGURE 4.25 Comparison of the GDP size in selected countries
level of chain volume GDP (i.e. real
GDP that has been adjusted statistically
to remove the effects of changing prices
on the value of output) can be used
as a stand-alone indicator of living
standards.
However, perhaps the most obvious
weakness is that without recalculating
data and allowing for a country’s
population size, GDP on its own tells
us almost nothing that is useful about
living standards. For material living
standards, what we really need to know
is the annual real value of GDP per
head or per capita (i.e. a nation’s real
GDP divided by its population size).
Even then, it tells us nothing about the
quality of life or non-material wellbeing.
Take a look at Figure 4.25. It compares the relative sizes of GDP ($) in selected countries. For example, it shows
that China’s GDP is about 12 times bigger than Australia’s. However, because China’s population is around 55
times that of Australia’s, their average GDP per capita is only about one-fifth the level of ours. Hence, their
material living standards are much lower. The takeaway here is that unless GDP is expressed in per capita terms
it is meaningless, even as a measure of material living standards.

258 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.14.2 Limitations of using real GDP per capita as a measure of
material living standards
Realising the complete uselessness of GDP on its own to tell us anything about overall living standards, we
often see chain volume GDP per capita quoted. However, this too has limitations and it’s what is left out of
the numbers that means it is a very rough measure indeed. It certainly does not tell the whole story about living
standards.
Because real GDP per capita takes account of population size, it is clearly an improvement on just using real
GDP. However, it still has serious limitations. These are summarised in Table 4.8.

TABLE 4.8 Limitations of using real GDP per capita as a measure of overall living standards
Limitations of using real GDP per capita as a Limitations of using real GDP per capita as a
measure of material living standards measure of non-material living standards
• Not all goods and services produced are • The depletion of important common access and
included in GDP— the measure is incomplete. non-renewable resources is not considered.
• The value of some production that is included is • The impact of CO2 emissions on climate is not
imputed or is ‘guesstimated’. considered.
• It fails to take account of how evenly goods, • Happiness and the loss of leisure time to work
services and income are shared or distributed are not considered.
across the whole population.

Limitations of using real GDP per capita as a measure of material living standards:
Material living standards reflect the annual level of incomes and purchasing power per person. Certainly, real
GDP per head is almost a reasonable guide to average income levels and hence consumption. However, it has
three main limitations.
Failure to consider inequality in the distribution of goods, services, and incomes
Perhaps the most important weaknesses of using average real GDP per capita as a measure of material living
standards is that it doesn’t tell us how evenly or unevenly the goods, services and incomes are shared or
distributed between individuals. If the income cake is divided evenly, then the average level of GDP would
be meaningful. However, if there is great inequality, as found in many countries, then the figure would be of
limited use. In Australia, for example, there is much inequality. The top 20 per cent of income earners receive
around 40 per cent of all income and the lowest 20 per cent receive just 7 per cent (i.e. the latter group is unable
to consume the same quantity of goods and services). So, average GDP per capita doesn’t tell us very much
at all.
GDP statistics do not include the value of all economic activity
Chain volume GDP measures the total real market value of finished goods and services produced in a country
over a period. However, this fails to include the value of all economic activity making it an underestimation of
the goods and services produced and available for consumption. Here we might think of the following excluded
items left out of GDP:
• Do-it-yourself home production such as painting, housework, parenting and gardening are not included.
• Production involved in the cash economy, such as work that is paid in cash and not declared to the tax
office and hence is not included.
• Production in the black economy (e.g. the value of illegal activities like crime and drugs) is not known and
hence can’t be incorporated in the figures.
• The value of goods and services produced by unpaid volunteers is not counted.

TOPIC 4 Economic activity 259

The value of some production must be imputed or ‘guesstimated’:
Because of the lack of an alternative, the ABS is forced to ‘guesstimate’ or impute the value of some types of
goods and services that are produced but not sold or marketed in the normal way. This may lead to inaccuracies.
For example:
• An estimate of the value of farm production that is consumed on the farm and not sold is estimated and
then included as part of GDP.
• An estimate of the annual value of accommodation provided by houses occupied by their owners is also
estimated and added to GDP.

Limitations of using real GDP per capita as an indicator of non-material living standards
It is fair to say that a country’s average real GDP per capita tells very little about society’s non-material living
standards or the general quality of life. For example, real GDP per capita fails to take account of negative
externalities that lower non-material living standards. Negative externalities (i.e. the environmental and other
costs imposed on third parties not connected with the economic activity that result from growing the production
and/or consumption of goods and services) are not taken into account in calculating real GDP per capita. There
are many examples of such external costs resulting from increasing production that undermine our personal
wellbeing, yet are ignored in GDP. For example:
• the loss of leisure time for families to spend together due to the pressures of work
• youth problems caused by more adults working long hours and under-parenting of children
• increased stress levels and loss of job satisfaction due to pressure to be more efficient and work harder
• the destruction of the natural environment — for example, the exploitation and depletion of environmental
or common access resources
• the costs to current and future generations of generating carbon pollution (CO2 ), that accelerates global
warming and climate change.
Because these external costs are not subtracted from the annual value of production, using real GDP per capita
as a measure greatly exaggerates our actual living standards.

FIGURE 4.26 When more goods and services are produced and
consumed from manufacturing, mining, agriculture and the generation
of power, more carbon emissions are released into the atmosphere,
contributing to global warming, climate change and severe weather
events. In addition, pollution of oceans can occur, perhaps due to oil
spills. These undermine both current and future living standards.

260 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.14 Activities
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4.14 Quick quiz 4.14 Exercise

4.14 Exercise
1. Explain what it means if Australia’s GDP rises by 3 per cent. (1 mark)
2. The value of GDP can be calculated by summing up the total value added to a nation’s production of finished
goods and services. According to the circular flow model, outline two other ways of calculating the dollar
value of a country’s GDP. (2 marks)
3. Examine the table below showing the recent real value of GDP measured in US$ for three countries—
Australia, Saudi Arabia, and Germany:

Country Real value of GDP (US$ millions)

Australia 1 620 600
Saudi Arabia 842 588
Germany 4 230 200
Source: Data derived from OECD.Stat, see https://stats.oecd.org.

Outline the main reason why we cannot conclude much from this data about the actual material living
standards that exist in Australia, Saudi Arabia and Germany. What additional data would we need to know to
draw more accurate conclusions? (2 marks)
4. Examine the table below before answering the questions that follow.

