Macroeconomics: The Four Stages of the Business Cycle - Essay Example

Question a) Illustrate and explain the four stages of the business cycle in relation to the key macroeconomics objectives in context of the global financial crisis that the world is experiencing since October 2008. The fluctuation of the economic activity in the economy is characterized by the different stages in the economy. These stages - recession, recovery, growth and decline; repeat over time, with time and magnitude of each varying in length from one occurrence to another (DeLongi). We will have a look at each one of them individually and make effort to determine what the world has been experiencing since October 2008. 1. Recession In periods of recession, economic activity drops down to almost null - at the end of both the consumers and the business owners; buying, selling, production and employment are at their lowest. The severity of recession is known as depression. 2. Recovery When recession eases and the economy takes an opposite direction to take an upturn towards better financial prospects, there emerges the hope of recovery. It can be considered as the transition phase which leads to growth. 3. Growth As the trough advances towards the peak, the era of growth begins; the consumer confidence increases and business activity starts to pick up - since employment is generated, income of the citizens increase and hence increasing demand and hence production levels picking up and so the cycle continues. But, this activity period is coupled with increasing price levels. 4. Decline The boom does not last forever, even healthy economies face worst. Like recovery, this is a transition period where economy starts to move towards the bottom. Consumer purchases lowers, demand weakens and hence business activity starts to fall. There are multiple reasons that lead to changes in the levels of the economic activity - volatility of investment spending, momentum or follow the herd strategy of the consumers, technological innovation, varying inventory levels, fluctuation in government spending, effect of political conditions on business cycles, monetary policy, change in import and export situations, etc (Knoop, 2004)ii. The global financial crisis all started with the panic emerging in the banking system, with need to nationalize the banks. The credit system was affected with consumers and businesses facing difficulty in obtaining credit, housing market was highly affected. Thus, activity dropped hugely; there was fall in profits of many companies, pessimism and loss of confidence, net worth of businesses declined, and businesses precipitating into bankruptcies. This era can be characterized as Recession. (b) What are the key differences between the Classical and the Keynesian point of views Which of these frameworks has the Australian government been favouring in the global financial current crisis of 2008 and 2009 Classical economics believe that market will adjust itself and has its basis on Say's Law - people supply things to the economy and in return receive income to demand things of the value they have supplied. With regards to unemployment it is believed that unemployment is caused by excess supply due to higher wage levels. Classical economists therefore say that when left on its own, equilibrium wage levels will be achieved and economy will be at a full employment. In 1936, John Meynard Keynes, emphasized the role of the government for stabilizing the economic output over the different business cycle. He pointed out that the private sector decisions can lead to the inefficient macroeconomic outcomes, whereas public sector interference via monetary policy and fiscal policy can lead to positive outcomes. Since individuals and institutions, lead to micro level decisions which leads to economy operating below its potential output and growth. Therefore, economy should be stimulated by reducing interest rates, investing in the infrastructure by the government. This helps in economic activity to pick up. Cheaper credit will be available for businesses to fund their capital requirements for daily operations and expansion purposes. And induced spending by the government injects income into the economy, which stimulates production and consumption. Australian government's approach to the handling of the global financial crisis to support the economy was that of Keynesian approach to macroeconomic - on December 4, 2008 Australia's central bank cut its benchmark cash rate by a bigger-than-expected 75 basis points to 5.25% in an increasingly urgent effort to save the economy from the recession rapidly engulfing much of the developed world. Following this, on December 8, 2008, the Australian government delivered more than A$ 8 billion in cash payments to families and pensioners to stop the economy from sliding into recession. The Australian government wants people to spend the money in the run up to Christmas, rather than pay off their debt. The cash is part of a A$ 10.4 billion economic stimulus package announced on 14 October 2008 and aimed at boosting consumer confidence and retail sales as Australia fights off slowing growth and rising unemployment due to the global downturn. Question 2 (a) Illustrate and explain the circular flow of income and expenditure in a four sector macroeconomic model. The four sector macroeconomic model comprises of households, firms, product markets and factor markets. The model states that the flow of goods and services from the product and the factor markets is balanced by the payments received from the house holds and the firms for the products and services they purchase. So, to say that households and firms are on the buy side and products and factor markets are on the sell side. In the model, firms use factors of production by buying them from the household. The payments made for the usage of these factors of production are added to the production cost for the firms. The firm sells the products and services so produced to the households for their consumption. The charges from provision of these products and services are the revenue; what is left after payment for all factors of production is the profit. The profits flow to the households in the form of dividends. (b) 'High GDP growth means all citizens of a country are happy'. Critically discuss this statement. The high GDP growth is not always reflective of betterment to/in the economy and for the citizens. GDP growth may be high because of rising prices in the economy because GSP is measured by the market value of the output produced in the economy. Moreover, GDP is a representation of the growth of the economy and not the individuals living in the country. It might be happening that a certain group of people are getting