Question: Discuss the main stages in an economies business cycle and analyse how governments can influence the different periods in a business cycle.
Business cycles depict the fluctuations in economic activity over a period of time categorised into two main stages – contraction and expansion. They indicate the state of a nation’s economy and are used by economists as a tool to analyse and predict upcoming trends such as employment, income, supply and demand. Expansion, also known as recovery, is a period characterised by augmenting levels of business activity and increased GDP. On the other hand, contraction is a phase of the cycle when the economy as a whole is in decline. Governments employ strategies such as the monetary and fiscal policy which aim to maintain economic stability and achieve overall national progression.
A contraction in the business cycle indicates that an economy is slowing down as shown through decreased production, lower income and higher employment rates. Contraction periods are measured from the peak of a cycle to its trough (refer to Figure 1). During periods of economic downturns businesses tend to reduce their demand for labour and production as well as avoid investment. This has a domino effect of individuals as increased unemployment rates and less earnings lead to lower quality of life. An extended contraction period in a business cycle can have negative effects of a country’s stability, international standing and quality of life. A recession is classified as two consecutive quarters of negative GDP growth.
Governments aim to offset prolonged down-swings by stimulating and encouraging economic activity. They may increase the nation’s demand for goods and services which subsequently mean businesses require a larger work force to sustain their increased production levels. The government may also decrease tax and interest rates and allow people to retain more of their income meaning they have more to invest back into the market. The inflation target is a policy set by the RBA which aims to maintain a steady growth of inflation at about 2-3% over a medium term in the business cycle. By controlling the rate of inflation and ensuring that it increases at a steady rate, the RBA is able to preserve the value of the Australian dollar while simultaneously encouraging strong and sustainable growth.
During periods of expansion, an economy sees cyclical growth in aspects including increased individual and national revenue, higher employment rates, consumption and production. A period of expansion is measured from the peak of the previous cycle to the trough of the current cycle for example point A to point B in Figure 1. When economic growth and GDP levels are above the trend line in a business cycle, economies experience augmented levels of supply and demand and are therefore predisposed to to a reduction in unemployment levels and poverty. For example, the Okun’s Law expresses that for every 2% of GDP above the trend tine equates to 1% less unemployment. Economic upturns result in a boom in investment, consumption, manufacture and overall growth and countries see an improvement in economic activity and quality of life.
However, if an economy is growing at an unsustainable rate or ‘overheating’ to the point where it’s productive capacity is unable to keep up with demand, the government may intervene to maintain economic stability. Through the fiscal policy government may slow activity by decreasing expenditure and increasing taxation. An increase in taxes means individual have less money to spend and hence decrease demand. Higher taxation may also cause enterprises to lower production levels and reduce investment into the growth of their businesses. Through the Monetary Policy, the Reserve Bank of Australia has the power to decrease the supply of money in an economy and ultimately affect the rate of inflation. They also influence the behaviour of investors, borrowers and lenders through the manipulation of interest rates, exchange rates and cash reserve requirements.
The business cycle demonstrates how economies have a tendency to fluctuate and change over time. It has direct relationships between a countries income, production, GDP and employment status. The position of an economy has an impact on individuals and businesses as it can greatly impact a country’s overall quality of life as well as its economic or political standing in the world. The government’s role in the business cycle is to prevent extreme changes, maintain stability, preserve the value of its nation’s currency and encourage growth.