Information Australia Russia

Real GDP (US$ millions) 1 620 600 1 650 600
Population size (millions) 26 146
Average real GDP per head $.................. $..................

a. Given the information for Australia and Russia shown in the table, calculate the level of average material
living standards. (2 marks)
b. Explain why the answers you calculated may not be an accurate guide to general living standards in these
two countries. (2 marks)
5. Inflation (generally rising prices paid for goods and services) needs to be taken into account to accurately
measure the rate of economic growth, otherwise we cannot be sure what has happened to the real volume of
goods and services produced each year. If a country experiences rapid inflation of 10 per cent for the year,
explain how this normally would affect the nominal or market value of GDP (measured in dollars) and the
apparent rate of economic growth, if no attempt was made to remove the effects of inflation and convert this
to the real value of GDP. (2 marks)
6. Explain why real GDP per capita tells us almost nothing useful about a country’s non-material living
standards. (2 marks)
7. Giving examples, explain the meaning of negative externalities and how they affect our wellbeing or overall
living standards. (4 marks)

TOPIC 4 Economic activity 261

 8. Classify each of the events listed in the table that follows into those that are most likely to affect material
living standards and those that are most likely to affect non-material living standards, explaining your
reasons. In some cases, you might want to explain how both aspects of wellbeing could be affected by the
event. (20 marks)

Likely effect on Likely effect on

material living non-material living
Event standards standards
a. Your boss gets you to work more unpaid
overtime.
b. The level of GDP per hour worked increases.
c. Population densities in capital cities rise and the
city’s footprint grows.
d. Due to a new freeway, the time taken to travel to
work falls.
e. New mineral resources are discovered and
mined.
f. There was a rise in the minimum wage to around
$812.60 per week as in 2022–23.
g. Crime rates soar.
h. Inflation rises to high levels.
i. The minimum age for voting is increased to 25
years.
j. Welfare benefits are abolished.

Solutions and sample responses are available online.

4.15 Alternative measures of economic activity and

living standards
KEY KNOWLEDGE
• Alternative measures of economic activity and living standards
Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission.

Our overall living standards reflect both our material wellbeing (annual per capita income and the quantity
of goods and services each person consumes) and non-material wellbeing (the quality of our daily life
or existence). The most used indicator of Australian living standards or general wellbeing is the annual
average level of real GDP per person. This is calculated annually by dividing the real value of GDP by the
country’s total population. Sometimes, too, another measure is used such as the average disposable income per
person per year, which is derived also from the GDP figures. However, as mentioned previously, real GDP per
capita as a measure of overall living standards is flawed. For example:
• It is a single average number that cannot possibly measure all the dimensions of our wellbeing.
• It unrealistically assumes that the goods and services produced are shared evenly among all individuals.
• It fails to include some goods and services that have been produced, and only inaccurately imputes or
guesstimates the value of others.
• It says nothing about non-material living standards. For instance, it ignores the negative externalities
associated with economic growth — costs like climate change, the environment, reduced leisure time,
rising crime rates and reduced happiness — that clearly have a negative impact on our wellbeing.

262 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
With these shortcomings in mind, economists have investigated alternative indicators of living standards such as
MAP, HDI, Green GDP, and GNH. These are summarised in Figure 4.27.

FIGURE 4.27 Other measures of a nation’s living standards

Alternative measures of a nation’s living standards

Measures of Australia’s Human Development Gross National

Green GDP
Progress (MAP) Index (HDI) Happiness (GNH)

4.15.1 Measures of Australia’s Progress (MAP) as an indicator of

living standards
Unlike GDP, Measures of Australia’s Progress (MAP) is not a single statistical indicator of overall welfare.
Rather, it is a suite or collection of measures published by the Australian Bureau of Statistics (ABS), illustrated
in Figure 4.28. It arose partly out of public interest as to whether ‘life in our country is getting better’ and
whether this can be sustained indefinitely into the future. In addition, many felt that GDP alone was far too
narrow as a measure of economic progress or wellbeing.
MAP involves four main categories of measures used by the ABS:
• society
• the economy
• governance
• the environment.

FIGURE 4.28 Measures of Australia’s Progress (MAP)

Measures of Australia’s Progress (MAP)

Is life in Australia getting better?

SOCIETY ECONOMY ENVIRONMENT GOVERNANCE

Health Opportunities Healthy natural Trust

Close relationships Jobs environment Effective governance
Home Prosperity Appreciating the Participation
environment
Safety A resilient economy Informed public debate
Protecting the
Learning and Enhancing living environment People’s rights and
knowledge standards Sustaining the responsibilities
Community Fair outcomes environment
connections and International economic Healthy built
diversity engagement environments
A fair go Working together for
Enriched lives a healthy environment

What do these symbols mean?

The headline progress indicator for this theme has shown progress.
The headline progress indicator for this theme has shown regress.
The headline progress indicator for this theme has not changed greatly.
There is a data gap for this theme as there is currently no headline progress indicator.

TOPIC 4 Economic activity 263

It is important to realise that not every reader of this ABS publication will feel that all measures are important to
their personal definition of progress, but the hope is that the data will be used to support opinions and perhaps
shape government policy. Indeed, looking at the evidence and scorecard, particular indicators appear to show
progress, while others show regression or deterioration.
Most commentators believe that MAP is a superior approach to indicating changes in Australia’s living
standards. This is because unlike real GDP or income per capita, which only focus on some limited influences
on our wellbeing, MAP also factors in elements that say something about non-material wellbeing associated
with changes in our environment, society, and governance

4.15.2 The Human Development Index (HDI) as an indicator of

living standards
These days, the Human Development Index (HDI) is one of the most widely used indicators of economic
development and general wellbeing. It is an index created by combining a range of economic and social
indicators (although it fails to incorporate environmental considerations). Each year, the United Nations
Development Program calculates an HDI for most countries, and then ranks these from highest to lowest (using
a scale where 1 equals the highest score and 0 is the lowest level of development). Data is published annually in
the Human Development Report. As outlined below, the HDI is constructed to reflect both economic and social
indicators:
• The indicator of material living standards in the HDIs. The main economic indicator of wellbeing
in the HDI is real national income per capita. This figure is adjusted to remove variations in the actual
purchasing power of money in different countries (called purchasing power parity or PPP, expressed in
US$), as well as adjusted downwards for inequality in the distribution of goods and services.
• Indicators of social or non-material living standards in the HDI. Two key social measures used in the
HDI are life expectancy (calculated at birth and expressed in years) and education standards (shown by both
the mean and expected years of schooling).
Figure 4.29 shows international comparisons of the HDI for selected countries. Here, Norway is on top,
Australia is ranked eighth, while, unfortunately, the Central African Republic is last, sitting in one hundred and
eighty-eighth place.

FIGURE 4.29 International comparisons of living standards using the Human Development Index (HDI)
Very high human development Low human development
Score Score
(Inequality (Inequality
Rank Country adjusted HDI) Rank Country adjusted HDI)
1. Norway 0.899 180. Eritrea 0.459
2. Ireland 0.885 181. Mozambique 0.316
3. Switzerland 0.889 182. Burkina Faso 0.316
4. Hong Kong, China 0.824 183. Sierra Leone 0.291
(SAR)
5. Iceland 0.894 184. Mali 0.289
6. Germany 0.869 185. Burundi 0.303
7. Sweden 0.882 186. South Sudan 0.276
8. Australia 0.867 187. Chad 0.248
9. Netherlands 0.878 188. Central African 0.232
Republic
10. Denmark 0.883 189. Niger 0.284

264 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Very high (≥ 0.800)
High (0.700–0.799)
Medium (0.550–0.699)
Low (≤ 0.549)
Data unavailable (0.00)

Source: Based on data from Human Development Report 2020, The Next Frontier: Human Development and the Anthropocene,
United Nations Development Programme, pp. 343–346.

4.15.3 Green GDP as an indicator of living standards

Another alternative measure of living standards is green GDP. This is calculated by using data for real GDP and
subtracting the estimated value or cost of environmental damage (e.g. depletion of resources, the costs of climate
change and the loss of biodiversity) in producing a nation’s GDP.
One attempt at this measures the real value of goods and services or GDP produced (converted to common US$)
per ton of carbon emissions. This also reveals information about a nation’s contribution to climate change. Not
surprisingly, low-income countries usually have the greenest GDPs. Overall, the hope is to reveal a broader
picture of our general wellbeing, rather than simply using real GDP.

