Business Cycle, Indicators, and Aggregate Supply: Key Concepts for Economics

Business Cycle (definition)

Short-term fluctuations in economic activity (aggregate demand or GDP) in the economy, reflecting the tendency for output to deviate from potential output

Boom

The peak phase of the business cycle where GDP is at or above potential output, unemployment is low, and inflation may be rising

Upswing

The phase of the business cycle where economic activity is increasing, GDP is rising, and unemployment is falling

Trough

The lowest point of the business cycle where GDP is at its minimum, unemployment is at its highest, and economic activity is weakest

Downswing

The phase of the business cycle where economic activity is declining, GDP is falling, and unemployment is rising

Leading economic indicators

Indicators that predict changes in the business cycle BEFORE they occur (e.g. building approvals, share prices)

Coincident economic indicators

Indicators that reflect what is happening in the economy at the same time a change occurs (e.g. retail sales, employment)

Lagging economic indicators

Indicators that become apparent AFTER a change in the business cycle has occurred (e.g. unemployment rate, interest rates)

Exogenous factors (business cycle)

External causes of business cycle fluctuations such as droughts, floods, geopolitical events, or global financial shocks

Endogenous factors (business cycle)

Internal causes of business cycle fluctuations such as changes in investment, consumer debt, and business confidence

Cumulative process (business cycle)

The self-reinforcing expansion or contraction in the economy driven by the multiplier effect and changes in confidence

Upper turning point (business cycle)

The point at which a boom ends and a downswing begins, often caused by supply shortages or policy tightening

Lower turning point (business cycle)

The point at which a trough ends and an upswing begins, often caused by essential household consumption or policy stimulus

Automatic stabilisers (business cycle)

Built-in features of the tax and welfare system that automatically reduce the severity of business cycle fluctuations without new policy decisions

Percentage rate of change formula

((Year 2 − Year 1) ÷ Year 1) × 100

Trend line (business cycle)

The long-run average growth path of the economy, approximately 3.6% per year in Australia since 1960

Aggregate Expenditure (AE) definition

The total amount of spending on goods and services across the whole economy; AE = C + I + G + (X − M)

Consumption (C) — share of AE

Approximately 55% of AE; the most stable component, comprising household spending on goods and services

Investment (I) — share of AE

Approximately 16-25% of AE; the most volatile component; expenditure by firms on new capital goods

Government spending (G) — share of AE

Approximately 20-25% of AE; divided into G1 (day-to-day spending) and G2 (infrastructure investment)

Net exports (X−M) — share of AE

Ranges from −1% to +5% of AE; exports minus imports; Australia has run a trade surplus since 2016

Five factors affecting Consumption

1) Disposable income 2) Interest rates 3) Stock of wealth 4) Consumer confidence 5) Economic policy

Five factors affecting Investment

1) Risk 2) Interest rates 3) Profitability 4) Business confidence 5) Economic policy

Two factors affecting Government spending

1) Phase of the business cycle 2) Political ideology of the party in power

Four factors affecting Net Exports

1) Australia's business cycle 2) Business cycle of trading partners 3) Exchange rates 4) Terms of Trade

Disposable income (consumption)

Income households receive after tax; the most significant factor affecting consumption; positively related to spending

Wealth effect (stock of wealth)

As asset values (e.g. houses, shares) rise, households feel wealthier, borrow more against equity, and increase consumption

Terms of Trade (TOT)

An index of export prices relative to import prices; tells us the number of imports we can buy with each unit of exports sold

Consumption function

C = a + bY; shows the level of consumption at every level of income; 'a' = autonomous consumption; 'b' = MPC

Autonomous consumption

The level of consumption when income (Y) = 0; shown by the vertical intercept 'a' of the consumption function

Marginal Propensity to Consume (MPC)

The proportion of each extra dollar of income that is spent on consumption; MPC = ΔC ÷ ΔY; it is the gradient of the consumption function

Marginal Propensity to Save (MPS)

The proportion of each extra dollar of income that is saved; MPS = ΔS ÷ ΔY; MPC + MPS = 1

Savings function

S = −a + (1−b)Y; shows the level of savings at every level of income; gradient = MPS

Macroeconomic equilibrium (AE model)

Occurs when AE = Y (actual output = planned expenditure) so inventories are unchanged and there is no incentive to change output

