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.

 

Opportunity Cost

The real or opportunity cost 

 

is the 

 

alternative forgone.

 

As anyone knows we can’t have it all, there are trade-offs with any choice we make.

The real or opportunity cost of any choice is the value of the alternative forgone.

It’s true on a societal level and a personal one. We face limitations, both with our time and money.

Budget constraints force us to make choices about how we spend the limited income we have at our disposal. After we have paid taxes, we allocate our income and either spend it or save it.

If we can save, we can then choose what to do with the savings, but

 

an individual’s evaluation

of the allocation of their funds is

subjective and

will depend on their 

ATTITUDES

 

 

 

Do you remember when your parent used to say “because I said so!”? You knew there was more to the story, but you knew they just didn’t have the time or energy or will to explain why!

Take the now-defunct carbon tax as an example. Observing the debate it seemed to me that politicians typically lack sufficient skills to convince any kid they need to eat their greens, let alone the voting public that it needs to pay more for the things they buy!

Pollution is a negative externality; an undesirable by-product of another productive activity and is an example of market failure. It’s widely understood that the factors of production involved in producing an item determine its cost. What most people are not conscious of is the hidden costs, those that aren’t obvious, the costs that we all bear whether we buy the product or not. The most obvious example being pollution.

Price is a rationing device and the only way to make consumers bear the actual cost of a product, and perhaps change their consumption patterns, is to internalize or price the hidden costs, in other words, make them pay for it.

For those who have teenage children, how many times have you caught yourself saying things like, “wait till you’re paying the bills, then you’ll switch off the lights”!

True?

That’s because they don’t yet bear the cost, their usage of your electricity is not priced; it’s not internalized.

But at the same time, I do feel sorry for policymakers because there are no easy answers. Opportunity cost, the alternative foregone is never more apparent than when looking at the competing claims on the budget. Every budget decision means that some other wish has to be crossed off the list or at best trimmed back. There is also the unintended trade-offs that come with policy decisions.

Ever been to a dinner party or BBQ where someone pronounces with the enormous certainty that ignorance allows, “the government should just….”?

Similarly, those that claim housing affordability will be magically fixed by changing the tax rules around negative gearing don’t seem to have any inkling (or alternative suggestions for that matter) about how the public sector would provide all that rental accommodation in the absence of investor activity. They have even less appreciation of the private vs public efficiency trade-off or the likely effect on rent of an investor exodus from the housing market. One politician recently responded to the suggestion by saying “oh, it’s complicated”. Really?! They should be able to do better than that! They could:

Explain that tax breaks for investors encourage the supply of housing in an already constrained market more cost-effectively than the public sector could ever do and that it encourages a rapidly aging population to invest for the future and reduce the burden on the future public purse.

Explain that housing starts are a leading indicator of economic activity and therefore, jobs and the multiplier effect of house construction is huge. Building new properties has a ripple effect on consumption that is hard to replicate.

Explain that the new driver of growth and therefore jobs are population growth and the houses and infrastructure and services they will demand, all 32,000,000 of us by 2033. That’s less than 13 years from now! Incentivizing the simple ‘changing of hands’ in the property investment market may be a lot less socially beneficial than encouraging new construction.

But then things are never that simple….

 

 

 

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?