Equilibrium in our economy

Equilibrium within an economy is achieved when the aggregate supply is equivalent to the aggregate demand. That is, when income is equal to the sum of consumption, investments, government expenditure and the level of imports deducted form the level of exports.

There is only one component to the aggregate supply, which is income, measured by the producer price index (PPI) – the change in prices to consumers set by business. A increase in PPI indicates an increase in inflation, higher economic activity, and thus higher income levels.

On the other hand, several components are examined to determine the aggregate demand. The level of consumption (measured by the consumer price index) is important to examine as in order for consumption to occur, their needs to be demand of funds. Since consumer staple goods are always going to be in demand, if it is observed that this sector is falling, then it can be concluded that the economy is falling apart, hence the demand for funds are reducing. In comparison, if the consumer discretionary sector rises, is symbolizes a growing economy, hence an increase in demand for funds (this is because people would only spend money on luxury goods when they are confident in the market).

Furthermore, if there are high investments in the economy, this is reflective of a high demand; to have the funds to invest. A great influence on investment however, is policies restricting or incentifying investments, and the cash rate. A high rate increases investments from overseas and thus demand, and a low rate increases demand to invest domestically (as it is relatively cheap to borrow funds). A low rate also increases inflation and uncertainty, evoking the public to take risks with higher returns. This further increases the demand for funds. Similarly, high government expenditure raises inflation with the same results.

Government expenditure has short-term benefits, but may be damaging in the long run. Short term, it increases economic activity as the government spends money on projects such as infrastructure. This increases the demand for labour thus businesses needing more funds. Long term however, this would decrease competition and lower demand.
Lastly, exports and imports also affect the aggregate demand. High export levels would increase the demand for labour and investments while higher imports would reduce demand. This is greatly affected by the exchange rate and the terms of trade. A high exchange rate reduces exports as our products are represented by a higher price (similar to high terms of