Business Cycle

• In 2020, as a result of the COVID-19 pandemic, we had our first recession in 29 years
• Recession is defined as two consecutive falls in quarterly real GDP
• •Business cycle refers to fluctuations in economic activity around a long term growth path
• •Economic activity is measured using data on production, employment and national income, but its main measurement is real GDP
• •Shows the level of quarterly real GDP in Australia over the past 30 years

  •Notice how most of the period shows a relatively smooth and linear line –constant upward trend

  •Means real GDP increases at a constant rate

  
• •Graph shows percentage growth rate of quarterly real GDP – fluctuations are quite volatile

  
• •A country’s potential real GDP is the level of real GDP that can be produced when the economy is at full employment or full capacity

  •Occurs when unemployment is close to 4% - natural rate of unemployment
• •Country’s potential GDP will grow over time at a steady rate  - due to population growth, increases in factors of production and improvement in quality of resources
• •Actual real GDP can change unpredictably  as real GDP is affected by many shocks that hit the economy (positive – strong surge in economic activity, or negative – leading to a slowdown) 
• Four phases:

  •Expansion

  •Peak (upper turning point)

  •Contraction ( recession)

  •Trough (lower turning point)

  
• •Business cycle refers to the expansion and contraction in economic activity that occurs around this long term growth rate
• •One business cycle is measured as the period of time between two troughs (or two peaks)
• •If actual GDP is above potential GDP then the economy experiences a positive output gap and unemployment rate will fall below 4%
• •If actual GDP is below potential GDP then the economy experiences a negative output gap and unemployment will rise above 4%
• •Expansion is typically much longer than a contraction

  •Expansions usually last up to 10 years while contractions are brief, lasting one to two quarters
• •Annual growth rate is found by adding quarterly growth rates
• •Notice how each time the economy falters, it quickly recovers – nature of the economy to bounce back after economic shock

  
• •All economies are subject to cyclical fluctuations in economic activity and growth
• •Australia is heavily influenced by activities in China

  •Most economies are subject to the same global shocks – increase in oil prices affects everyone. A shock in a major economy like US or China affects everyone
• Expansion

  •Most common phase

  •Beginning occurs with two consecutive quarters of real GDP growth – period where real GDP increases

  •Initial part of expansion, just after the trough, is called recovery phase
• Expansion characteristics

  •Economic activity increases – rise in employment and production

  •Increase in consumption and investment

  •Increase in real incomes and living standards

  •Rising share prices and house prices – household wealth increases
• Peak (boom)

  •Peak is upper turning point – marks end of expansion and beginning of contraction

  •At peak, rate of economic growth has slowed – because the economy is operating and full employment at the peak

  •This means there is no more labour resources to expand production and therefore growth slows
• Peak (boom) characteristics

  •High levels of consumption expenditure

  •High levels of business and household confidence

  •Low levels of unemployment  - below natural rate indicating shortage of skilled labour

  •High demand inflation – as excess demand for goods and resources cause wages to rise which then feed into higher price levels

  •RBA will increase short term interest rates to reduce inflation and slow economy
• Booms can’t last forever

  •In the upswing prior to the boom, businesses invest in new capital equipment in anticipation of being able to sell more goods and services in the market

  •But when sales start to level off, returns to investment fall, so it becomes more risky

  •Lower investment translates into lower output and income

  •Sales start to flatten as demand levels off
• Booms can’t last forever

  •At the end of the boom, rates of increase in output start to fall as bottlenecks (shortages of labour or productive capacity) occur

  •It is difficult to produce more and more output from fully utilised stocks of capital equipment, and the pressure of consumer demand may result in price increases, rather than increases in output

  •The effects of falling aggregate output and income levels start to spread throughout the economy and it becomes obvious that the rate of growth is slowing
• Booms can’t last forever

  •governments tend to introduce contractionary economic policy to reduce the level of activity

  •Macroeconomic policy usually involves increasing interest rates (monetary policy) in order to discourage borrowing and consumer spending

  •The government may also increase taxes and reduce their spending – contractionary fiscal policy
• Contraction (recession)

  •Period in which level of real GDP falls or growth rate of real GDP is negative

  •Recession is two consecutive quarters of negative economic growth

  •Key indicator is sharp rise in unemployment rate

  •Normally short lived – less than a year
• Contraction (recession) characteristics

  •Sharp fall in business and consumer confidence

  •Low consumption and investment

  •Lower spending equals lower output and income

  •Decline in share market
• Trough

  •Lower turning point of business cycle – end of recession and beginning of expansion
• Trough characteristics

  •Low levels of spending

  •High cyclical unemployment

  •Low labour force participation rate – people feel less chance of finding employment

  •Low inflation – may see deflation

  •Low business and consumer confidence and rise in savings
• Trough

  •Trough is a turning point because at some point, spending will begin to rise as firms need to replace or update worn out capital equipment which increases business investment

  •Interest rates low which may encourage households and firms to begin borrowing on the expectations that conditions will improve

  •Government spending usually higher with increase welfare payments directed to boost consumer and investment spending
• ·productive machinery will eventually wear out and require replacement and this results in new investment

  ·businesses will seek to innovate with new products and more efficient processes and seek to gain a competitive advantage

  ·the lower interest rates due to expansionary government policy may also induce some further investment borrowing with the expectation that conditions will eventually improve

  ·consumers may begin increasing spending on durables as the cost of credit falls
• •Macroeconomic indicators are economic variables that provide insight into the health of the economy

  •Indicators can confirm trends in economic activity as well as predict future economic activity
• •Real GDP is considered the main macroeconomic indicator – changes in real GDP will help confirm the position of the economy

  •GDP data released quarterly

  •Average growth should be around 3% so we expect quarterly growth rates around 0.7%
• •A variable that increases during an expansion and falls during a contraction is called a procyclical variable

  •These include consumer spending, investment, employment and household confidence
• •A variable that decreases during an expansion and increases during a contraction is called a countercyclical variable

  •Examples include unemployment, business failures and government welfare spending
• •Classify economic indicators by their timing relative to the business cycle. Three main types are:

  •Leading economic indicators

  •Coincident economic indicators

  •Lagging economic indicators
• Leading indicators

  •Leading indicators change before a direction become evident in the rest of the economy - they therefore predict trends in economic activity

  •Examples of leading indicators include building approvals, share prices, levels of inventory held by firms, new employment vacancies and levels of business confidence

  •Leading indicators reflect the expectations of households and firms about the future of the economy
• Leading indicators

  •Share prices are the most well-known and widely followed leading indicator

  •Share prices are based in part on what companies are expected to earn, so if share prices rise, the market is expecting the economy to improve and for business profits to increase

  •Leading indicators provide an early indication of significant turning points in the business cycle
• Coincident indicators

  •Coincident indicators are those that move in line with the level of economic activity

  •They change simultaneously with economic conditions  - used to identify current state of the economy

  •Examples include manufacturing output, employment and retail sales