TOPIC 4 Economic activity 265

4.15.4 Gross National Happiness (GNH)
Starting in 2011, the United Nations invited member nations to measure their happiness. This was known as
the World Happiness Report. Essentially, Gross National Happiness (GNH) is a composite index made up of
several indicators including GDP per head, social support, health and life expectancy, freedom to make life’s
choices, generosity, and trust. It is updated annually.

Figure 4.30 uses data to rank the highest and lowest countries based on their score (near 10 represents excellent
happiness, near 0 represents great unhappiness). Notice that Finland ranks highest (7.632), Australia is in tenth
place (7.272) and Burundi scores lowest (2.904).

FIGURE 4.30 Gross National Happiness (GNH) scores and ranks for the happiest and most unhappy countries
Freedom to Perceptions
Overall GDP per Social Healthy life make life of
rank Country/region Score capita support expectancy choices Generosity corruption
1 Finland 7.632 1.305 1.592 0.874 0.681 0.192 0.393
2 Norway 7.594 1.456 1.582 0.861 0.686 0.286 0.340
3 Denmark 7.555 1.351 1.590 0.868 0.683 0.284 0.408

4 Iceland 7.495 1.343 1.644 0.914 0.677 0.353 0.138

5 Switzerland 7.487 1.420 1.549 0.927 0.660 0.256 0.357
6 Netherlands 7.441 1.361 1.488 0.878 0.638 0.333 0.295
7 Canada 7.328 1.330 1.532 0.896 0.653 0.321 0.291
8 New Zealand 7.324 1.268 1.601 0.876 0.669 0.365 0.389
9 Sweden 7.314 1.355 1.501 0.913 0.659 0.285 0.383
10 Australia 7.272 1.340 1.573 0.910 0.647 0.361 0.302

147 Malawi 3.587 0.186 0.541 0.306 0.531 0.210 0.080

148 Haiti 3.582 0.315 0.714 0.289 0.025 0.392 0.104
149 Liberia 3.495 0.076 0.858 0.267 0.419 0.206 0.030
150 Syria 3.462 0.689 0.382 0.539 0.088 0.376 0.144

151 Rwanda 3.408 0.332 0.896 0.400 0.636 0.200 0.444

152 Yemen 3.355 0.442 1.073 0.343 0.244 0.083 0.064
153 Tanzania 3.303 0.455 0.991 0.381 0.481 0.270 0.097
154 South Sudan 3.254 0.337 0.608 0.177 0.112 0.224 0.106
155 Central African
3.083 0.024 0.000 0.010 0.305 0.218 0.038
Republic
156 Burundi 2.905 0.091 0.627 0.145 0.065 0.149 0.076

266 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.15 Activities
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4.15 Exercise
1. Identify and outline the main weaknesses of using real GDP as an indicator of overall living
standards. (2 marks)
2. Describe the main features of the HDI as an alternative measure of living standards, giving reasons why some
prefer it to real GDP per head. (3 marks)
3. The ABS developed MAP as an alternative measure of changes in Australian living standards. Describe the
main features of the approach developed by the ABS called Measures of Australia’s Progress (MAP, see ABS
1370.0). You may like to use the Measuring Australia’s Progress (MAP) weblink in the Resources tab to view
the video about this measure. Identify the key areas within the four wellbeing categories of measure in which
Australia has seen either progress or regression. (4 marks)
4. Another alternative to real GDP per head as an indicator of wellbeing is Gross Domestic Happiness (GDH).
This indicator attempts to compare the happiness of people living in different countries, since perhaps the
bottom line of living standards is happiness. The figure below is a diagrammatic representation of what some
economic research has discovered about the growth in national production and average incomes per head on
the one hand, and the perceived wellbeing including happiness of people on the other.
a. By reference to the graph, explain whether a continued rise in the level of real GDP per head leads to an
equal rise in wellbeing including happiness. (2 marks)
b. Suggest and outline why this relationship between increased GDP per head and happiness behaves like
that shown on the graph. (2 marks)

However, as GDP per head continues to rise to

higher levels, improved wellbeing, happiness
and living standards more closely reflect better
Level of wellbeing and happiness

lifestyle rather than GDP or incomes.

Initially, improved happiness and wellbeing

are due to rising GDP per head and
better material living standards.
0
Level of GDP per head per year

TOPIC 4 Economic activity 267

 5. Examine the table below showing hypothetical data for a country over a two-year period:

Indicator 2023 2025

50 000 60 000
a. Annual value of real GDP ($ million)
10 12
b. Population size (millions)
1000 2000
c. Estimated value of environmental damage including
pollution ($ million)
80 85
d. Percentage of school age children completing Year
11
500 600
e. Number of serious crimes per 100 000 people
100 100
f. Index (on a base of 100 points) measuring the
change in inequality in the way income is shared or
divided

a. Explain which of each of these data might be used to determine how overall living standards might have
changed during the over the period between 2023 and 2025. (2 marks)
b. Showing your working, calculate the change in average material living standards over period between 2023
and 2025. (2 marks)
c. See if you can think of a way to calculate the change in average non-material living standards in this
country over the period between 2023 and 2025. For example, could you use relevant data to construct a
single index of non-material living standards? (3 marks)
d. Describe how overall living standards in this country have changed during the period from
2023 to 2025. (2 marks)

Solutions and sample responses are available online.

268 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
4.16 Review
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4.16.1 Summary
The nature and purpose of economic activity
• Economic activity is simply a term used to describe the process of making or selling goods and services.
Scarce resources are used to produce and sell goods and services, in exchange for income.
• Non-economic activities are generally not sold for money but are done for emotional reasons, concern for
others, or on a volunteer basis.
• The main purpose of economic activity is to use resources efficiently to produce and sell those goods and
services that best help to maximise the general satisfaction of society’s wants and wellbeing. Consumption
is the ultimate purpose or goal of economic activity.
The meaning of material and non-material living standards
• Living standards relate to our general level of wellbeing. There are two main elements that affect our
general or overall living standards:
• Material living standards are affected by the annual average level of income and consumption per person
per year.
• Non-material living standards reflect various elements that affect the quality of daily life.
• Material and non-material living standards are affected by the level of economic activity.
• When the pace of economic activity gets stronger this tends to increase material living standards, while
some aspects of non-material living standards might suffer (e.g. environment, sustainability for future
generations due to resource depletion).
• Weaker economic activity tends to undermine material living standards because of lower employment,
incomes, and consumption. Lower economic activity, causing higher unemployment and reduced
incomes, mostly erodes the quality of life and non-material living standards (e.g. social isolation,
reduced mental and physical health, unhappiness, possibly higher crime rate, increased stress). One
possible upside of slower economic growth is reduced pollution and pressure on the environment.
The five-sector circular flow model
• The circular flow model is a diagram that simplifies the operation of the economy. It shows how the main
parts of an economy interact to produce and distribute goods, services, and incomes.
• The five-sector circular flow model is more realistic than the three-sector model introduced earlier, because
it allows for saving and international trade.
• The five sectors or key parts of the economic model include:
• The consumer or household sector
• The producer or business sector
• The financial sector
• The government sector
• The overseas sector.
• The model has four main flows or streams that link the sectors of the economic model:
• Flow 1 Resources
• Flow 2 Incomes
• Flow 3 Spending/AD (C + I + G + X – M)
• Flow 4 Production/GDP

