Business Cycles

An economic model illustrating

 

increases and decreases in a nation’s

 

real GDP over time.

As we have seen the fundamental economic problem is scarcity. There are insufficient resources, globally, nationally and personally to meet all our needs and wants.

Priorities need to be determined and choices made, nationally and individually.

Not making a choice also carries a cost, a lost opportunity.

In a highly specialised economy, your income determines your ability to consume, and income (and ‘wealth’ – a store of income in the form of assets) are unevenly distributed.

Australia is a modified, free enterprise economy.

Economies lie on a continuum from total laissez-faire, free market, unbridled self-interest to the other extreme of centralised planning and control.

While the profit motive and self-interest are driving forces in the decisions about what, how and for whom to produce in Australia, the government plays an active role in regulating, enforcing and incentivising economic decision making and alleviating the most severe excesses of the system.

The market is efficient; the interaction of supply and demand allocates goods and services highly effectively through the rationing device, we know as the price.

In a perfectly operating market, as demand for particular goods rises, supply expands to meet the demand. If supply cannot meet the rising demand, prices rise to distribute the available stock. The reverse is also true. If demand for a good or service falls, producers will run down their inventories and cut back on production, perhaps even cease production and prices may fall. Resources are then free to flow into the production of alternative goods and services.

That’s the theory!

It is, however, a simplistic, textbook version of the economy and relies on the assumption that a ‘laissez-faire’ (meaning to leave alone) strategy is best. It relies on perfect competition’ – but perfect competition is conditional on ‘perfect knowledge’ (amongst other things) which empowers consumers to efficiently ‘shop around’.

In reality, many factors come into play that may inhibit the free operation of markets. Supply is not always perfectly ‘elastic’ or responsive to the heightened demand for a particular good – rather than increased supply; we may simply end up with higher prices for the same product or service.

So, while the market system may be efficient in many ways, it is not necessarily equitable, nor is it always self-correcting!

Modern economies, like Australia’s, are subject to market failure.

The government in Australia manages the economy and its failings through a combination of macroeconomic policies designed to smooth out the worst extremes of the business cycle – the regular periods of instability accompanied by inflation at its peak and unemployment at its trough.

Fiscal Policy influences the economy through budgetary and taxation measures. When the economy is slowing, and unemployment is rising, the government can inject money into the economy by running a budget deficit = spending greater than revenue. (injections > leakages*)

When the economy is overheating, and inflation is rising, a surplus budget will dampen demand and put downward pressure on prices. (leakages>injections)

Remember that every policy decision has trade-offs and unintended side effects.

Running a surplus may reduce inflation, but it may also mean the loss of jobs. Running a deficit may employ more people but at the cost of higher prices.

Nothing is simple or straightforward!

Remember the circular flow of income model or the ‘above ground pool’ analogy? The size of the pool and therefore, the number of people who can get in and get wet depends on the balance between leakages and injections.

 

Fiscal Policy aims to maintain the level of the water in the pool but it is also deliberately formulated to incentivise participation and enterprise and encourage self-sufficiency.

Tax concessions, grants and exemptions are provided by the government to encourage property investment because of its significant contribution to incomes, output and employment directly and indirectly via the multiplier effect on the economy as demand for complementary goods and services rise in accord with housing construction.

Property investment also provides a means of building wealth and reducing future welfare costs and so incentives are deliberately designed to encourage planning, entrepreneurship and self-reliance.

The government also depends on the Reserve Bank’s implementation of Monetary Policy to help even out the ups and downs in the business cycles.

Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. In determining monetary policy, the RBA has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term. https://www.rba.gov.au

Interest rates are eased to encourage spending and growth and therefore, employment and tightened to control inflation.

 

Through a combination of Monetary and Fiscal Policy,

governments aim to even out the extremes of the business cycle.

 

The Study of Scarcity

“…you can’t always get what you want.”

 

The Rolling Stones may have said it in the most entertaining way in the late ’60s, but economists have been saying it for centuries,

Economics is the study of choice.

The pillars of modern mainstream economics include the concepts of scarcity, opportunity cost, self-interest, specialisation, market dynamics and market failure – all of which are relevant to an understanding of the reasons to invest and why property provides a relatively safe and predictable way to do so.

The fundamental problem we all face is scarcity, and it applies to us collectively and as individuals.

Typically, your income is the resource you have at your disposal to satisfy your wants and needs.

Income is the return to the factors of production. There are four types of factor income:

Most of us will earn a wage or salary in return for labour,

but we also have the opportunity to

earn income in other ways too.

 

Once you have earned your income, there are only three things you can do with it; you can spend it, you can save it and, you can pay taxes.

There are no other alternatives!

Most people have the tax taken out automatically before they get to make any choices about consuming or saving. What you have left is disposable income.

Disposable Income = Gross Income – Taxation

Our predicament compels us to make choices. As rational human beings, it’s assumed that we all try to allocate our scarce resources to our competing needs and wants to maximise our satisfaction.

We are all economists!

In the next section, we will examine how we make those choices.

How do we as a nation and as individuals

increase our standard of living

by reducing scarcity and

enhancing our choices in life?