Factors that cause business cycles in Australia

Countries across the globe experience ups and downs in the economic activity. In some years, a good number of industries operate below capacity and unemployment surges while in other years industries booms and unemployment reduce. The period of economic downturn is referred to as recession and moments of economic prosperity is known as booms or expansions (Arnold, 2013, p.56). Therefore, this paper explores the causes and outcomes of business cycles in Australia. The application, effectiveness, and limitations of monetary and fiscal instruments in stabilizing the economy are also discussed. Besides, this study seeks to understand whether the economic policies applied by Australia during the Global Financial Crises differed from those used during Great Depression of the 1930s.  

Studies show that a variety of factors are responsible for business cycles encountered in an economy. Some of the factors include interest rates, consumer and business confidence, and the multiplier effect. Interest rates directly impact the consumer expenditure and finally economic growth. When the interest rates are cut, individuals borrow more money resulting in a higher spending and increase in economic growth. On the other hand, a hike in the cost of borrowing results in a decline in household consumption and investments and hence economic downturn (Sloman et al., 2015, p.42).

Some economists also attribute the business cycles to consumer and investor confidence. During the recovery phase, the consumers and investors are confident and optimistic, and thus they increase their consumption and investment causing economic growth. Since consumption and investments contribute significantly to the Gross Domestic Product, when the confidence in economy drops, an economy is likely to go into recession.

Moreover, according to the multiplier effect, a reduction in injections is likely to cause a significant decline in the real Gross Domestic Product. For instance, if government scales back public expenditure, there will be a drop in the aggregate demand and an increase in unemployment. The demand of products in the economy will also decrease as a result of joblessness causing a recession (MAY LI & SPENCER, 2016, p.95). Similarly, a positive injection such as an increase in government investments leads to a progressive effect on the economy.

The impacts of the business cycle on the economy differ during boom and recessions. During expansion, the businesses grow to create more jobs and hence a decline in unemployment rate. The increase in the incomes of individuals will also exert pressure on goods and services resulting in inflation and finally depreciation in the country’s currency. On the contrary, an economy shrinks during the recession. A decline in economic output during contraction stage of business cycle results increase in unemployment (Arnold, 2013, p.59). Therefore, the governments should intervene through appropriate policies to minimize the impacts of business cycles.

Effects of business cycles on the economy

Australia encountered a significant and sustained drop in the terms of trade during the mid-1920s. This scenario resulted from a decline in prices of Australia’s leading agricultural exports, especially wool. This problem was made worse by Australia’s reliance on the gold standard. In 1925, the Chancellor of the Exchequer, Winston Churchill, reinstated the Great Britain to the gold standard. This move resulted in an overstatement of gold price making the exports of British expensive in the global market. Since Australia pound was prized in connection to the pound sterling, its exports were also affected. The prices of wool decreased gradually from the mid-1920s, and that of wheat also declined sharply from 1930 and hence depression. The drop in metal export prices in 1982 also made Australia’s economy to contract by 2.23% (Australian Government, 2015).

In the 1920s, the government of Australia borrowed a lot from the capital market of London. Most of the borrowed money was used in the development of public infrastructure. However, the growing British worries concerning poor investment returns in 1929, made London stop lending to Australia. The banks in London then started pressuring the government of Australia to remit payments on overdrafts (The National Museum of Australia, 2017). Moreover, banks in Australia restricted loans to the local economy thus worsening the situation.

Studies show that the 1991 recession in Australia was caused by tighter monetary and budgetary policies. During this period, Australia’s economy declined by 0.38% (The World Bank, 2017). The focus on current account deficit made the government slow and reluctant to ease monetary and fiscal policy. Therefore, the contractionary shock and the general drop in world economic caused an economic downturn in Australia.

The use of contractionary monetary and fiscal instruments by the government reduced the buying power in the economy. The scenario is depicted by the shift in the aggregate demand from AD1 to AD. Consequently, real Gross Domestic Product declined from Y2 to Y1 and the general price also dropped from P2 to P1.

Since the recession of 1991, Australia has maintained a remarkable economic expansion unmarred by the recession. Even during the global financial crisis of 2008/2009, Australia’s economy did not experience economic downturn. In 2008, the country’s economy grew by 3.70% and in 2009 by 1.81% (The World Bank, 2017). Some of the factors that have caused economic progress in this country include, floating exchange rate, growth in productivity, the housing boom,  household consumption, exports,

Response to previous economic crises

The Australian dollar has performed a critical countercyclical function by falling and rising in response to several external occurrences that would have destabilized the domestic economy. For example, during the dot-com bubble and Asian crisis, the Australian dollar declined sharply in reaction to worsening economic conditions in overseas thus shielding the local economy. Also, the Australian dollar appreciated robustly between 2006 and 2008 as the commodity price increased (RESERVE BANK OF AUSTRALIA, 2017). This occurrence played a significant role in dissipating pressure thus preventing the economy from overheating.

A substantial increase in productivity has been instrumental to economic expansion in Australia, especially in the mid and late 1990s. Pickup in productivity in this country is attributed to some reforms. Foremost, changes to industry policy and competition have enabled the businesses to become competitive and outward looking. Furthermore, labor market changes increased the flexibility of this sector to respond varying economic environment without generating large sways in unemployment or unsustainable stress on wages (Australian Government, The Treasury, 2016). The improvement in Australia’s labor productivity is shown in the graph below.

