9. Business Cycle and IS-MP Framework

business cycle

short-term fluctuations in economic activity

potential output

level of output that occurs when all resources are fully employed

output gap and formula

difference between actual output and potential output;

((actual output - potential output) / potential output) x 100

negative output gap

economy is producing less than it can

positive output gap

the economy is producing more than its potential

stages of the business cycle

peak, trough, recession, expansion

characteristics of the business cycle

recessions are short and sharp, expansions are long and gradual, cycles are persistent, cycles impact many parts of the economy

leading indicators

variables that tend to predict the future path of the economy e.g. business confidence, consumer confidence and the stock market

lagging indicators

variables that tend to follow business cycle movements with a bit of delay; unemployment

okun’s rule of thumb

for every % point that actual output < potential output, the unemployment rate will be around half a % point higher.

annualised rates

data from a time period of less than a year converted into an annual rate

seasonally adjusted rates

data stripped of predictable seasonal patterns

top 10 economic indicators

real GDP, real GDI, employment, unemployment rate, real retail sales, business confidence, consumer confidence, inflation rate, wage price index, stock market

aggregate expenditure

the total amount of goods and services that people want to buy across the whole economy; AE = C + I + G + NX

macroeconomic equilibrium

occurs when the quantity of output collectively produced is equal to the quantity of output that buyers collectively want to purchase

output > AE then

businesses will cut back their production

if output < AE then

businesses will ramp up production

comprehensive framework

1. develop the IS curve 2. develop the MP curve 3. put them together

how real interest rates affect AE

lower interest rates boost consumptions, investment, government spending and net exports

the IS curve…

illustrates how lower real interest rates lead to a more positive output gap

called IS because…

investment and spending , interest sensitivity, investment and saving

the IS curve structure

is the macroeconomic demand curve (downward sloping), real interest rate is a price and output gap is a quantity

the reserve bank

sets the nominal interest rate (monthly on the 1st tuesday) to influence the real interest rate

monetary policy

the process of setting interest rates in an effort to influence economic conditions

cash rate

interest rate on a set of overnight loans that almost certainly are repaid the next day

risk-free interest rate

interest rate on a loan that involves no risk

risk premium

the extra interest lenders charge to account for the risk of loaning money

the MP curve…

illustrates the current real interest rate

MP stands for…

monetary policy

the MP curve shifts because…

the RBA changes its monetary policy or changes in the financial markets shifted the risk premium

multiplier and formula

a measure of how much GDP changes as a result of direct and indirect effects from each extra dollar of spending; 

change in GDP = change in spending x multiplier

IS curve shifters

consumption, investment, government purchases, net exports

MP curve shifters

financial shocks: changes in borrowing conditions that change the real interest rate