Role of inventories in AE equilibrium

If AE > Y, inventories fall and firms increase output; if AE < Y, inventories rise and firms reduce output; equilibrium restores when AE = Y

Multiplier (k)

k = 1 ÷ (1 − MPC) or k = 1 ÷ MPS; the number by which an initial change in expenditure is multiplied to give the total change in output (ΔY)

Multiplier process

An initial change in spending (ΔI) creates income, which is re-spent, creating more income; total ΔY is greater than the initial ΔI

Common MPC values and multipliers

MPC 0.6 → k = 2.5; MPC 0.75 → k = 4; MPC 0.8 → k = 5

Aggregate Demand (AD) definition

The total amount of spending in the economy at each price level; AD = C + I + G + (X − M)

Why is the AD curve downward sloping?

Because there is an inverse relationship between the price level and total spending, explained by the income effect, interest rate effect, and open economy effect

Income effect (AD curve)

Rising price levels reduce purchasing power of household income, so consumption falls and there is an upward movement along the AD curve

Interest rate effect (AD curve)

Rising price levels increase demand for money, pushing interest rates up, raising borrowing costs, reducing consumption and investment, and moving up the AD curve

Open economy effect (AD curve)

Rising domestic prices make exports less competitive (X falls) and imports more attractive (M rises), reducing net exports and moving up the AD curve

Movement along the AD curve

Caused by a change in the general price level (inflation)

Shift of the AD curve

Caused by a change in any component of AE (C, I, G, or net exports) due to non-price factors

Short-run Aggregate Supply (SRAS)

A curve showing the actual level of real GDP firms will produce at each price level; upward sloping because input prices (especially wages) are fixed in the short run

Why is the SRAS upward sloping?

In the short run, wages are fixed; if prices rise, firms earn higher profits and increase output; if prices fall, firms reduce output to avoid losses

What causes the SRAS to shift right?

Falls in production costs (e.g. lower oil/wage costs), improvements in technology, or improvements in labour productivity

What causes the SRAS to shift left?

Rises in input costs (e.g. oil price shocks, higher wages), natural disasters, or negative supply shocks

Long-run Aggregate Supply (LRAS)

A vertical curve showing the potential (full employment) output of the economy; price level is irrelevant to long-run output

Why is the LRAS vertical?

In the long run, input prices adjust fully to price level changes, so firms earn no extra profits from inflation and have no incentive to increase output beyond potential

What causes the LRAS to shift right?

Increases in the quantity or quality of factors of production (labour, land, capital, enterprise); represents long-run economic growth (~3.5% per year)

Short-run macroeconomic equilibrium (ADAS)

Where the AD curve intersects the SRAS curve; actual GDP may be above or below potential output

Long-run macroeconomic equilibrium (ADAS)

Where AD = SRAS = LRAS; unemployment ~4.5%, inflation 2-3%, GDP growth ~3.5%

Deflationary gap (negative output gap)

Actual GDP is below potential GDP; cyclical unemployment above 4.5%; low inflation; spare capacity in the economy

Inflationary gap (positive output gap)

Actual GDP is above potential GDP; unemployment below 4.5%; inflation is above target; economy is overheating

Keynesian AS curve — 3 stages

Keynesian stage (perfectly elastic, high UE); Intermediate stage (rising prices as capacity fills); Classical stage (perfectly inelastic at full employment)

Fiscal policy (definition)

Measures undertaken by the government in relation to taxation and expenditure, aimed at influencing the nation's aggregate demand

Discretionary fiscal policy

Deliberate government decisions to change spending or taxation to influence economic activity

Automatic stabilisers (fiscal policy)

Non-discretionary features of the budget (e.g. progressive taxes, welfare payments) that automatically stabilise the economy without new policy decisions

Budget outcome (surplus)

When government revenue > government expenditure; contractionary effect on the economy

Budget outcome (deficit)

When government expenditure > government revenue; expansionary effect on the economy; must be financed by borrowing

Budget outcome (balanced)

When government revenue = government expenditure; neutral effect on the economy

Structural budget

Reflects deliberate government decisions on spending and revenue; determines the stance of fiscal policy (expansionary, contractionary, or neutral)

Cyclical budget

Reflects changes in the budget due to the automatic response of tax revenue and welfare spending to the business cycle