richer and richer and the poor are moving towards further poverty. Question 3 (a) i) Suppose a country has no growth in technology, and capital and labour hours are growing at the same rate. What is the growth rate of real GDP per hour of work Explain. The real GDP growth rate is impacted by aggregate hours and labour productivity. Increase in aggregate hours is derived from the increase in labour force rather than the growth in the average hours per worker. Therefore, it can be clearly put that for a growth that has to be sustained over a longer period of time, population growth is the only source and not the growth in average hours per worker. ii) Suppose capital in the country described in part (i) above continues to grow at its previous rate, technology growth is still zero but growth in labour hours falls to half its previous rate. What happens to real GDP per hour of work In the light of the following formula, the growth rate of real GDP per hour worked, the growth rate will fall and will fall by much more than the fall in the labour hours. Growth rate of real GDP per hour worked = 1/3 (Growth rate of capital per hour of work) +( Growth rate of technology) Growth rate of technology = (Growth rate of real GDP per hour worked) - 1/3 (Growth rate of capital per hour of work) (b) Draw a diagram for the Malthusian equilibrium and explain the mechanism by which the economy gets to the equilibrium point. Now suppose the subsistence level increases because a disease forces workers to eat more to stay alive. Show this situation on the diagram. What happens to the Malthusian equilibrium quantity of labour input Malthus in 1978, in an essay on Principles of Population presented an idea that the population in an economy needed a certain level of output for its survival and the Malthusian level of equilibrium occurs at a point where the output is just enough in order to survive for the population. It can be portrayed with an example that if food output fell below a certain level, then there wouldn't be enough food for the whole population to live and therefore people would die of starvation. Since there occurs diminishing marginal product of labor, so as the population increases the number of people in the labor force grow, but as the concept of aggregate hours suggests that output increases with the additional number of people to workforce and not the increase in hours from the aggregate work force; the additional output produced by an additional worker would shrink to such a low level that it would not be enough to sustain the labor force producing it. Malthus's prediction was that once output reached the subsistence level, it was not possible for there to be any further long-term economic growth. This also meant that population could not permanently grow beyond the level needed to produce this subsistence level of output. Therefore, in the long run, the standard of living could not improve beyond the subsistence level. The subsistence line is a line representing the minimum level of output the population needs to survive or subsist. Important is also to note that if the population level at any point in time falls below the level needed to produce the subsistence level of output, then population increases. And the opposite occurs, if the population is greater than the level needed to produce the subsistence level of output, then the population decreases. Question 4 (a) Illustrate and explain the demand and supply of labour using a market model with equilibrium. Discuss the various types of unemployment and the policies adopted by the Australian government to reduce the natural unemployment rate. The demand for labour is a derived demand, i.e. its demand is dependent on some other good or service and will only be demanded if there is demand for that particular product (Becker 2007iii). And therefore, the economics of employing an additional amount of labour depends on the marginal revenue product of the worker i.e. what it can contribute to production. The supply of labour is the number of people that are offering their services at a particular wage level. For the workforce, they have to make a choice between working and not working and this selection involves opportunity cost. The workforce will only be willing to work if the wage rate exceeds the opportunity cost of the leisure. There are four types of unemployment: Cyclical unemployment, Frictional unemployment, Structural unemployment and Classical unemployment. Cyclical unemployment - This type of unemployment moves in tandem with economic cycle. The unemployment increases in times of recession (economic downturn) and comes down when the economy is progressing towards upturn. It can also be said that it has its cycles associated with the aggregate demand, it increases when aggregate demand is low and reduces when aggregate demand improves. Frictional unemployment - This kind of unemployment persists because of heterogeneity amongst job and workers - a mismatch of characteristics between the two can lead to this unemployment; the characteristics include skills, payment, work timing, location, attitude, tastes, etc. To fulfill this mismatch between the jobs, workers might leave their jobs in search of better options - this temporary unemployment period leads to frictional unemployment. Training, education, incentives, flexibility etc. can help reduce the frictional unemployment. It can be categorized as wait or frictional unemployment. Structural Unemployment - It occurs when there is a dearth of job opportunities for people who have sufficient skills and are actively seeking jobs. It might be happening because of the economic structure in transition. The people might be skilled but the opportunities available might render those skills useless. Classical Unemployment - Though there are vacancies available and people are ready and willing to work, but conditions like labour at higher rates or policies like minimum wage rates limit employers to hire these workers that are available, since their cost will exceed the benefits they derive out of hiring such type of labour. Or in other words, marginal revenue product of such labour is low. (b) Calculate the following, given an unemployment rate of 6 per cent. i) If the working- age population is 16 million and the total labour force is 10.4 million, how many people are unemployed Unemployed people are the percentage of workforce that is unemployed at any given moment; therefore number of people unemployed is: Labour force * unemployment rate = 10.4 million * 6% = 0.624 million = 624,000 people ii) Calculate the labour force participation rate. The labour force participation rate in an economy is the ratio of labour force to the total population: = (labour force / population) * 