Understand What Happens During the Business Cycle
Dating back at least to the early nineteenth century, most advanced economies including the Australian economy Opens in new window has experienced a business cycle, consisting of alternating periods of expanding and contracting economic activity.
The business cycle is the upward and downward movements of levels of GDP Opens in new window which refers to the alternating periods of expansion and contraction in economic activity relative to the trend in growth that the economy experiences in the long run Opens in new window.
Because real GDP Opens in new window is our best measure of economic activity, the business cycle is usually illustrated using movements in real GDP, that is, the economic growth rate. Opens in new window
During the expansion phase of the business cycle, production, employment and income are increasing above the trend in growth that the economy Opens in new window experiences over time. The period of expansion ends with a business cycle peak.
Following the business cycle peak, production, employment and income are falling below the trend in growth as the economy enters the contraction phase of the cycle.
The contraction phase may be followed by a recession Opens in new window, which occurs when total production and employment are decreasing and the rate of economic growth is negative. The contraction or recession Opens in new window comes to an end with a business cycle trough, after which another period of expansion begins.
Figure I helps to illustrate the phases of the business cycle as shown by fluctuations in real GDP during the period 1980 to 2013.
The figure shows that in 1982-1983 the Australian economy entered a recession, quickly recovered to reach a peak in 1985, only to go into an economic contraction in 1986.
The subsequent expansion phase was short lived with a fall in the rate of economic growth Opens in new window commencing in 1990, with the economy Opens in new window then entering a recession Opens in new window.
The expansion that began after 1991 largely continued throughout the 1990s until 2008-2009, when a short contraction occurred—the result of the effects of the GFC Opens in new window. Since then, economic growth Opens in new window has occurred, although mostly below trend.
A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income and wholesale-retail trade.
Australia’s economy Opens in new window contracted but economic growth was negative for only one quarter (December 2008), and therefore arguably Australia did not experience a recession. By 2010 Australia’s economy Opens in new window was again growing at close to trend rates, although this slowed from 2011 onwards.
What Happens During the Business Cycle?Each business cycle is different.
The lengths of the expansion and contraction phases and which sectors of the economy Opens in new window are most affected will rarely be the same in any two cycles.
As the economy Opens in new window nears the end of an expansion interest rates Opens in new window are usually rising, and the wages of workers are usually rising faster than prices Opens in new window. As a result of rising interest rates and rising wages, the profits of firms will be falling.Typically, towards the end of an expansion both households and firms will have substantially increased their debts.
These debts are the result of firms and households borrowing to help finance their spending during the expansion.
An economic contraction will often begin with a decline in spending:
- by firms on capital goods, such as machinery, equipment, new factories and new office buildings, or
- by households on new houses and consumer durables, such as furniture and cars.
- As spending declines, firms selling capital goods and consumer durables will find their sales declining.
- As sales decline, firms cut back on production and begin to lay off workers.
- Rising unemployment and falling profits reduce income, which leads to further declines in spending, and a recession may occur.
As the contraction or recession Opens in new window continues, economic conditions gradually begin to improve.
The declines in spending eventually come to an end; households and firms begin to reduce their debt, thereby increasing their ability to spend; and interest rates decline, making it more likely that households and firms will borrow to finance new spending.Firms begin to increase their spending on capital goods as they anticipate the need for additional production during the next expansion.
Increased spending by households on consumer durables and by businesses on capital goods will finally bring the recession to an end and begin the next expansion.
The Effects of the Business Cycle on Car SalesDurables are goods that are expected to last for three or more years.
- Consumer durables include furniture, appliances and cars.
- Producer durables include machines, tools, vehicles and some computer equipment.
- Consumer non-durables include goods such as food and clothing or services such as haircuts and medical care.
During an economic contraction or recession workers reduce spending if they lose their jobs, fear losing their jobs or suffer wage reductions.
Because people can often continue using their existing furniture, appliances or cars, they are more likely to postpone spending on durables than spending on other goods.
Cars are among the most expensive products consumers buy, so consumers are very likely to postpone buying a new one during a recession.Car manufacturing firms’ sales have been significantly affected by the business cycle.
The sustained economic expansion during the 1990s and into the 2000s led to a trend increase in car sales. However, there are also noticeable cycles associated with changes in economic growth Opens in new window and fluctuations in car sales.
One of the most important of these fluctuations was the introduction of the Goods and Services Tax (GST) in 2000, after which the prices of new cars fell due to the removal of other sales taxes on cars.
In anticipation of this people delayed buying cars until the GST had come in after which there was a boom in sales as soon as it was introduced.
The economic contraction in 2008, which carried with it forecasts and expectations of a worse economic outcome, led to a significant fall in buying new cars, which was followed by a period of short recovery, before another downturn that largely trended with the rate of economic growth.