Expansionary fiscal policy

Government increases spending or cuts taxes to increase AD; shown by a rightward shift of AD in the ADAS model; used during a downswing/trough

Contractionary fiscal policy

Government decreases spending or raises taxes to reduce AD; shown by a leftward shift of AD in the ADAS model; used during a boom/upswing

Macroeconomic objectives of the government (5)

1) Sustainable economic growth (target ~3.5%) 2) Price stability (inflation 2-3%) 3) Full employment (4.5% UE) 4) Equitable income distribution 5) Efficient resource allocation

G1 government spending

Day-to-day government spending on goods, services, wages and salaries; relatively stable

G2 government spending

Government investment in infrastructure (e.g. roads, railways, NBN); varies with economic conditions and political ideology

Recognition lag

The time it takes to collect and analyse economic data before a policy decision can be made

Decision lag (fiscal policy)

Long for fiscal policy as spending/tax changes must pass through both Houses of Parliament

Implementation lag (fiscal policy)

Short for fiscal policy as changes can be implemented immediately once Parliament approves them

Effect (impact) lag (fiscal policy)

Short for fiscal policy as government spending and tax changes impact the economy relatively quickly

Monetary policy (definition)

Measures implemented by the RBA to influence the money supply and interest rates, aiming to change AD and achieve macroeconomic objectives

Cash rate

The interest rate on overnight loans between banks in the short-term money market; the RBA's key instrument for monetary policy

RBA objectives

1) Stability of the currency (price stability) 2) Full employment 3) Economic prosperity and welfare of Australians

RBA inflation target

2-3% consumer price inflation on average over the medium term

Headline inflation rate

The percentage change in prices over time as measured by the CPI

Underlying (core) inflation rate

The headline inflation rate excluding one-off or seasonal factors that cause short-term price volatility

Expansionary monetary policy

RBA lowers the cash rate → borrowing costs fall → C and I rise → AD increases; used during a downswing/trough

Contractionary monetary policy

RBA raises the cash rate → borrowing costs rise → C and I fall → AD decreases; used during a boom/inflationary gap

Open Market Operations (OMO)

The RBA buys and sells second-hand government securities in the STMM to implement its monetary policy decisions and maintain the cash rate target

OMO — expansionary

RBA buys more bonds → more cash enters the STMM → supply of funds increases → interest rates fall

OMO — contractionary

RBA buys fewer bonds → less cash in the STMM → supply of funds decreases → interest rates rise

Short-term money market (STMM)

The market in which short-term discount securities (Treasury notes, bank bills) are traded; where the RBA conducts OMO

Exchange Settlement Accounts (ESAs)

Deposit accounts held by banks with the RBA; used to settle debts between financial institutions; the mechanism through which OMO affects the cash rate

Nominal interest rate

The advertised interest rate before adjusting for inflation

Real interest rate

Nominal interest rate minus the inflation rate; the true cost of borrowing; used by businesses in investment decisions

Transmission mechanism of monetary policy

The process by which a change in the cash rate flows through the economy: cash rate → bank interest rates → C and I → AD → output, employment, and inflation

Decision lag (monetary policy)

Short — RBA Board meets 8 times per year and can change the cash rate quickly

Effect lag (monetary policy)

Long — changes in the cash rate take 12-18 months to fully flow through to household and business behaviour

Unconventional monetary policy

Policy tools used when the cash rate reaches its lower bound (near zero), such as quantitative easing (buying long-term bonds to lower long-term interest rates)

Labour productivity (LP) formula

LP = Q ÷ L (Output ÷ Labour hours worked)

Labour productivity (definition)

The output produced per unit of labour input (usually measured per hour worked)

Capital deepening

An increase in the amount of capital per worker; increases labour productivity; measured by the rate of change in capital stock per labour hour

Three main factors affecting labour productivity

1) Physical capital (capital deepening) 2) Human capital 3) Technological progress/change

Physical capital (labour productivity)

The tools, machinery, factories and infrastructure available to workers; more or better capital raises output per hour worked

Human capital (labour productivity)

The skills, knowledge and experience of workers gained through education and on-the-job training; improves labour productivity

Technological progress (labour productivity)

Improvements in technology increase the output per unit of input, shifting the SRAS and LRAS to the right