100 = (10.4 million / 16 million) * 100 = 65% iii) Calculate the employment- to- population ratio. The employment to population ratio is as under: = ( 624,000 / 16,000,000 ) * 100 = 3.9% Question 5 (a) Explain how Central Bank/Reserve Banks controls interest rates and bank lending. Explain why the Reserve Bank of Australia has adopted an expansionary monetary policy by cutting interest rates since October 2008. There are two primary ways, by virtue of which Central Banks control the monetary stock in the economic system. Firstly, by limiting the issuance of paper currency directly or with the use of monetary instruments, by influencing the levels of the bank reserves, that the banks are capable of maintaining (Lippi)iv. The tools used by the Central Banks include - open market operations, changing minimum reserve requirements, influencing the discount rate, etc. The open market operations involve buying and selling government securities, foreign exchange or other assets in the open market to inject or mop up liquidity respectively from the market. When the government purchases the assets, it draws cheque upon the seller, who deposits the cheque into the banking system thus increasing the liquidity position; whereas, when the government sells securities, the excess money in the system is mopped up as the buyer pays for the purchases. The benefit of open market operations is that it provides Central Banks to exercise full control over the outstanding money balances in the economy. Another tool is the minimum cash reserve requirements for the banks, which is mandatory for the banks. It does not directly influence the bank reserves but do so by altering the total value of deposits supported by available cash reserves. Discount rates are the rates applicable when banks go to borrow from the Central Bank's discount window; a lower rate will encourage borrowing, hence, increasing liquidity in the system and higher discount rate will mop up liquidity. All major economies, including Australia's has its central bank cut its benchmark cash rate by a larger 75 basis points to 5.25% in an increasingly urgent effort to save the economy from the recession rapidly engulfing much of the developed world. This effort was directed towards stimulating economy by encouraging borrowing of cheaper credit, hence increase spending by the consumer and stimulating demand. (b) Illustrate and explain why real GDP departs from Potential GDP in slum and boom phases of the business cycle. The potential GDP and real GDP are different because potential GDP reflects value of the output that will be produced if labour is employed at the normal levels of overtime and machinery and equipment is also utilized at the normal levels. Since boom and slum are the time periods, when economy is not at its normal conditions (Bade & Parkin, 2008)v. That is the reason potential GDP gives a smooth reflection over time and real GDP varies with the boom and the bust situation of the economy. Question 6 (Refer to Chapters 7 and 8) (a) Demonstrate how the size of the multiplier is determined and how a change in tax affects the size. An increase in spending can induce further rounds of spending, hence leading to increase in the national income; therefore the impact is that national income increases more than the amount spent. Hence the phenomenon is known as the National Income Multiplier. The size of the multiplier is determined by the withdrawals from the spending amount and the marginal propensity to consume. The higher the marginal propensity to consume, higher the multiplier effect (Lewis)vi. The change in the tax rates affect the spending levels by impacting the marginal propensity to consume. Higher tax rates would mean people have lower income at their discretion to spend hence multiplier effect will be lower. This is also conspicuous from the following formula: Multiplier Formula = 1/ (1 - marginal propensity to consume) (b) The table below shows real GDP and imports for an economy. Study the table and answer the following questions, and assume that exports are equal to $44 billion. Real GDP or income ($ billions) Imports ($ billions ) 120 24 180 30 240 36 300 42 360 48 420 54 i) Construct a graph showing how imports depend on income. The graph shows that imports are directly proportional to the income (real GDP). Therefore, it is implied that as income of the people in a particular country increases, their purchasing power increases and they have the more money to spend on the imported products. The relative magnitude depends on their choices between home country and foreign products. ii) Construct a graph showing how net exports depend on income. A net export is the differential between imports and exports. Imports depend on the home country's income, whereas, exports are driven by the changes in the income levels of the foreign country importing. Therefore, as income rises the net exports tend to decline. iii) If the level of GDP that occurs at spending balance is $360 billion, will there be a trade deficit or surplus What type of policy regarding government expenditure would bring the trade deficit or trade surplus closer to zero At a point where GDP is at $ 360 billion, there will be a trade deficit since the value of imports exceed the value of the exports. The imports stand at $ 48 billion and the exports at US $ 44 billion, hence a deficit of $ 4 billion. A multiple of policies can be adopted depending on the relative situation of the country. The trade deficit can be reduced by reducing the exchange rate of the country; this will make imports for other countries cheaper and hence will boost the home country exports. But this is also dependent on the elasticity of demand. Moreover, governments can impose trade quotas to restrict imports and reduce the trade deficit (Chyrsal & Lipsey, 1997)vii. (c) For each of the following actions, illustrate and explain what the effects might be on different categories of the national accounts and to the expenditure line i) Government expenditure on airport safety rises due to terrorism activities. This affects the balance sheet of the government by reducing the cash balance on the assets side of the balance sheet and increases the Social expenditure. ii) Australians buy more Korean made cars, instead of cars built in Australia. This effects the current account portion of the balance of payments of the national accounts. Imports will increase and exports decrease. The net affect depends on the relative magnitude of the two. iii) The government pays $20,000 to anyone who buys a newly built house. This transaction affects the Social Assistance Benefit given to the household sector in the income account and will increase the expenditure account of the government. Read More