ECONOMICS UNIT 3
The Australian business cycle: boom or bust?
Chris Williams
Fintona Girls’ School
Area of Study 2 in VCE Economics Unit 3 begins with a focus on the nature and purpose of macroeconomic activity, including the business cycle. This article considerswhat the business cycle is and speculates about the current phase of the business cycle, given the myriad of conflicting economic data. The leading indicators of the business cycle are discussed, which highlight the strengths and weaknesses of the Australian economy. The article providesstatistical data and measuresthat students can use when answering examination questions. Also includedarequestions and tasksthat will help students to consolidate their understanding of the concepts and information covered in this article.
Introduction
If you were a Martian coming down to Earth and the first thing you saw in Australia was GDP growth of 3.1 per cent, unemployment of 5.3 per cent and inflation of 2 per cent, you would be forgiven for thinking the Australian economy was in a wonderful position. However, the Australian economy is currently in a state of flux (many of you are probably asking, ‘When is it not?’). Media commentators, economists, market analysts and, hopefully, you as a student of economics are asking the question, ‘How is the Australian economy performing’?’
Various statistics are regularly released, some of which indicate a strong economy and others that suggest relative weakness in the Australian economy. This article examines some of themeasures of business cycle activity, which provide insight into the current state of the economy and where it might be headed. This information should assist you to interpret and use economic statistics when completing examination questions.
So which is it: is the economy strong or weak, or are we somewhere in between, and where do we sit in the business cycle? But first, what is the business cycle and each of its phases?
The business cycle
When discussing economic activity, the rate of economic growth as a measurement of this activity is often used; in other words, the percentage change in Gross Domestic Product (GDP). The Australian economy constantly fluctuates; however, it tends to move in trends over extended periods of time. Cyclical changes in the level of economic activity mean that in some periods the economyexperiences strong economic growth, while in other periods itexperiences low growth or even negative growth. Fluctuations in growth are known as the ‘business cycle’.
Within the business cycle you may see troughs, recoveries, peaks and contractions, but each of these does not have to be present in every cycle. No two business cycles are the same: from the early 1990s to mid-2009, Australia experienced an extended period of strong growth that was above the longer term average. In contrast, from 2009 there was weakness in the Australian economy that lasted for only one to two years before there was evidence of a minor recovery.
Below is a chart of the business cycle that Australia has experienced over the past 30 years, measured by GDP.
‘Australian GDP Growth and Inflation’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/au-gdp-growth.html
Trough
A trough is where the economy has reached a minimum (low) point in the cycle; it is where economic growth has fallen to its lowest level and is associated with low or even negative rates of economic growth. A trough, however, does not necessarily mean there is a recession, as the generally accepted definition of a recession is that there are two consecutive quarters of negative economic growth. While this may be the case, the lowest point of economic growth in a business cycle, be it positive or negative, will be identified as the trough.
Particular economic statistics will indicate when the economy is experiencing a trough. When demand for labour declines because of lower levels of growth, there is likely to be an increase in the level of unemployment. In these conditions inflation tends to be low or falling as lower levels of demand reduce pressure on prices. In these conditions, consumer and business confidence measures tend to be low and falling. Official interest rates will usually have been cut and will be below trend,while participation rates may also have fallen as many individuals give up looking for employment in a weak economy.
Recovery/expansion
Leading on from a trough is a recovery or expansion, which is when the economy is beginning to grow and GDP is startingto improve. Production increases and there is an upturn in the demand for goods and services. The low levels of inflation seen in the trough and the higher levels of unemployment keep costs low for businesses and allow for growth to occur; in particular, when the government uses macroeconomic and microeconomic policies to drive growth (you will learn about these policy options in Economics Unit 4).
During a recovery it is expected that GDP will recover from its low point, unemployment should start to improve and inflation should have started to rise. Incomes should increase, giving more people money to spend, which will also help to drive the recovery. Confidence, while still low, should start to improve and this, in turn, will lead to increased spending and investment by both consumers and producers respectively.
Peak/boom
The economic recovery may then lead to a peak or boom. This is when the economy experiences very strong rates of economic growth and production increases at an expanding rate. The peak is the highest level of economic growth in the cycle. The higher levels of growth will lead to increased demand for resources, including labour resources, and unemployment should fall. The lower levels of unemployment might also lead to wage increases and higher levels of consumer spending. As this occurs, consumer confidence and business confidence increase, and spending on investment increases, which, in turn, fuels economic growth. If the higher level of demand is not met by increased aggregate supply, capacity constraints will occur, which will exert pressure on prices, thus driving up inflation. This could mean a boom has occurred and can lead to increased demand for relatively cheaper imports, driving up the level of the current account deficit(CAD) and net foreign debt, leading to unsustainable rates of economic growth.