TOPIC 4 Economic activity 269

 • It should also be closely noted that, according to this model, the values of these flows are equal and are
interdependent — so if one changes, all change.
• The model can be used to help explain why the level of economic activity moves up and down in a cyclical
or wave-like manner.
• A rise in leakages relative to injections causes AD (flow 3) and economic activity/GDP (flow 4) to slow.
This reduces employment of resources, lowers incomes and undermines material living standards.
• A fall in leakages relative to injections causes AD (flow 3) and economic activity/GDP (flow 4) to rise,
causing increased employment of resources, higher incomes and improved material living standards.
The business cycle and recent trends in Australia’s economic growth
• Over a period of several years, the level of economic activity is unsteady — it speeds up and slows down in
a cyclical or wave-like way. This is called the business cycle. We use the business cycle model or diagram
to illustrate this.
• The business cycle consists of four key phases — the expansion, the peak (possibly a boom), the
contraction and the trough (possibly a recession). Each phase experiences different economic conditions
of output/GDP, unemployment and inflation.
• Domestic economic stability is the ideal situation and is somewhere midway between a boom and a
recession. Here, there is strong and sustainable economic growth (where GDP rises annually by around
3 per cent without inflation), unemployment is low (at around 4.0–4.5 per cent) and inflation is slow
(between 2–3 per cent a year).
• The Australian economy recently experienced the COVID-19 induced recession in the first part of 2020 and
a subsequent strong recovery during 2021–22.
Types of economic indicators
• There are three main types of indicators of economic activity that can shed light on conditions:
Lagging indicators of economic activity only tell the reader the level of activity that occurred some time
•
ago (e.g. GDP figures, the unemployment rate)
• Coincident indicators move very closely with actual changes in the level of economic activity
(e.g. monthly retail sales)
• Leading indicators can help to predict where the economy may be heading in the near future
(e.g. consumer confidence, business confidence).
• When examining statistical indicators related to changing economic conditions, economists look for
patterns in the data.
• The long-term trend refers to general or overall direction of change (upwards or downwards) in
economic activity measured over 10 or 20 years or more.
• The short- to medium-term cycles in economic activity are the wave-like changes in direction lasting
perhaps 1–5 years.
• Some data displays a seasonal pattern where peaks or troughs occur at the same month or time
each year.
• Erratic behaviour is where there is no obvious pattern because the data are reacting to one-off events.

The relationship between the business cycle and economic indicators

• As the economy travels along the business cycle from boom, to slowdown, recession and recovery, the
level of economic activity changes. In turn, this alters economic conditions affecting the rate of economic
growth/GDP, employment/ unemployment, inflation/purchasing power and living standards.
• In a recession caused by a drop in AD, there is a contraction of GDP over at least two consecutive quarters,
unemployment rises sharply, and inflation slows/or there is deflation.
• In a boom caused by a strong rise in AD beyond the economy’s productive capacity, there is an expansion
of GDP, unemployment falls to very low levels, and inflation accelerates due to widespread shortages of
goods and services (i.e. demand outstrips supply).

270 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
Factors that may affect Australia’s level of economic activity or rate of economic growth
• The level of economic activity or growth rate in GDP is determined by two key sets of factors — aggregate
demand and aggregate supply factors.
• Aggregate demand factors or conditions. Over the short- to medium-term, changes in aggregate demand
factors affect total spending on Australian-made goods and services (AD = C + I + G + C X – M) and
hence the national level of economic activity (measured by GDP). These factors may strengthen AD
or weaken AD by affecting the various components making up total spending. Using the circular flow
model stronger conditions generally boost AD, depress stocks, cause firms to expand output, employ more
resources and pay increased incomes, while weaker conditions generally have the reverse effects. Key
aggregate demand-side factors affecting these conditions include the following:
• changes in consumer confidence about future employment and income prospects can affect C and S
• changes in business confidence about future sales and profits can affect I
• changes in disposable income per head affect C and S
• changes in interest rates can affect S, C and I
• changes in taxes (T) can affect C while government spending directly affects G
• changes in the exchange rate for the A$ can affect X and M
• changes in the level of economic activity overseas can affect X.
• Aggregate supply factors or conditions. Most important for the medium- to longer-terms, the potential rate
of economic activity is governed by aggregate supply-side factors. These factors can affect Australia’s level
of AS, productive capacity, and size of our PPF. Over time, aggregate supply factors may become more
favourable growing AS, or less favourable reducing AS. They often affect the ability and willingness of
suppliers to produce goods and services. For example, if conditions become generally more favourable,
firms are keener to expand, growing their productive capacity. By expanding AS, this grows the country’s
potential GDP and income, and creates more employment opportunities. Examples of aggregate supply
factors include the following:
• the quantity/volume and quality/efficiency of labour resources available (e.g. affected by immigration,
birth rate, education, and skills)
• the quantity/volume and quality/efficiency of capital resources available (e.g. affected by level of
investment, interest rates, tax rates, and R&D)
• the quantity/volume and quality/efficiency of natural resources available (e.g. affected by mineral
exploration, land management, climate change and severe weather events)
• the level of production costs for producers and after-tax profits (e.g. affected by wage rates, labour
productivity, company tax rates, adequacy of government infrastructure, and education/training).
The measurement of economic growth using changes in real GDP
• The quarterly or annual rate of change in real gross domestic product or GDP (also called chain volume
GDP), is the most common general measure of economic growth or changes in the nation’s total output of
goods and services.
• There are three ways that the ABS calculates GDP. Referring to the circular flow model, we know that
GDP (the total value of finished goods and services produced) is also equal in value to AD (C + I + G +
X – M) and total incomes (e.g. wages + rent + interest + profits, etc.).
• However, real GDP on its own, as a measure of the size of our economy, lacks accuracy because it excludes
some production (e.g. the value of the cash and black market economies and DIY production), imputes
or ‘guesstimates’ the value of some output that is included (e.g. the net rental value of owner-occupied
dwellings).
The potential benefits of economic growth
• Economic benefits of growing the economy include more employment opportunities and jobs, and lower
unemployment rates as firms expand production. Economic growth also helps to raise personal incomes,
consumption and material living standards.
• Economic growth helps to increase government tax revenue and lower welfare outlays, strengthening the
government’s financial position and making the provision of essential services and welfare benefits for the
needy more affordable and sustainable. This supports better material living standards.

