Unit 4 is built around a single diagram — the AD/AS model — and everything else either feeds into it or is explained by it. Master that one diagram and the relationships around it, and the whole unit falls into place. Use this guide to connect the six topics before the final examination.
1. The business cycle
The business cycle is the fluctuation of real GDP around its long-term trend, moving through expansion, peak, contraction and trough. You should be able to explain its causes and turning points and read the macroeconomic indicators (growth, unemployment, inflation) that signal which phase the economy is in. This is the problem that the rest of the unit manages.
2. The aggregate expenditure model & the multiplier
Aggregate expenditure is total planned spending: AE = C + I + G + (X − M). You should be able to analyse the consumption function, the marginal propensity to consume and to save, equilibrium (including the role of inventories), and the multiplier — where an initial injection produces a larger final change in output, with k = 1 ÷ (1 − MPC). This is what determines how far aggregate demand moves.
3. The AD/AS model
The AD/AS model plots the price level against real GDP. You should be able to draw and shift the downward-sloping aggregate demand curve, the upward-sloping short-run aggregate supply curve, and the vertical long-run aggregate supply curve, find equilibrium, and use the model to explain the business cycle. Every policy in this unit is shown as a shift on this diagram.
4. Fiscal policy
Fiscal policy uses the government's budget (G and T) to shift aggregate demand. You should be able to evaluate balanced/surplus/deficit outcomes, automatic stabilisers vs discretionary policy, expansionary and contractionary stances on the AD/AS model, and the strengths and weaknesses (lags, debt, crowding out).
5. Monetary policy
Monetary policy uses the RBA's cash rate to shift aggregate demand through the transmission mechanism (lending rates, the exchange rate, asset prices/wealth, household cash flow). You should be able to evaluate conventional and unconventional policy, the conditions for changing stance, and the strengths and weaknesses against fiscal policy.
6. Labour productivity & long-run growth
Long-run growth comes from the supply side. Labour productivity — output per unit of labour input — rises with human capital, capital deepening and technological progress, shifting the LRAS curve right and raising potential output. You should be able to analyse productivity's drivers, the government policies that support them, and the effect on the AD/AS model and the Aggregate Production Function.
Must-know diagrams
- The multiplier process (shrinking rounds summing to k × the injection).
- The AD/AS model with a demand shift.
- Expansionary/contractionary fiscal policy on AD/AS (with LRAS and an output gap).
- The monetary transmission mechanism flow.
- A rightward LRAS shift from productivity growth.