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Lesson M07.L06: Demand and Supply Shocks: COVID-19 and Australia as Case Study

Module: Aggregate Demand and Aggregate Supply; Macroeconomic Policy Level: intro Duration: 30 minutes Learning Objective: Apply the AD-AS model to analyse Australia's COVID-19 economic shock. Data as of: 2023 Provenance: ABS | RBA | OpenStax Macro 3e

Explanation

The COVID-19 pandemic was an unprecedented macroeconomic shock to Australia. It simultaneously hit both the demand side (AD) and the supply side (SRAS) of the economy — a double shock rarely seen in peacetime.

The demand shock (AD falls):
From March 2020, lockdowns shut restaurants, retail, tourism, and travel. Consumer confidence collapsed. Household consumption (C) fell sharply. Business investment (I) froze as uncertainty spiked. International borders closed, destroying export income from education and tourism. All four AD components fell simultaneously, shifting AD sharply left.

Australia's real GDP fell by 7.0% in the June quarter 2020 — the sharpest quarterly fall since records began (ABS National Accounts, 2020).

The supply shock (SRAS falls):
Global supply chains broke down. Border closures disrupted the movement of workers and goods. Production costs rose. Absenteeism increased. Industries requiring physical contact (construction, healthcare, hospitality) faced reduced capacity. SRAS shifted left.

The policy response:

  • Fiscal policy: The federal government launched JobKeeper (~$70 billion total), which paid wage subsidies directly to businesses to retain workers. This, along with other stimulus, shifted AD back to the right.
  • Monetary policy: The RBA cut the cash rate to a historic low of 0.10% in November 2020 and introduced Quantitative Easing (QE) — purchasing $350 billion in government bonds to lower long-term interest rates. This further supported AD.

By 2021, Australia's GDP had recovered above pre-pandemic levels — an unusually rapid recovery, partly due to the scale and speed of the policy response.

Worked Example

Initial equilibrium (December 2019):
Real GDP = $2,050 billion (approximate AUD, ABS chain volume measure)
Price level index = 100 (CPI baseline)

March–June 2020 — Double shock:

Step 1: AD shock.
Household consumption falls by \(120 billion** (lockdowns, confidence collapse). Investment falls by **\)50 billion (business uncertainty).
Net exports fall by $30 billion (borders closed, education exports lost).
Total direct fall in AD = $120b + $50b + \(30b = **\)200 billion**

Step 2: Applying a simplified multiplier of 1.5:
Total AD shift = −\(200b × 1.5 = **−\)300 billion
New AD-implied GDP (before supply shock) ≈ $2,050b − \(300b = **\)1,750 billion

Step 3: SRAS shock.
Supply chains, reduced worker capacity, and border restrictions reduce potential short-run output by an additional $80 billion.
Equilibrium GDP after double shock ≈ $1,750b − \(80b = **\)1,670 billion
Implied GDP fall ≈ ($2,050b − $1,670b) / $2,050b = −18.5%** (illustrative; actual Q2 2020 fall was −7.0% in quarterly terms).

Step 4: Policy response.
JobKeeper + other fiscal stimulus adds approximately \(100 billion to AD. RBA cuts + QE add additional demand stimulus (~\)80b in AD equivalent terms).
Total AD boost ≈ +$180 billion → AD shifts right.

Step 5: Recovery trajectory.
By December 2021, GDP returned above $2,050 billion as AD recovered and supply chains gradually normalised (SRAS shifted back right).

Common Misconception

Misconception: The COVID-19 recession was purely a demand shock, similar to the 2008–09 Global Financial Crisis.

Correction: The COVID-19 recession was unusual because it combined a severe demand shock (AD fell) and a supply shock (SRAS fell) simultaneously. The GFC was primarily a demand shock caused by financial system collapse. COVID-19 also directly disrupted production through lockdowns, border closures, and supply chain breakdowns — shifting SRAS left at the same time as AD. This made it harder to stabilise the economy: AD stimulus alone could not fix supply-side constraints.

Practice Prompts

  1. Using the AD-AS diagram, show the effect of the JobKeeper program on the Australian economy in 2020. → Answer: JobKeeper maintained household incomes by paying wage subsidies, preventing a larger collapse in consumption. This shifted AD to the right (back toward the original level), reducing the recessionary gap. On the diagram, the AD curve shifts right from its COVID-shocked position, partially restoring equilibrium output.

  2. When the RBA cut the cash rate to 0.10% in November 2020, through which AD component(s) was this primarily intended to work? → Answer: Lower interest rates reduce the cost of borrowing, primarily stimulating business Investment (I) and household consumption on credit (C). A lower cash rate also tends to depreciate the AUD, boosting Net Exports (NX). All three channels shift AD to the right.

  3. By 2022–23, Australia faced high inflation (CPI peaked at 8.4% in December 2022). Using the AD-AS framework, explain one reason why the large fiscal and monetary stimulus of 2020–21 contributed to this inflation. → Answer: The fiscal and monetary stimulus shifted AD significantly to the right. When supply chain disruptions also kept SRAS from recovering quickly, the rightward AD shift pushed the price level up. Excess demand relative to supply — illustrated by AD shifting right while SRAS was still left of its pre-COVID position — drove inflationary pressure.

Further Resources