TOPIC 4 Economic activity 271

 • Economic growth can especially help improve some aspects of non-material living standards:
• reduced unemployment can improve happiness, relationships, self-esteem, health outcomes (mental and
physical), and reduce social isolation, crime, and stress
• enable people to enrich their lives by travel and involvement in the arts
• provide opportunities to exchange some reduction in hours of work for more leisure time.
The potential costs of economic growth
Sometimes economic growth can bring economic, environmental, and social costs. For instance:
• Economic costs might include:
• reduced capacity of future generations to enjoy reasonable living standards due to resource depletion and
environmental issues
• an acceleration of the inflation rate where higher prices may erode the purchasing power on incomes
• higher levels of structural unemployment resulting from the use of new technology like robotics in
manufacturing and workers lacking the necessary skills to gain employment.
• Environmental costs might include:
• the creation of negative externalities (i.e. where costs associated with the production and consumption
of goods are transferred to third parties not directly involved with the activities) such as pollution, global
warming and climate change, destruction of native habitat, loss of life in weather events, food insecurity,
displacement of island communities due to rising sea levels, urban over-crowding and waste disposal
problems, all of which lower our quality of life
• degrading of the quality of common access resources (e.g. air, water, forests, oceans) on which we all
depend.
• Social costs might include:
• reduced leisure time as people work more and pursue material goals
• reduced health due to increased stress and effects of pollution and climate change
• harm to families and society generally due to under-parenting caused by work
• increased inequality in the distribution of goods, services, and incomes given some government
measures that unfortunately make the tax system less progressive, and tax cuts that have led to
underfunding of welfare, education and health for those on lower incomes
• affluenza and an obsession with the pursuit of material goals at the expense of other important aspects
that lead to happiness and fulfillment.
Limitations of using real GDP and real GDP per head to measure living standards
• Some people mistakenly assume that the value of chain volume GDP (i.e. real GDP that has been adjusted
statistically to remove the effects on the value of output of changing prices) can be used as a stand-
alone indicator of living standards. However, perhaps the most obvious weakness is it fails to allow for a
country’s population size. What we really need to know is the annual real value of GDP per head (i.e. a
nation’s real GDP divided by its population size). Even then, it tells us nothing about the quality of life or
non-material wellbeing.
• An improved indicator of living standards is the value of chain volume GDP per capita, but even this does
not look at all aspects of living standards.
• Real GDP per capita is a poor measure of material living standards because:
• it fails to consider how evenly or unevenly goods, services, and incomes are distributed — it’s only an
average
• real GDP statistics do not include the value of all economic activity such as do-it-yourself home
production (e.g. including parenting and gardening), the cash economy and the illegal black market
economy. This means GDP is an underestimation of the quantity of goods and services produced and
available for consumption.
• Real GDP per capita is also a poor measure of non-material living standards because it does not capture
or take account of negative externalities (i.e. costs imposed on third parties that result from growing the
production and/or consumption of goods and services). These costs include climate change resulting from
carbon pollution (CO2 ). This results in more severe and frequent weather events involving the loss of
life, destruction of business, the displacement of communities, reduced leisure time for families to spend

272 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 together, youth problems caused by the under-parenting of children, increased stress levels and loss of job
satisfaction due to pressures to be more efficient.
Alternative measures of economic activity and living standards
• Real GDP per head (chain volume GDP) is a very narrow and limited indicator of society’s wellbeing. It
does not accurately reflect our material welfare, and it tells us almost nothing about our non-material living
standards.
• For this reason, alternative measures have been proposed that attempt to provide a more balanced picture
of our wellbeing. These include:
• Measures of Australia’s Progress (MAP)
• Human Development Index (HDI)
• Green GDP
• Gross National Happiness (GNH)

4.16.2 Key terms

Affluenza is a term used to describe a situation where making money and consuming goods and services is an
obsession that hurts individuals and others around them.
Aggregate demand (AD) represents the total value of all spending each year on Australian-made goods and
services (AD = C + I + G + X – M).
Aggregate demand factors are the conditions affecting total spending or demand for a nation’s goods and
services and include consumer or business confidence. Stronger aggregate demand factors boost spending,
while weaker conditions slow spending.
Aggregate supply (AS) represents the total volume of goods and services that the nation’s producers are
collectively prepared to make available over a period.
boom is a period of excessively strong economic activity and is shown as a peak on the business cycle.It is
caused by spending or demand rising faster than productive capacity or supply, leading to widespread shortages
of good and services and hence inflation.
Business confidence relates to the level of optimism or pessimism by firms about their future level of sales and
profits. It affects upcoming levels of new private investment spending and hence AD.
business cycle diagram is used to describe how GDP changes upwards and downwards over a period of
years. Typically, the economy passes through four main phases — a boom, slowdown, recession and recovery. In
addition, the ideal economic situation is called domestic economic stability. This is located on the business cycle,
midway between a boom and a recession.
Chain volume GDP is the value of final output of a nation’s goods and services. It is measured over a period of
time and is adjusted statistically downwards to compensate for the effects of inflation, or upwards to compensate
for the effects of deflation, on the value of national production.
Circular economy is a more sustainable type of economic system where minerals and some other resources
are used to make more durable goods that, when they have finished their useful life, can be recycled rather than
thrown away as waste.
Climate change relates to global warming caused by the release of greenhouse gasses resulting from the
production, consumption and disposal of goods and/or services.
Coincident indicators are measures of the economy that move very closely with actual changes in the level of
economic activity (e.g. share prices, monthly retail sales).
Common access goods are those things we all share and depend on like air, rivers and oceans.
Consumer confidence relates to the level of household optimism or pessimism about their future employment
and income prospects. It affects upcoming levels of household consumption spending and hence AD.
Cyclical unemployment is when individuals lose their job due to weak AD and a slowdown or recession.
Disposable income is money available for spending after households receive welfare and pay tax. It affects AD.
Domestic economic stability is the ideal economic position for an economy to be in. Conditions do not get
better than this, where simultaneously there is a strong and sustainable rate of economic growth (around 3 per
cent rise in GDP per year), full employment (around 4.0–4.5 per cent unemployment rate) and low inflation (an
annual rise in general prices averaging 2–3 per cent).
Economic activity occurs when resources are used by an economy to produce goods and services. In the
process, this also affects inflation and unemployment rates in an economy.