Healthy conditions in Australia’s housing industry have contributed economic expansion in this country (Jericho, 2017). The boom in this industry is attributed to several factors. For example, the main cities in Australia such as Melbourne and Sydney are experiencing an increase in population and thus a surge in demand for dwelling units. In the previous years, the cost of borrowing for homes in Australia declined, and the credits were readily available to the individuals. These scenarios have played a significant role in amplifying the buying power in the housing sector. Additionally, increase in incomes of Australians, tax concessions on housing and negative gearing schemes have surged the demand for housing units (Dufty-Jones & Rogers, 2016, p.24).

On the chart below, it is evident that construction activity in Australian housing market is on the increase. The jobs generated in this sector contribute to economic growth of Australia.

The export earnings play a significant role in the economic progress of Australia. Statistics from Australian Bureau of Statistics show that the export earnings in 2016 were 32.6 billion U.S dollars. During this financial year, the income from exports increased by 4.2% and thus contributed substantially to the trade surplus. The Liquefied Natural Gas (LNG), iron ore, gold, coal, tourism, and education are among the segments that registered a notable growth (Department of Industry, Innovation and Science, 2017).

There are several outcomes associated with business cycles. During the recession, many businesses close down while others reduce their workforce. Such incidence leads to increase in the level of unemployment in the country and consequently deterioration in the living standards of individuals. For instance, in mid-1930, the unemployment rate was 21% and rose to 32% in mid-1931 (Australian Government, 2015). Moreover, when Australia went into recession in 1991, the level of unemployment increased substantially the impact spread to 1992 and 1993. In 1991, the unemployment rate was 9.58% and rose to 10.73% in 1992 and 10.87% in 1993. Although Australia managed to escape economic downturn during the financial crisis of 2008/2009, the level of unemployment rose sharply in 2009 to 5.56% from 4.23% in 2008 (The World Bank, 2017).

Current state of the economy

Recessions also result in social and political consequences. For example, during the Great Depression of the 1930s, many Australians lost their homes, and they were forced to inhabit makeshift houses with poor sanitation and heating (Australian Government, 2015). Such devastating experience made the Australians to lose confidence in government. 

On the other hand, during booms, the level of employment economy increases. When the economy is prospering, there is increased confidence among the consumers and producers. As a result, consumption levels surges paving the way for the expansion business enterprises as well as the establishment of new firms.  On the graph below, it is evident that as Australia’s economy started recovering from the recession and expanded in the mid and late 1990s, the level of unemployment began declining.

During the Great Depression of the 1930s, Australia responded to the crisis through contractionary monetary instruments. On the chart below, the real M1 (currency held by individuals and existing deposits at banks) declined by 12% between 1928/1929 and 1929/1930 (Gruen & Clark, 2009). This situation exhibits that monetary policy employed during this depression was tragically tight.

On the other hand, during the Global Financial Crisis, the monetary instrument was eased aggressively. The overnight cash rate was slashed 425 basis points to 3%. Major economies such as United States, Canada, and the United Kingdom also enacted a similar policy (Nyasha & Odhiambo, 2016, p.166). This interest rate policy response is shown in the chart below.

Australia also responded to the Great Depression of the 1930s by enacting a contractionary fiscal policy. There was a significant reduction in government expenditure. The federal and state taxes were also increased, and new taxes introduced. However, during the Global Financial Crisis, Australia introduced a fiscal stimulus to help the recovery of the economy. Economic Security Strategy package and Nation Building and Jobs Plan are some of the fiscal responses (Phillips, 2014, p.299).

The monetary and fiscal instruments employed during the Global Financial Crisis played a significant role in stabilizing the economy of Australia and helped this country to avoid an economic downturn. The reduction of the interest rates lowered the cost of borrowing thus increasing the aggregate demand resulting in a rise in short-term equilibrium output. The fiscal stimulus also raised the consumption levels in the economy. The impact of these expansionary policies on Australian economy is demonstrated on the AS-AD model below.

While the GFC policy responses were effective in stabilizing the economy, the instruments applied during the Great Depression of the 1930s were unable to curb the crisis. Recovery in this country began in 1993 due to increase in exports after the enactment of Ottawa Agreement (1932) that granted Australia preferential trade accords to British territories (Australian Government, 2015).  

The adoption of contractionary policies during the Great Depression of the 1930s worsened the economic downturn. The reduction of government expenditure, the increase of taxes and introduction of additional taxes were detrimental to the purchasing power in the economy. The weak demand for products contributed to high levels of unemployment during this particular period. Moreover, some of the responses to the recent economic crisis like the reduction in the cost of borrowing for homes have contributed to surging demand in the housing sector and thus housing affordability crisis.

Conclusion

Rather than experiencing uninterrupted growth, for some reasons, economies encounter alternating phases of prosperity and recession. Deterioration in terms of trade and tighter economic policies are some of the factors that have caused recessions in Australia. Booms have been driven by floating exchange rate, growth in productivity, the housing boom, and export growth. Lastly, during the Great Depression of the 1930s, Australia employed contractionary economic policies and expansionary policies during Global Financial Crises.

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