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.

 

Bringing it all Together

It is a decision you make,

 

an attitude you adopt and

 

a plan you implement.

We all acknowledge that the vast majority of us ‘can’t have it all’. Thankfully, most of us in this, the lucky country, experience scarcity, not on an absolute level, but relative to what we could have and would like to have.

Given we live in an orderly society, protected by the rule of law and property rights, we can plan and influence, if not determine, the future we want to enjoy.

We are living in a highly specialised society. We earn an income and must allocate it to satisfy as many needs and wants as we can. We prioritise our needs and those of our dependents first, and the surplus income is then either spent on wants or saved.

In Australia, income is unevenly distributed, as is wealth. Inequality is a function of luck, hard work, education, inheritance, physical attributes, prevailing public policy, social norms and demographics, and the media to name just a few contributing factors.

But it is also a product of attitude.

 

Wealthy people typically have a different approach to money.

They don’t just work for their money; they make their money work for them!

We have seen that investment creates enhanced capacity for the future. It is holding off on satisfying all our wants now in the expectation of improved future satisfaction.

It’s akin to ‘delaying gratification”.

 

As a nation, we must invest and create productive capacity so that we can increase the size of the employment pool’ (or circular flow) or the ‘national pie’.

A growing economy means that the production possibility frontier shifts out to the right, the national pie gets bigger, the circular flow of income increases or the water level in the swimming pool rises. More of us can get in and get wet!

As individuals or households,

you too can increase the size

of your own ‘circular flow’

and expand the possibilities

Retirement is a phase of life that looms large for us all. Australians are living longer and healthier on average than ever before. To maintain a reasonably consistent lifestyle in the ‘third stage’ of life, you need to decide which pillars of the retirement income system you will rely on and to what extent – the Age Pension, Compulsory Superannuation, private savings and investments and ownership of your own home.

The burden of welfare is increasing and absorbing an ever-increasing proportion of public funds, limiting expenditure on other essential and socially beneficial programs. Governments encourage working Australians to contribute and prepare for their retirement through legislation and incentives such as tax breaks on super contributions, negative gearing on property investments and tax exemptions on post-retirement income amongst the perks on offer.

Just as nations do, you need to make a conscious ‘policy decision’ to refrain from satisfying every want now, (saving) and invest for the future.

It will involve a trade-off, an opportunity forgone.

 

 

 

The time is right to prioritise and get your ‘ducks in a row’

You don't have to be a loser

You don’t have to be a ‘loser’….. The Reserve Bank has to maintain “the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people.” It’s a big ask! The RBA’s decisions to cut the cash rate to record lows would not have been an easy one. As with every decision, there are trade-offs and unintended costs.

Economic prosperity requires a growing economy with the capacity to sustain and expand employment opportunities. It’s not hard to see why a rate cut was not just welcomed by loan holders but necessary.

When you add the conservative and surplus seeking tightening of the fiscal strings by Governments and cautious consumers saving rather than spending, it is imperative to add some fuel to the fire. With spare capacity in the economy, it’s hoped lower interest rates will provide further stimulus to consumer spending without the usual threat of inflation.

Weak expenditure (C) and investment is the preferred target variable in the RBA’s sights.

So, why isn’t the latest cut ‘music to the ears’ of everyone?

It comes down to the fact that Monetary Policy is what’s referred to as a ‘blunt instrument’- interest rate changes apply generally and are therefore non-specific and often inequitable. The unintended trade-off and inequity of the interest rate reductions is undoubtedly the ‘pay cut’ delivered to retirees dependent on income generated from cash in the bank – the ‘losers’ in this situation.

Cash is considered to be a safe alternative on the risk scale, and many convert their assets to cash to avoid volatility in retirement. What they don’t count on is suffering ‘collateral damage’ for the sake of macro-management and being forced to erode their capital.

It’s a good recommendation for holding property into retirement and generating income from rent rather than interest alone. It will never be more comfortable than it is now to start building or to grow a portfolio of properties that will allow you to retire with some unencumbered assets generating reliable income.

You don’t need to be one of the losers….

 

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?