TOPIC 4 Economic activity 273

 Economic growth exists when a country’s economy gets bigger and there is a rise in the volume of goods and
services produced between one year and the next.
Erratic behaviour of economic activity show no pattern of change since their direction is caused by
unpredictable, one-off events.
Exchange rate for the A$ relates to the value of an $A when it is swapped for another currency in international
transactions. Its level affects the values of exports and imports and hence AD.
Expansion or the recovery phase of the business cycle is where the level of real GDP is rising and growth rates
are increasing towards perhaps 3 per cent per year.
Export spending (X) represents overseas spending on Australian-made goods and services (e.g. cotton, wool,
minerals, manufactured items and travel). This is an injection on the circular flow model that adds to AD.
The five-sector circular flow model is a diagram that shows how the various parts of an economy interact
through the four main flows – resources, incomes, spending and production. The five sectors include the
household, business, financial, government and overseas sectors.
The goal of full employment is the lowest rate of unemployment, in 2022 around 4.0–4.5 per cent of the labour
force, which does not accelerate inflation.
Government spending (G) represents public sector outlays that are designed to help satisfy the needs and
wants of the community for goods and services (e.g. roads, water, schools, telecommunications). This is an
injection that adds to AD.
Green GDP is a measure of a nation’s economic growth adjusted downwards for the environmental impacts
(e.g. the depletion of resources, environmental degradation and loss of biodiversity) of producing goods and
services. Some believe this more accurately reflects society’s living standards than the traditional GDP measure.
Gross domestic product (GDP) is a quarterly or annual measure of the value of finished goods and services
produced by a nation. On the circular flow model, is also equal in value to AD and total incomes.
Gross National Happiness (GNH) is a composite index made up of several indicators such as GDP per head,
social support, health and life expectancy, freedom to make life’s choices, generosity and trust. Some believe this
is a better guide to living standards than the traditional GDP measure.
Human Development Index (HDI) is one of the most widely used indicators of our economic development and
wellbeing. It is an index created by combining a range of economic and social indicators. However, it does not
incorporate environmental considerations.
Import spending (M) is expenditure by Australians on foreign-made goods and services, which is designed to
help satisfy our needs and wants (e.g. oil, electronics, travel). It is a leakage on the circular flow model,
slowing AD.
Income is the payment of money, generally to those who have sold productive resources to firms.
Inflation refers to a situation where most prices paid for a basket of consumer goods and services are rising over
a period, causing a drop in the purchasing power of money. It may be the result of higher production costs or
general shortages of goods and services due to too much spending.
Infrastructure represents capital resources like roads, ports, power, hospitals, railways, and water supply that
enable businesses to produce other goods and services. Often this is provided by governments, sometimes in
partnerships with private firms. There is economic infrastructure (e.g. the construction of the NBN, the new airport
in Western Sydney) and social infrastructure (e.g. schools and hospitals).
Injections are elements in the circular flow model (e.g. investment spending/I, government spending/G, and
export spending/X), which act like an accelerator and add to the total value of spending on Australian-made
goods and services.
Interest rates are the price or cost of borrowing credit from banks and influence the incentive to save and the
levels of consumption and investment spending.
Lagging indicators are measures of the economy that only tell the level of activity that occurred some time ago
(e.g. GDP figures, the unemployment rate).
Leading indicators are measures that can help to predict where the economy may be heading soon (e.g.
consumer confidence, business confidence).
Leakages are elements in the circular flow model (e.g. savings/S, taxes/T and spending on imports/M) that act
like a brake and slow down the total value of spending in our economy.
Living standards refers to how well-off a nation is overall. There are two components — material living standards
(relate to the level of incomes and the quantity of goods and services consumed by each person each year), and
non-material living standards (relates to the quality of daily life for individuals as affected by subjective elements
including levels of happiness, job satisfaction, crime, environmental health, mental and physical health, life
expectancy, urban congestion, hours of work and leisure, family tensions and stress).

274 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
Long-term or run refers to changes in economic activity or other variables that occur over perhaps 10 or 20
years, or more.
Material living standards are dependent on a person’s level of income and consumption of goods and services,
measured over a period. Real GDP per head per year is often used as a rough indicator of average material living
standards.
Measures of Australia’s Progress (MAP) is not a single statistical indicator of overall welfare, but is a collection
of measures within four areas — society, the economy, governance, and the environment. It allows people to
determine whether their wellbeing is progressing or regressing.
Negative externalities are the costs transferred to third parties not directly involved in economic activities, which
result from the production and consumption of goods and services (e.g. global warming).
Non-economic activities are those generally not sold for money, but are performed for emotional reasons,
concern for others, or on a volunteer basis. Their value is not included in GDP.
Non-material living standards are not related to the quantity of goods and services that we have, but instead
are elements of our wellbeing that affect the quality of our daily lives, and may perhaps involve levels of freedom,
happiness, quality of family life, justice, amount of leisure time, crime, health and life expectancy, pollution, and
the state of the natural environment.
Overseas economic activity relates to whether globally, demand and economic conditions abroad are strong or
weak. Its level affects the sales of Australian exports or injections and, hence, AD.
Peak is a phase on the business cycle diagram that occurs when GDP reaches its maximum level, and the rate of
growth is strong. If there is a boom, inflation will rise and unemployment will fall to very low levels.
Private consumption spending (C) represents household expenditure that is designed to help satisfy
people’s immediate needs and wants for goods and services (e.g. food, holidays and clothing). It is the biggest
single component of AD.
Private investment spending (I) is outlays by businesses for the purchase of machinery, technology and
buildings (e.g. a tractor, a robot or a factory) used to help make other goods and services. It is designed to
help grow efficiency and expand a firm’s productive capacity by growing its physical capital resources.
Productivity is an aggregate supply factor that is a measure of efficiency — that is how much output is
gained from a unit of resources or inputs used in production. GDP per hour worked is a measure of labour
productivity that can grow a nation’s productive capacity and potential GDP.
Purchasing power parity is used to make adjustments to the purchasing power of money in different countries
so as to allow international comparisons of incomes. The adjusted number is usually expressed in international
dollars.
Recession is a period on the business cycle where there is very weak economic activity and GDP falls over at
least two consecutive quarters (a 6-month period). It is caused by a lack of spending, leading to much unused
productive capacity. This results in high levels of unemployment, lower average incomes and depressed material
living standards.
Recovery is a period on the business cycle where the levels of national production and employment are rising.
Seasonal pattern in data or graphs are those that occur in the same month or time each year.
Severe weather events include floods, cyclones, drought, and bushfires. They are unfavourable aggregate
supply conditions that are linked with economic activities, increased CO2 emissions, and global warming.
Short-term refers to changes in the direction of an economic variable lasting perhaps 1–5 years.
Slowdown is the downswing phase on the business cycle where the rate of growth in GDP is decelerating.
Typically, this is caused by a softer levels of national spending. Here, unemployment rises and inflation slows.
Structural unemployment can occur when firms change their production methods and use new technology to
become more efficient (such as robots on an assembly line, ATMs for banking, automated warehouses, online
shopping and so on). It can also occur when firms relocate perhaps overseas, or there is a mismatch between the
skills possessed by unemployed workers and the requirements of the jobs that are currently available.
Total income is one of the four flows making up the circular flow model. It represents the total value of payments
to individuals selling resources used by firms to produce goods and services. It is equal in value to AD and GDP.
Trough is the phase on the business cycle diagram that occurs when production reaches its lowest level. It
may also represent a recession or depression, where GDP falls. Usually, unemployment is higher, and inflation is
slower.

TOPIC 4 Economic activity 275

 Resources
Resourceseses
Digital documents Topic summary (doc-37941)
Key terms glossary (doc-37948)
Crossword (doc-39029)
Wordsearch (doc-39030)
Match-up definition (doc-39031)

4.16.3 Practice school-assessed coursework

OUTCOME 1
Explain the purpose of economic activity, the distinction between material and non-material living standards and
the factors that may affect level of economic activity and growth, discuss the costs and benefits of economic
growth and examine the impact of economic activity on living standards using alternative measures.

TASK: REPORT ON AN INVESTIGATION OR INQUIRY —

Tracking Australia’s changing economic and other conditions affecting our living
standards
Background
In the years leading up to mid-2008, the Australian economy experienced near-boom conditions. However, during
2008–09 this was suddenly interrupted by the global financial crisis (GFC) and there was a sharp contraction.
Australia narrowly avoided a recession. This period was followed by a long and slow recovery till 2020. However,
the last couple of years have seen considerable instability generated by the combined effects of sometimes
volatile aggregate demand and aggregate supply conditions. For instance, in the first half of 2020, there was
the COVID-19-induced recession where spending was weak, followed by a strong recovery. There were also
bushfires, floods, cyclones, drought, the pandemic lockdowns, disruptions to supply chains, and war in Eastern
Europe.