Contraction
The unsustainable nature of the boom, in particular, higher prices and an increase in the CAD, will eventually lead to policy decisions from the government to slow the economy. In addition, the capacity constraints the boom has caused will lead to a lower rate of growth in production and economic activity will slow. This leads to the next phase in the business cycle: a contraction. A contraction will result in the rate of GDP growth slowing down, unemployment will start to increase and inflation, while still high, should start to fall. Consumer and business confidence will start to fall and spending and investment will contract, while savings rates will start to increase. Pressure on the current account should also ease as the demand for imports begins to fall.
So where does this leave Australia currently? Is the economy reaching a peak, is it contracting or is it expanding, or are we close to the bottom of the business cycle, that is, a trough? The next section focuses on a review of the relevant economic data and includes an assessment of where specific pieces of data fit into the business cycle. Determining where Australia currently sits in the economic business cycle will be left to you!
A sluggish economy indicates a contraction, which is a stage in the business cycle where GDP growth declines, unemployment increases and inflation starts to fall.
Current statistics
Economic growth/GDP
The most common measure of economic growth is GDP, which is the final market value of all goods and services produced in the economy over a given period of time. The September quarter figures released in December 2012 indicated that GDP had slowed compared with previous rates, with growth at 3.1 per cent for the year to September. On the face of it, 3.1 per centseems quite sound (it had been up to 4.5 per cent in March 2012) and is close to its long-term average. However, the September figures showed a quarterly growth rate of just 0.5 per cent and, if annualised, the result would be a growth rate of just 2.0 per cent.
The mining sector has accounted for much of the economic growth over the past three years, while other sectors in the economy have continued to weaken. In addition, growth in Victoria and NSW has struggled to stay in positive territory. Spending on mining investment grew at a rate of 29 per cent in the six months to September 2012 at an annualised rate, while spending on the rest of the economy grew at just 0.4 per cent over the same time period. So, where is growth likely to come from in the future? While it is expected that economic growth will decline in the next 12 months, it is likely that growth will continue to come from the mining sector.Based on the previous three GDP results only, it could be said that the economy is currently in the contractionary phase of the business cycle.
Inflation
Inflation is a sustained increase in the general level of prices over time and is measured in two ways by the ABS. The headline rate (CPI), which includes the price movement of all goods and services purchased by the average Australian household over a given period of time, and the underlying rate, which excludes the volatile or outlying prices that influence inflation. The Reserve Bank of Australia (RBA) uses estimates of underlying (or core) inflation when determining interest rates. Headline inflation is currently at 2.0 per cent while underlying inflationis at 2.5 per cent. Both measures are well within the RBA goal range of 2–3 per cent on average over the course of the business cycle. Given that inflation is under control, where in the business cycle would this statistic fit? It could be in either the trough or recovery phases, as inflation has been slowly increasing over the past six months.
‘Australian GDP Growth and Inflation’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/au-gdp-growth.html
Unemployment
Unemployment is defined as all those over 15 who are without work or working for less than one hour per week, and actively seeking work. Unemployment is currently 5.3 per cent and has been relatively stable for the past two years, hovering around the 5 per cent mark. Looking at this statistic, historically, any number around 5 per cent is considered to be very low; however, there is much debate about whether the natural rate of unemployment has changed, and that 5 per cent may not be as low as it was once considered to be.
It is not just the rate of unemployment that is significant but also the participation rate. The participation rate is defined aspersons15 years and over who are members of the labour force (either working or seeking work), expressed as a percentage of the population. The participation rate in Australia has fallen from 65.5 per cent earlier in the year to 65 per cent. This means there are fewer people looking for work and this will assist in maintaining the low unemployment rate. So on the face of it, the low unemployment rate would place the economy towards the higher point of the business cycle; however, when looking at this in conjunction with the participation rate, this may not in fact be the case.
