eco chap 7 - macro and business cycle

What is macroeconomics?

Macroeconomics is the study of the performance of the economy as a whole and the policies used to improve that performance. It focuses on aggregate economic activity — total production, overall price levels, employment and unemployment.

The two most important areas of macroeconomics research?

Long-term economic growth.
Shorter-term business cycles.

Objectives of macroeconomics?

Economic growth – increasing productive capacity over time to raise living standards.
Full employment – keeping unemployment close to the natural rate.
Price stability – achieving a low and stable inflation rate.
Productivity growth – increasing labour productivity over time.

Models of macroeconomics?

Aggregate Expenditure (AE) model – explains how changes in expenditure affect income and output.
Aggregate Demand/Aggregate Supply (AD/AS) model – explains fluctuations in both output and the price level.
Aggregate Production Function (APF) – explains the importance of labour productivity.

Types of government policy in macroeconomics?

Fiscal policy – government spending and taxation.
Monetary policy – actions of the Reserve Bank to set interest rates.
Supply side policies – government policies to increase labour productivity.

Definition – Business Cycle

The business cycle refers to the recurring pattern of expansion and contraction in economic activity over time.
Measured using real GDP.

What is Potential GDP?

Potential GDP is the maximum or full employment level of production that can be attained given the economy’s factors of production and level of technology.
In Australia: grows around 2.5–3% per year (labour force growth + productivity growth).

What is an Output Gap?

• Positive output gap → actual GDP above potential, unemployment below natural rate
• Negative output gap → actual GDP below potential, unemployment above natural rate

What is a Peak?

The last month before key economic indicators (employment, output, retail sales) begin to fall.

What is a Trough?

The last month before key economic indicators begin to rise.

Typical characteristics of an Expansion

• increased business investment in plant and equipment
• rising household income
• rising levels of household consumption spending, particularly on discretionary items
• decreased household saving ratio
• rising retail and motor vehicle sales
• increased levels of household and business confidence
• increasing asset prices, including shares and property
• higher business profitability
• increasing labour market participation
• falling cyclical unemployment

Typical characteristics of a Contraction

• decreased business investment in plant and equipment
• falling household income
• falling levels of household consumption spending, particularly on discretionary items
• increased household saving ratio
• falling retail and motor vehicle sales
• declining levels of household and business confidence
• decreasing asset prices, including shares and property
• falling business profits and increased bankruptcies
• decreasing labour market participation
• rising cyclical unemployment
A contraction is associated with a decline in economic prosperity and living standards.

What is a Recession?

• Technical definition: two or more successive quarters of negative GDP growth
• NBER definition: significant decline in economic activity across most sectors, lasting more than a few months, visible in production, employment, and real income

What happens to Inflation in a Contraction?

• Inflation falls (disinflation) as demand declines
• In prolonged recession, inflation may turn negative (deflation)

What are turning points in the business cycle?

The beginning and end of a contraction are the turning points in real GDP.

• Peak = highest level of real GDP before falling (expansion ends).

• Trough = lowest level of real GDP before rising (contraction ends).

What is the major cause of business cycles?

Macroeconomists believe the main cause of business cycle fluctuations are economic shocks – either positive (booms) or negative (contractions).

Examples of negative economic shocks

• Covid pandemic (2020)

• Global Financial Crisis (2009), banking/finance disruption

• Natural disasters such as droughts, floods, earthquakes, climate events

• Wars, military conflict, terrorism

• Sharp falls in financial markets

Examples of positive economic shocks

• Rising commodity prices (iron ore, coal, gas) leading to mining boom

• New technologies (e.g. artificial intelligence) resulting in investment and jobs growth

What role does spending play in the business cycle?

Changes in aggregate demand (total spending) drive expansions and contractions.
Components of spending:
• Consumption (55% of total, most stable)
• Investment (most volatile, drives cycles)
• Government spending
• Net exports

What is a lower turning point (trough) caused by?

