Impact of Drought on Macroeconomic Equilibrium in Australia

This essay evaluates the likely effect of drought on the macroeconomic equilibrium of Australia, including the impact on aggregate supply and demand, government policy intervention, and the overall economic consequences.

Running head: ECONOMICS
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Introduction
Drought refers to a natural disaster occurs when economy experiences lower than
average rainfall in a region. Drought has an adverse effect on people’s life, business and on
government expenditure. The impact of drought might local affecting only those in the
drought-stricken regions or there might be economy wide effect of drought covering areas
outside the drought-stricken area (Freire-González, Decker & Hall, 2017). The effect of
drought is not limited to agricultural sector only. Sectors like energy production, recreation or
tourism sectors are also vulnerable to the natural disaster. The essay summarizes the likely
impact of drought in macroeconomic equilibrium of Australia along with the effect of
government policy intervention.
Analysis
Concept of macroeconomic equilibrium
Macroeconomic equilibrium refers to a stable state of the economy that is attained
where aggregate demand equals the aggregate supply. Aggregate supply signifies total
amount of available goods and services in the economy. This represents aggregate amount of
goods and services that all firms in the industry are willing to sell at a given price level
(Goodwin et al., 2015). Aggregate demand on the other hand captures total demand for the
final goods and services in the economy at a given price level.

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Figure 1: AD-AS model macroeconomic equilibrium
The AS-AD model shows macroeconomic equilibrium corresponding to the point
where aggregate supply interests the aggregate demand curve. The Gross Domestic Product
and price level in the economy are determined corresponding to the equilibrium point. In the
above figure, the downward sloping curve AD represents aggregate demand and the upward
sloping curve AS represents aggregate supply (Agenor & Montiel, 2015). E, the equilibrium
point obtained from intersection of aggregate demand and aggregate supply determines real
GDP as Y* and price level as P*.
Impact of drought on macroeconomic equilibrium on Australia
The macroeconomic model of aggregate supply and aggregate demand suggests that
change in either aggregate demand or aggregate supply causes a change in the equilibrium
position. This alters the real GDP and price level. Sudden shocks to aggregate demand and
aggregate supply shift aggregate demand or aggregate supply curve. The economy attains
new equilibrium as per changes in aggregate demand or aggregate supply. Drought is an
example of adverse supply shocks (Uribe & Schmitt-Grohe, 2017). The outbreak of drought
adversely affect aggregate supply by destroying crops. Dry condition and insufficient
precipitation because of drought can kill or damage crops. The adverse effect on aggregate

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supply is not limited to agricultural sector. There is also interruption in energy production
following drought. Production of both thermal and hydropower energy decline because of
lack of water supply (Brown et al., 2016). The disruption in agricultural production and
energy production have an adverse effect on aggregate supply of the economy. As aggregate
supply curve shifts inward, macroeconomic equilibrium changes. Price level in the economy
will be settled at a high level while real GDP declines. The figure below explains the possible
changes in macroeconomic equilibrium of Australia following drought.
Figure 2: Effect of drought on macroeconomic equilibrium
The initial macroeconomic equilibrium is given as E as obtained from the intersection
of aggregate demand and aggregate supply. Now cause of drought, the economy faces an
adverse supply shock. This shifts the aggregate supply curve leftward to AS1. The economy
attains a new equilibrium at E1. At the new equilibrium position, GDP or aggregate output
declines while price level increases due to supply shortage.
Agriculture though constitutes a relatively as small share of Australian economy;
drought has a significant impact on the economy. Drought occurred in the year 2002-03

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affected many of the regions of rural Australia. In August 2003, several areas of Queensland,
New South Wales, Victoria, Tasmania, Western Australia and South Australia were declared
as drought-stricken areas (treasury.gov.au, 2018). Drought by lowering aggregate supply had
a considerably contractionary effect on the economy. The impact was much larger relative to
size of the economy. Gross Domestic Product declined by 24.3 percent with a decline in rural
export by 26.6 percent and that of rural income by 46.2 percent. There was a significant
decline in rural employment with employment reduced nearly by 100,000 people. Above all,
the shortage of production in farm sector caused food price to rise by great extent.
(sbs.com.au, 2018) The negative supply shock arising from drought thus cause an overall
contraction of the economy in terms of a lower GDP, lower unemployment and lower
employment.
Government policy intervention for drought
Government needs to intervene in the market whenever there is a distortion in free
market forces. The unexpected supply side shocks from drought hampers macroeconomic
equilibrium. Government therefore needs to intervene the market to ensure economic
expansion. Government might take an expansionary fiscal policy to boost aggregate demand
and increase both real GDP and price level (Agenor & Montiel, 2015). Government might
introduce resilience packages to farmer to ensure a minimum income for farmer families. The
effect of such expansionary fiscal policy is illustrated below.

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Figure 3: Effect of government intervention on macroeconomic equilibrium
Suppose, initial equilibrium in the economy is at E1. Now an increase in government
spending to support the economy expands aggregate demand. This shifts the aggregate
demand to the right to AD2. The economic recovery resulted from government policy
intervention moves the equilibrium up from E1 to E2. Associated with the new equilibrium
there is an increases in both real GDP and price level. Australian government has taken
several attempts to design a drought policy to support the economy (Vidot, 2018). Some
examples of government policy intervention in Australia are irrigation expansion, National
Disaster Relief and Recovery Arrangement, National drought policy and such others.
Conclusion
The essay briefly evaluates likely effect of drought on macroeconomic equilibrium of
Australia. Drought is a natural disaster affecting the entire economy. As drought disrupts
production in different sectors especially the farm sector, there is an adverse supply shock in
the economy. As aggregate supply contracts, real GDP declines and price level increases. As
aggregate output contract, there is a contraction of employment as well. In such a situation,
government policy intervention is needed for economic recovery. Government can adapts

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expansionary fiscal policy for economic expansion. An increase in government spending to
support farmers and other sector helps to increase both aggregate output and price.

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References
Agenor, P. R., & Montiel, P. J. (2015). Development Macroeconomics Fourth
edition. Economics Books.
Brown, J. R., Kluck, D., McNutt, C., & Hayes, M. (2016). Assessing drought vulnerability
using a socioecological framework. Rangelands, 38(4), 162-168.
Freire-González, J., Decker, C., & Hall, J. W. (2017). The economic impacts of droughts: A
framework for analysis. Ecological economics, 132, 196-204.
Goodwin, N., Harris, J. M., Nelson, J. A., Roach, B., & Torras, M. (2015). Macroeconomics
in context. Routledge.
sbs.com.au. (2018). Drought could cost economy up to $12b. Retrieved from
https://www.sbs.com.au/news/drought-could-cost-economy-up-to-12b
treasury.gov.au. (2018). The impact of the 2002 drought on the economy and agricultural
employment. Retrieved from https://treasury.gov.au/publication/economic-roundup-
autumn-2004/the-impact-of-the-2002-drought-on-the-economy-and-agricultural-
employment/
Uribe, M., & Schmitt-Grohe, S. (2017). Open economy macroeconomics. Princeton
University Press.
Vidot, A. (2018). Dry argument: Australia's drought policy dilemma. Retrieved from
https://www.abc.net.au/news/rural/2014-02-21/drought-assistance-in-australia/
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