1. ECO120 Macroeconomics Rod Duncan Lecture 5- The business cycle, or why we do well in some years and worse in others

2. Announcement Your first Econlab homework is due in your tutorial this week. Go to MyEconLab, click on Homework and do the assigned homework. Print your answers out and bring them to your tutorial. Each one is worth 2% of your final grade!

3. Measuring GDP Alternative methods of calculating GDP –Expenditure approach: add up the total spent by all members of the economy (value of all goods and services bought) –Income approach: add up the incomes of all members of the economy (value of all goods and services sold) –Value-added approach: add up the value added to goods at each stage of production

4. Expenditure approach GDP is calculated as the sum of: –Consumption expenditure by households (C) –Investment expenditures by businesses (I) –Government purchases of goods and services (G) –Net spending on exports (Exports – Imports) (NX) Aggregate Expenditure: AE = C + I + G + NX

5. Expenditure approach Later on in the subject we will introduce the aggregate demand-aggregate supply model (AD-AS). The expenditure approach underlies the AD curve in the AD-AS model. Factors that shift components of demand will then also shift the AD curve. –If income taxes change, household consumption (C) will change, so the AD curve will shift.

6. The big picture P, Wealth, H/h Expectations, H/h Taxes P, i, Business Expectations, Business Taxes C Government policy, and? G P, and? NX AEAD I

7. Income approach The income approach is probably the next most straight-forward way of measuring economic activity. When you buy a good, the cash that you pay (the market value) to a firm doesn’t stay with the firm. The value gets returned to households. –The firm pays its employees (households). –The firm pays other firms for its purchases. –The rest gets returned as profits to shareholders (households).

8. Firms as fictions In that sense, firms don’t really exist. They are just convenient accounting fictions. A firm is a representation of the households who own the shares in the firm (or for a private firm, own it outright). Firms were invented as a way of allowing people to own a business, but not be personally liable if the business fails. To say “firms don’t pay enough taxes” is really to say “shareholders don’t pay enough taxes”.

9. Income approach We measure the value of the income earned by households in the production of goods- think of the cash a firm receives on a sale: –Wages paid to employees (suppliers of labour) –Profits/rent/bonds payments returned to suppliers of capital –Indirect taxes (GST) paid to government Since the Tax Office collects all these details to calculate income taxes, we can have a reasonably good measure of this.

10. Value-added (production) approach This approach is probably the most difficult to understand. Why can’t we simply add up the value of all the goods and services bought in a year? The problem is that a lot of sales of goods are “intermediate” goods- that is goods that will be used to make other goods. If we simply added up the sales of all the goods in a year, we would wildly over-calculate GDP.

11. Ford as a car assembler Ford is more of a car-assembler than a car- maker. Ford buys seats from one supplier, brake systems from another and tires from a third. Imagine Ford uses $20,000 worth of components in a $30,000 car. Adding up the sales, we get $50,000, but the consumer buys a $30,000 car!?! The answer is that Ford adds only $10,000 worth of value. The rest of the value of the car is the $20,000 in components.

12. Valuing economic activity In the end, we can either value (1) the $30,000 car purchased by the consumer, (2) the $30,000 income returned by Ford to workers, capitalists and suppliers, or (3) the $20,000 in components plus the $10,000 in value-added by Ford. All 3 approaches result in the same answer… $30,000- the value of the car.

13. What is a business cycle? If we measure GDP, we find that there are two major patterns we can identify over time: 1.GDP grows larger over time, so we saw Australian GDP in 2000 was 40 times larger than Australian GDP in 1960; and 2.GDP is not steady, but tends just jump up sometimes and jump down other times.

14. Long-run view of GDP

15. Short-run view of GDP

16. So what is the real view? If you take a very long-term view of GDP, the growth is by far the most important feature of GDP. If you take a very short-term view, the sudden swings in GDP can seem the most important feature. Which aspect do you think newspapers take if the aim of the papers is to make news seem important? Which aspect do you think politics concentrates on?

17. Growth in GDP The growth in GDP is the rate at which GDP is increasing relative to the last time you measured it. Growth is usually expressed as a percentage of the previous observation, so you take the change in GDP and divide it by the last GDP measurement.

18. Calculating growth GDP in $Change in GDP in $ Quarterly Growth in (%) Annual Growth in (%) Mar 2007251380 Jun 200725440130211.2 Sept 200725693425331.0 Dec 200725903721030.82 Mar 200826079217550.683.74

19. Growth in GDP

20. There is a long-run average rate of quarterly growth- and it’s greater than zero. But growth is not the same quarter after quarter, and some periods seem to have higher levels of dispersion of growth rates. We might want to: 1. raise the average rate of growth, and 2. lower the dispersion (variance) in growth rates.

21. Why is it called a cycle? Some of the early economists studying macroeconomic data had physics/engineering backgrounds. When they saw the up and down nature of GDP over time, they were reminded of the motions of waves (cycles) from physics. So they brought over all the physical descriptions of cycles or waves into macroeconomics.

22. The business cycle

23. Parts of the business cycle 1993 Real GDP Year 2006 Trough Peak Trend GDP or Full-employment GDP Actual GDP