Outline of the task

As you know, when the level of economic activity and growth change, this has knock-on effects for jobs,
unemployment, incomes and both material and non-material living standards. Your task here is to conduct
research and then prepare and present a report about Australia’s changing macroeconomic conditions over
recent years. The report has three parts:
1. Describe Australia’s changing macroeconomic and other conditions affecting living standards
• Recent trends in material living standards: Consider three areas.
° Recent trends in economic growth: Using graphs, briefly describe the most recent trends in real or
chain volume GDP (using annual or quarterly changes in real GDP as the measure) as an indicator
of the level of economic activity and as a guide to changes in national incomes.
° Recent trends in unemployment: Using graphs, briefly describe the most recent trends in the
unemployment rate (percentage of the labour force).
° Recent trends in inflation: Using a graph(s), briefly describe the most recent trends in the rate of
inflation (use the annual or quarterly percentage change in the consumer price index or CPI as the
measure).
• Recent trends in non-material living standards: Using graphs, describe the most recent trends in two
indicators of non-material living standards
2. Factors that have caused changes in economic activity and hence living standards
• Aggregate demand factors: Select two important aggregate demand factors and explain how each has
helped to shape recent economic conditions. Using two graphs, describe the most recent trends in these
aggregate demand-side conditions.
• Aggregate supply factors: Select two important aggregate supply factors and explain how each has helped
to shape recent economic conditions.
3. Your forecast!
• Given trends in economic growth over the last quarter (3 months), have a go at predicting the near-term
future direction of the economy. A clue — recent trends in leading indicators might be useful here!

276 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Research resources
There is much economic information available on the internet although not all sources are reliable. Often,
quarterly or monthly data are useful for spotting changes in the economy’s direction since it is more up-to-date.
As a start, you might like to check out some of the weblinks in the online resources.

Presentation
Your report must include graphs and commentary. It could be presented in one of the following formats:
• a PowerPoint presentation involving a series of illustrated slides, cartoons, pictures and of course graphs
• a feature newspaper report or article
• a wall poster for classroom display involving headings and a series of graphs with commentary beneath
each.

Resources
Resourceseses
Digital document Practice school-assessed coursework (doc-38077)
Weblinks Reserve Bank of Australia, RBA Chart Pack
Australian Bureau of Statistics (ABS) – GDP
Australian Bureau of Statistics (ABS) – Unemployment
Australian Bureau of Statistics (ABS) – Inflation
Trading Economics (data for Australia)
Macrotrends

4.16 Exam questions

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Section A: Multiple choice questions

Question 1

Which of the following statements about economic activity is least correct?

A. It refers to the actions of individuals involving the making and selling goods and services.
B. To be included in GDP, goods and services usually need to be sold for money or income.
C. The value of GDP is commonly used as a measure of economic activity.
D. The value of work performed by volunteers is normally included in GDP.

Question 2

In an economy, real economic growth always occurs when:

A. there is more spending on goods and services between one year and the next.
B. there is more production of goods and services between one year and the next.
C. there are more resources available between one year and the next.
D. business activity is steady between one year and the next.

TOPIC 4 Economic activity 277

 Question 3

Concerning chain volume GDP as a measure of total economic activity or the size of the economy, which
statement is generally false?

A. It measures the annual value of most goods and services produced.

B. In the circular flow model, it can also be estimated by measuring AD or the total incomes paid to producers.
C. It has had to be adjusted to help remove the effects that inflation or deflation have on the value of production.
D. Its value includes all goods and services produced in the country (including washing the dog, home-grown
vegetables, trade in illegal guns) and it makes a downward adjustment to allow for negative externalities.

Question 4

Which one of the following would have an effect on the rate of economic activity and economic growth that is
different from that of the other three?
A. The government announces a cut in income tax.
B. Households feel pessimistic about their future employment prospects and fear that they may soon become
unemployed.
C. The rate of economic growth in the United States and Japan strengthens, combined with a lower exchange
rate for the A$.
D. Interest rates fall following an announcement by the RBA.

Question 5

Given the hypothetical data in the table below, predict what might be happening to the country’s rate of economic
activity or growth. Assume that the country has been enjoying a 4 per cent annual rate of economic growth with
fairly low unemployment.

Annual percentage growth Annual percentage growth

Component of AD last year this year
C 5 1
I 4 2
G 2 1
X 7 4
M 9 9

A. The rate of economic growth will probably tend to accelerate.

B. It is impossible to predict anything about the rate of economic growth.
C. The rate of economic growth will probably tend to slow.
D. There will tend to be a boom.

Question 6

Referring again to the table from question 5 and the two-year trend in the components of AD (C + I + G + X − M),
which one of the following causes is most likely to be a correct explanation?
A. Businesses became more optimistic about sales and profits.
B. Economic activity overseas must be rising.
C. There has probably been a fall in household disposable income.
D. The government has recklessly increased budget spending on public works and community services such as
health and education.

278 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Question 7

In the long-term, an economy needs more than just increased spending to sustain an increase in production or
GDP. Which of the following is the least correct explanation of this statement?
A. Strong spending or AD on its own cannot make an economy grow any faster once it has reached its
productive capacity or potential GDP.
B. The lack of access to extra resources restricts production levels and economic growth in some economies.
C. Some economies cannot lift the growth rate in output because of low efficiency in production.
D. In the long term, spending is always too low for the economy to fully use its capacity.

Question 8

Which one of the following aggregate supply developments would tend to affect Australia’s long-term rate of
growth in output or GDP in a different way from that of the other three?

A. The use of genetically modified crops by farmers

B. Successful measures to help drought-proof Australian farmers
C. Legislation that lowers the minimum retirement age for workers to 60 years
D. Legislation that raises the minimum school leaving age to 17 years

Question 9

Which of the following would not tend to lift Australia’s long-term level of national output?

A. A fall in the percentage of adult females choosing to be in the labour force

B. Government policies designed to help lift efficiency by providing free re-training courses for the unemployed
C. An increase in the normal retirement age from 65 to 67 years
D. Encouragement of mineral exploration and R&D.

Question 10

Concerning the effects of an increase in the level of economic activity, which of the following is false?

A. Attempts to increase the level of economic activity through greater efficiency and cost cutting by firms can
sometimes lead to higher structural unemployment in the short-term.
B. Higher economic activity usually causes unemployment to fall.
C. Without special government policies, such as progressive income taxes or welfare benefits for the needy,
there is the danger that rises in economic activity may increase inequality in incomes.
D. An increase in economic activity usually slows the rate of inflation.

Question 11

Increased economic activity:

A. can lead to global warming and severe weather events that undermine material and non-material living
standards.
B. can sometimes contribute to lower living standards for future generations.
C. can cause negative externalities such as reduced leisure time, traffic congestion, urban overcrowding, and
waste disposal problems for cities.
D. can cause all the above.

TOPIC 4 Economic activity 279

 Question 12

The level of private consumption spending (C) and the level of economic activity or GDP are likely to fall if there
was a:

A. rise in consumer confidence. B. fall in household savings.

C. rise in household income. D. rise in government tax rates.

Question 13

The level of private investment spending (I) and rate of economic activity or GDP would tend to increase if there
was a:

A. rise in business confidence about future sales and profits.

B. rise in interest rates on bank loans to businesses.
C. fall in business profits.
D. rise in the rate of company tax on firms.