‘Factors of Production and Labour Market’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/factors-prod-labour-mkt.html
Consumer and business confidence
Consumer and business confidence refers to the expectations of consumers or businesses about their future economic prosperity. Consumers will be more optimistic about their future employment, income and living standard prospects if the economy is growing well and businesses will be more likely to increase investment when the economy is in the expansionary or peak phase of the business cycle. Consumer confidence, measured by the Westpac Melbourne Institute Survey of Consumer Sentiment, has been slowly improving over the past 12 months; however,it was still quite low in December 2012 as the index was 100, meaning that as many people were confident in their position as those who were not. This low level of confidence would suggest that consumers are unlikely to increase spending (see the next section on savings) and implies that the economy is still in the beginning stages of a recovery or still in acontractionary phase.
In February the Westpac Melbourne Index of Consumer Sentiment rose 7.7 per cent to 108.3 (from 100.6 in January), which is the strongest sentiment reading since December 2010. Although confidence is still well below levels seen during the RBA’s easing cycle of interest rate cuts in 2008–09, the improvement may suggest that consumers are starting to respond to lower interest rates.
According to the NAB Monthly Business Survey (January 2013), business confidence was weak over 2012 and has now fallen to its lowest level since May 2009 during the GFC. Industries that performed the worst included retail, construction and manufacturing. Interestingly, resources companies are now also starting to show signs of weakening confidence with a fall in the level of Chinese demand for exports and a fall in the terms of trade. Companies were particularly concerned about a global slowdown, the high Australian dollar and fiscal tightening by the government. This low level of confidence by Australian businesses resulted in reduced levels of investment spending and hence lower economic growth, which can cause future capacity constraints. It is another indicator that we may be towards the bottom of the business cycle.
‘Household Sector’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/household-sector.html
Although consumer confidence is still low, the Westpac Melbourne Index of Consumer Confidence rose 7.7 per cent in February this year, indicating an improvement in consumer confidence.
‘Business Sector’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/business-sector.html
Savings
In line with the lower levels of consumer confidence, the rate of savings has increased as consumers spend less and save more of their income. Having fallen to below 0 per cent during the strong economic times of the early to mid-2000s, the Household Savings Ratio rose to above 10 per cent in 2009 and remains above that levelcurrently. A savings rate of 10 per cent is also quite a high rate historically (over the past 25 years)in Australia and indicates that the consumption component of GDP is weak and will not contribute meaningfully to any increase in economic growth. Savings will tend to be low during strong economic times and high during periods of economic weakness and, therefore, this indicates that the economy isclose to the bottom of the business cycle.
‘Household Sector’, Chart Pack, Reserve Bank of Australia, 9 January 2013,
http://www.rba.gov.au/chart-pack/business-sector.html
Current account deficit
The current account deficit (CAD) improved significantly during the mining boom because ofChina’s high demand for resources and the terms of trade increasing to record levels, the driving force for which wasthe high growth in the level of exports, particularly mineral exports. However, we have seen the trade balance (net goods and services) fall below zero again and the CAD fall below negative 3 per cent of GDP. This is not due to an increase in imports, but a reduction in the value of our exports. In a strong economy, we usually see an increase in the level of the CAD as a percentage of GDP as capacity constraints from higher consumer spending drive up imports. Currently, the increased CAD as a percentage of GDP is because of lower levels of exports, mainly due to a fall in China’s demand for commodities and a fall in the terms of trade. The worsening in the CAD reflects a weaker economy rather than a stronger one.
‘Balance of Payments and External Position’, Chart Pack, Reserve Bank of Australia, 9 January 2013, http://www.rba.gov.au/chart-pack/business-sector.html
Currently, the increase in Australia’s current account deficit is due to a fall in exports, mainly because of a decline in China’s demand for commodities.
Conclusion
This article has provided an overview of key economic indicators or statistics used to track business cycle activity. These statisticswill help you togauge where the Australian economy currently sits in the business cycle. You should continually update this data over the course of thisyear.
In Economics Unit 4, these statistical measuresof business cycle activity will be vital to your understanding of the reasoning behind government policymaking. You will also need to be able to make a connection between these measures and the economic theory you are now learning. In addition, using the statistics effectively in School-assessed Coursework and in the end-of-year examination will assist you to demonstrate the knowledge and skills that your teacherand the examiners are looking for.
References
The following references are useful sources of up-to-date statistics that can be accessed throughout the year.
- Reserve Bank of Australia: http://www.rba.gov.au
- Australian Bureau of Statistics: http://www.abs.gov.au
- Westpac Melbourne Institute of Consumer Sentiment: also:
- NAB Monthly Business Survey:
Questions and tasks