• Negative shock reduces spending → falling sales and rising inventories

• Firms decrease production and cut planned investment

• Employment falls, unemployment rises

• Falling income lowers consumption and investment further (“snowball effect”)

• Government responds with expansionary fiscal policy (higher spending, lower taxes) and monetary policy (lower interest rates)

• These policies stimulate demand and generate recovery

What is an upper turning point (peak) caused by?

• Economy reaches full employment level of GDP

• Scarcity of labour/resources raises wages and production costs

• Inflationary pressures increase (cost of living rises)

• Reserve Bank increases interest rates to slow demand

• High inflation, higher borrowing costs and lower confidence reduce spending

• Output begins to fall and contraction starts

What are macroeconomic indicators?

Economic variables that provide insight into the health of the economy.
They confirm trends and can predict future activity.

Why are economic indicators important?

• Households → want to know about jobs, prices, interest rates.

• Businesses → decisions about hiring, investment.

• Government/policy makers → trends in labour market and spending.

Types of economic indicators by scope

• Broad indicators: GDP, inflation, unemployment → overall state.

• Partial indicators: retail sales, housing construction → specific sectors.

Why is real GDP the most important indicator?

• Measures aggregate activity, confirms position in business cycle.

• Released quarterly by ABS.

• Average annual growth: 2.5–3% (≈ 0.6–0.8% per quarter).

What are procyclical and countercyclical variables?

• Procyclical: rise in expansion, fall in contraction. Examples: consumer spending, investment, employment.

• Countercyclical: fall in expansion, rise in contraction. Examples: unemployment, business failures, welfare spending.

Three types of economic indicators by timing

1. Leading

2. Coincident

3. Lagging

What are leading indicators?

• Change before direction of the economy is evident.

• Predict trends in activity.

• Examples:

  • Building approvals

  • Share prices

  • Inventories

  • Job vacancies

  • Business confidence

Why are share prices a leading indicator?

• Reflect expected company earnings.

• Rising share prices = expected higher profits and growth.

Why are building approvals a leading indicator?

• Signal future house construction (6–12 months ahead).

• Construction has multiplier effects (e.g. home furnishings).

What are coincident indicators?

• Move at the same time as economic activity.

• Show the current state of the economy.

• Examples:

  • Factory production

  • Employment

  • Retail sales

What are lagging indicators?

• Change after the economy changes.

• Confirm trends predicted by leading indicators.

• Examples:

  • Unemployment rate (rises after contraction starts)

  • Inflation rate (rises after activity increases)

  • Nominal interest rates

What is the ultimate aim of economics?

To increase average living standards over time.
Living standards depend on:
• Income and wealth
• Prices of goods and services consumed

What are the 3 key aspects of macroeconomic performance?

• Production of goods and services – Real GDP and Real GDP per capita
• General price level – CPI or GDP deflator
• Labour market – employment to population ratio, unemployment rate

Why is Real GDP per capita the ‘best’ measure of living standards?

Takes population into account – shows whether goods/services per person are rising or falling.

What were the 4 periods of Australia’s growth (2014–24)?

• 2014–18 Trend growth: GDP ↑ 2.6% p.a., GDP per capita ↑ 1%. Living standards rising.

• 2019–20 Covid recession: First recession since 1991, widespread disruption.

• 2020–22 Strong recovery: Boom conditions – rapid spending, jobs, production.

• 2022–24 Slowdown: High inflation, per capita recession (population > GDP growth) → living standards fell.

What is Australia’s inflation target?

2–3% on average over the business cycle (price stability).

What is full employment in Australia?

Target unemployment rate: 4–4.5%.
• Equivalent to natural rate of unemployment (frictional + structural).
• RBA uses NAIRU (Non-Accelerating Inflation Rate of Unemployment) – 4–4.5%.

What is the Economic Hardship Index?

Measure of average economic well-being.
• Sum of: unemployment rate + inflation rate + cash rate.
• Threshold = 10% (4.5% unemployment + 2.5% inflation + 3% neutral cash rate).