Question 14

The value of spending on Australian exports (X) is likely to rise if:

A. there was a recession overseas.

B. exports become dearer or less competitive for overseas buyers.
C. the exchange rate for the A$ fell making exports cheaper for overseas consumers.
D. there was a drought or floods in Australia that destroyed our crops.

Question 15

Which statement about Australia’s AD is most correct?

A. C represents private household consumption including spending on takeaway food, holidays, and clothes.
B. Aggregate demand is the total of all types of spending on our goods and services over a period of time,
represented by C + I + G + X + M.
C. I represents business spending, which would rise if business confidence fell.
D. If AD rose, GDP would fall.

Question 16

Using the table that follows, which of the following statements about AD in a hypothetical economy in 2023 and
2024 is incorrect?

Component 2023 ($ millions) 2024 ($ millions)

Private consumption (C) 9.6 10.0
Savings (S) 1.3 1.4
Private investment (I) 3.6 3.5
Tax revenue (T) 3.6 3.6
Government outlays (G) 4.0 4.3
Imports (M) 3.5 3.8
Exports (X) 3.6 3.9

280 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
A. AD was higher in 2024 than in 2023.
B. AD was $17.3 million in 2023 and $17.9 million in 2024.
C. Theoretically, the change in private or household C in 2024 may have reflected weaker consumer confidence
than existed in 2023.
D. The value of net exports over the period 2023 to 2024 did not change and was equal to $0.1 million in both
years, thereby tending neither to boost nor slow AD and the rate of economic growth.

Question 17

Again, using the data contained in the table from question 16, which statement about leakages and injections is
most correct?

A. The total value of leakages rose between 2023 and 2024.

B. The total value of leakages increased from $8.4 million in 2023 to $8.8 million in 2024.
C. The total value of injections was lower in 2023 relative to the total value of injections in 2024.
D. All of the above statements are correct.

Question 18

Which of the following would be least likely to increase a country’s rate of economic growth and activity over the
short-term?

A. Increased investment levels and the expansion of capital resources

B. Farming methods resulting in better soil management and fertility
C. Increased concern over environmental matters and Indigenous land claims (which have reduced access to
natural resources)
D. The accelerated application of new technology in industry

Question 19

A negative externality is best illustrated by which of the following examples?

A. You clean up and beautify your front garden, which is visible from the street.
B. The club near your house runs its noisy and unruly venue each Friday and Saturday night until 3 am.
C. A coal mining company restores a damaged mine site and replants the native vegetation.
D. You pay for the cost of renovating the inside of your house.

Question 20

Concerning types of economic indicators, which of the following is most correct?

A. Consumer confidence is a coincident indicator of economic activity.

B. GDP is a leading indicator of economic activity.
C. New building approvals by councils are an example of a leading indicator of economic activity.
D. Over a year, unemployment can change in a seasonal way.

Resources
Resourceseses
Digital documents Multiple choice answer grid (doc-37958)
Multiple choice answers (doc-37959)

TOPIC 4 Economic activity 281

 Section B: Extended response questions
Question 1 (9 marks)

a. Clearly distinguish material living standards from non-material living standards. (2 marks)
b. If a nation’s real value of GDP in 2023 was equal to $1500 billion, and its population was 25 million,
calculate the average value of real GDP per capita. Show your working. (1 mark)
c. Explain the extent to which GDP per capita is an accurate measure of a nation’s overall living
standards. (3 marks)
d. Identify and explain an alternative measure of a society’s overall living standards to real GDP per capita.
Explain why your chosen measure may be superior to using real GDP per capita. (3 marks)

Question 2 (9 marks)

a. Explain what is meant by the business cycle. (2 marks)

b. Neatly draw and fully label a typical business cycle diagram for an economy. (3 marks)
c. Distinguish a period of boom from a period of recession. (2 marks)
d. Explain what is meant by domestic economic stability. (2 marks)

Question 3 (16 marks)

Economists use the five-sector circular flow model to help understand how the economy operates and the impact
of various events on domestic macroeconomic conditions.

a. Neatly draw and fully label a five-sector circular flow model representing the Australian economy. (5 marks)
b. Define the following terms:
• Aggregate demand (AD)
• Gross domestic product (GDP)
• Total incomes
c. Distinguish injections from leakages. (2 marks)
d. Recently, the level of consumer confidence fell below 100 points. Use the circular flow model to
explain, step by step, the likely consequences of this event on Australia’s economy, ensuring that your
explanation follows a logical sequence. (3 marks)
e. Using the five-sector circular flow model to help sequence or order your ideas in a logical manner,
explain the likely domestic macroeconomic effects of a rise in the total value of leakages relative to the total
value of injections. (4 marks)
f. Identify an aggregate demand factor that is likely to have accelerated Australia’s level of aggregate demand
during the last couple of years and then explain its likely impacts on the level of economic activity. (2 marks)

Question 4 (8 marks)

a. Define the term, aggregate supply factors. Draw a fully labelled production possibility diagram to show,
hypothetically, how more favourable aggregate supply factors might theoretically affect the size of Australia’s
production possibility frontier, potential level of GDP and AS. (3 marks)
b. Identify a suitable example of an aggregate supply factor and then explain how this factor might have tended
to slow Australia’s rate of economic growth in recent years. (3 marks)
c. Explain how improvements in education standards and skills might affect Australia’s AS and potential rate of
growth in GDP. (2 marks)

282 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition
 Question 5 (10 marks)

Aggregate demand and aggregate supply factors can affect the level of economic activity. Giving brief reasons,
classify each of the items in the table below as an aggregate demand factor, or an aggregate supply factor, or in
some cases, possibly both an aggregate demand factor and an aggregate supply factor:

Factor An aggregate demand An aggregate supply Both an aggregate

factor (explain why) factor (explain why) demand and aggregate
supply factor (explain
why)
a. Disposable income
b. Spending on education
and skills
c. Level of economic
activity in China
d. Interest rates
e. Business confidence
f. Outlays on
infrastructure
g. The value of the A$
h. Lower rate of company
tax
i. Labour productivity
j. Climate change with
global warming

Question 6 (6 marks)

Examine the graph before answering the questions relating to it:

110 108.8

106.2
105.3
105 104.1 104.6 104.3
102.2
100.8
100

96.6 95.8
95

90.4
90

86.4

85
Jul 2021 Oct 2021 Jan 2022 Apr 2022
Source: Trading Economics, Monthly changes in Australia’s consumer confidence, see https://tradingeconomics.com/australi
a/consumer-confidence.

TOPIC 4 Economic activity 283

 a. Define the term, consumer confidence. (1 mark)
b. Referring to graph statistics, describe the overall change in consumer confidence between November 2021
and June 2022. (1 mark)
c. Explain whether consumer confidence is an aggregate demand or aggregate supply factor. (1 mark)
d. Other things remaining constant, explain how you would expect the recent change in consumer confidence to
affect each of the following:
• level of economic activity and GDP
• the unemployment rate and level of disposable income
• the inflation rate. (3 marks)

Question 7 (4 marks)

Explain the ways in which the ABS’s Measures of Australia’s Progress provides a more complete picture of
changes in living standards over time, than simply using changes in real GDP per head.

Solutions and sample responses are available online.

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284 Jacaranda Key Concepts in VCE Economics Units 1 & 2 Twelfth Edition