Week 12

• Business cycle


  Periods of economic expansion and economic contraction relative to the trend rate of economic growth
• Expansion phase


  Production, employment and income are increasing above trend growth
• Contraction phase


  Production, employment and income are falling below trend growth
• Recession


  Occurs when total production and employment are decreasing and the rate of economic growth is negative
• Technical definition of recession

  Two successive quarters (6 months) of negative economic growth
• Business cycle


  1. Expansion phase ends with business cycle peak

  2. Contraction phase comes to an end with a business cycle trough, after which another period of expansion begins
• Each business cycle is different. The lengths of the expansion and contraction phases and which sectors of the economy are most affected will rarely be the same in any two cycles
• As the economy nears the end of an expansion interest rates are usually rising and the wages of workers are usually rising faster than prices. As a result of rising interest rates and rising wages, the profits of firms will be falling. Typically, towards the end of an expansion both households and firms will have substantially increased their debts
• An economic contraction will often begin with a decline in spending by firms on capital goods such as machinery and equipment, or by households on new houses and consumers durables, such as furniture and cars


  As spending declines, firms selling capital goods and consumer durables will find their sales declining. As sales decline firms cut back on production and begin to lay off workers. Rising unemployment and falling profits reduce income, which leads to further declines in spending and a recession may occur
• Consumer durables


  • Affected by the business cycle more than non-durables such as food and clothing
  • People postpone buying durables particularly expensive items such as new cars, during a contraction or recession
• During economic expansions


  The inflation rate usually increases
• During contractions


  The inflation rate usually decreases
• Contractions and recessions cause the unemployment rate to increase
• The rate of unemployment continues to rise after a recession is over because discouraged works re-enter the labor force and firms continue to operate below capacity after the recession is over and may not re-hire workers for some time
• Contractions and recessions are partly due to business cycles and partly due to economic shocks
• Australian experience


  • 1974: Oil price shock (OPEC)
  • 1990: Government induced recession due to high interest rates
  • 2007/08: Global financial crisis- credit shortage
• Reasons why business cycles fluctuations are less severe

  • The increasing importance of services and the declining importance of goods
  • The establishment of unemployment benefits and other government transfer programs that provide funds to the unemployed
  • Active federal government and central bank polices to stabilize the economy
  • The stability of the financial system in Australia
• Money


  More than just notes and coin. The main component of a country's money supply is not cash but deposits in banks and other financial institutions
• Functions of money


  • Medium of exchange
  • Means of evaluation (Unit of account)
  • Means of storing wealth
• Banks


  • Banks are by far the largest group of financial institutions, accounting for 55% of total assets
  • Banks accept deposits and by making loans they create credit
• Bank liabilities


  Most of the banks liabilities take the form of the accounts, or deposits held with banks by individuals, companies, universities and so on
• Bank assets


  The banks hold a small proportion of their assets in currency and hold deposits with the Reserve bank in the same way that the public holds deposits with the bank. The great majority of the bank's assets comprise loans to customers
• Factors influencing the balance between bank liabilities and assets

  • Profitability
  • Liquidity
  • Capital adequacy
• Profitability


  Profits made by lending out money at a higher rate than that paid to depositors
• Liquidity


  The ease with which an asset can be converted into cash without loss
• Bank reserves


  The notes and coins inside a bank plus a banks deposit account at Reserve Bank
• Capital adequacy


  A measure of a bank's capital relative to its assets, where the assets are weighed according to the degree of risk
• Roles of the Reserve Bank of Australia

  • To oversee the whole monetary system and ensure that banks and other financial institutions operate as stably and as efficiently as possible
  • To carry out monetary policy
• Functions of the Reserve Bank of Australia

  • Issue notes
  • Acts as a Bank
  • Holds the official foreign currency reserves
  • Acts as a lender of last resort
  • Operates monetary policy
• Monetary base


  Cash (notes, coins) in circulation, plus deposits held by banks at the RBA
• Broad money


  Cash in circulation, plus bank deposits, plus deposits in NBFIs
• Creation of credit


  1. Bank Multiplier = 1/L where L = liquidity ratio

  2. Banks' liquidity ratio may vary

  3. Customers may not want to take up the credit on offer

  4. Banks may not operate a simple liquidity ratio

  5. Some of the extra cash may be withdrawn from the banks
• Relationship between the money supply MS and the rate of interest


  An increase in the supply of money will cause the rate of interest to fall, whereas a fall in the supply of money will cause the rate of interest to rise
• Motives for holding money

  • Transactions motive
  • Precautionary motive
  • Assets motive
• Determinants of the size of the demand for money MD

  • Nominal GDP
  • Frequency with which people are paid
  • Financial innovations
  • Speculation about future return on assets
  • Rate of interest
• Equilibrium in the Money Market

  Equilibrium occurs when the demand for money (MD) is equal to the supply of money (Ms). This equilibrium is achieved through changes in the rate of interest
• Shift in the money supply

  A shift in either the Ms or the MD curve will lead to a new equilibrium quantity of money and rate of interest at the new intersection of the curves
• Effect of a rise in money supply

  Will lead to a fall in the rate of interest, which will lead to a rise in investment and other forms of expenditure, such as on consumer durable goods and housing, which is financed by borrowing. The rise in investment and consumption will mean increased injections into the circular flow of income, resulting in a rise in aggregate demand, GDP and possibly inflation. The fall in the interest rate is likely to cause the exchange rate to depreciate, increasing exports and decreasing imports