Discuss the impact of the international business cycle on domestic economic performance and policy
settings.
All countries that participate in world trade impact on the international business cycle. The further an
economy is ‘integrated’ into the world economy, the more the international business cycle will affect that
economy. Globalisation is leading toward further and deeper economic integration and as this happens, the
international business cycle will have even more of a dramatic effect on domestic economic growth,
performance and policy settings. A rise in the international business cycle tends to increase demand and
output in trading countries whereas a fall in the international business cycle tends to decrease demand and
output in those countries. Fluctuations in the business cycle will have an affect on domestic economic
performance and domestic economic policy should be aimed at moderating the effects of the international
business cycle on the domestic economic cycle.
The international business cycle is defined as being increases in world GDP over time. The general trend is
for world output to grow over time and since world war two, industrialised countries have averaged growth
between 3-4% per year. Over 1990-1998 Australia was the only OECD country to sustain growth over 3%.
The international business cycle can be drawn graphically as seen in the diagram below.
The international business cycle is characterised by four phases in the cycle. These are:
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Expansion. (Primarily caused by an increase in demand).
Peak. (Demand pull inflation setting in, demand falls off).
Contraction. (Further falling demand and rising unemployment).
Trough. (Fall in output and demand reach their minimum point).
Influences on the International Business Cycle.
Many factors can lead to alterations in the business cycle. No matter what factors affect the cycle however,
it can usually be defined as being either a money shock or a real shock.
Real shocks involve a change in real variables leading to varying consumer and industry confidence.
Examples of real shocks include the 1973 and 1979 oil crises and the events of September 11, 2001. These
shocks tended to send advanced economies into mild/significant recessions which, when transmitted
through the business cycle, affected all economies in varying degrees.
Money shocks involve changes in financial variables and good indicators of this happening include the
crash of Wall St. in 1987 and the Asian Crisis of 1997. The Asian Crisis caused world GDP to fall 2% in
the following year and has left lasting effects on the countries involved in the crisis. The Asian Crisis was
caused by a collapse of the Thai Baht which triggered increasing uncertainty toward the Asian newly
industrialised economies from foreign investors. Capital flight resulted and money was pulled out of Asia
and placed in Russia (who had extremely competitive hedge funds) and the USA. Investor’s transferring
money into Russia knew that the interest rates were unsustainable, but invested anyway since it was
assumed the World Bank would not let them fold. The World Bank was predominantly occupied with Asia
however and Russia collapsed, leaving many foreign investors reeling and those with any capital left
sending it to the economically stable USA. Money lost in the Asian Financial Crisis had a dramatic effect
on the international business cycle, but it wasn’t all bad news as the depreciation in trading economies
currencies allowed them to trade themselves out of trouble.
How does the International Business Cycle affect us?
Economic Growth.
Varying trends in the international business cycle tend to be mirrored or repeated in domestic economies.
Australia’s economic growth (increases in real GDP over time) fell in 1983, the early 1990’s and in 2001,
directly corresponding to global slowdowns in these periods of time. The Asian crisis also threatened to
severely stunt our economic growth in 1997 but our depreciated dollar (a result of the crisis) made our
exports extremely competitive and therefore growth was not poor as a result of our increased export
revenue.
Unemployment, Inflation.
Changes in the international business cycle have an effect on domestic demand levels, domestic inflation
levels and the cost of imports. Therefore, changes in the international business cycle will affect our
domestic unemployment levels since demand and inflation greatly influence unemployment. Generally,
inflation tends to rise during the upswing and peak of the international business cycle whereas
unemployment increases during the downswing or recession.
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A downswing in the business cycle will tend to cause cyclical unemployment (a type of
Keynesian unemployment caused by deficient international demand)
An upswing in the international business cycle would tend to increase the price of imports,
causing imported inflation and therefore, this may cause unemployment in certain import reliant
industries as producers choose between the higher costs of imported capital products and
domestic labour. Generally however, an upswing in the international business cycle has a positive
effect on domestic unemployment.
An upswing in the international business cycle usually causes domestic inflation to rise and this in
turn could cause unemployment through the conflicting nature of unemployment and inflation.
I.e, when the government tries to target inflation in the short run via monetary policy a tradeoff in
rising unemployment may have to be endured. This is displayed in the “J-Curve” below.
An upswing in the business cycle could also possibly cause structural unemployment. If the world
economy is experiencing unusually high levels of growth and demand, domestic governments
might cut subsidies/protection aimed at uncompetitive industries and channel funds into
competitive export industries to take advantage of increased world demand.
External Stability
External stability refers to the situation when export income is sufficient to finance import expenditure.
Changes in the international business cycle can either have a positive or negative effect on our external
stability. External stability can be analysed through the current account deficit, particularly the goods
balance. Australia has inherently been an ‘importing’ nation with a consistent deficit in the goods balance.
If the growth rates of our trading partners outstrips domestic growth, the demand for exports would
increase and therefore our goods balance would improve, moving us toward external stability. Conversely,
a decrease in the growth rates of our trading partners would decrease demand for exports, leading us into
less export revenue and external instability.
Policy Settings
Macroeconomic policies in response to fluctuations in the international business cycle.
The Australian government may be required to alter macroeconomic policy settings in response to the
international business cycle. This is done through monetary policy (conducted through the Reserve Bank)
and fiscal policy (the Federal Government). During recent years, fiscal policy has tended to play more of a
background role in economic management which is left largely to monetary policy.
The Reserve Bank of Australia (RBA) will tend to conduct monetary policy in response to the international
business cycle depending on our domestic economic conditions.
Examples of how the RBA may react to changes in the international business cycle:
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If the world economy experiences strong growth compared to weak growth domestically, the RBA
may wish to allow world consumer confidence to spread into our economy.
If domestic economic growth is sustainable and world growth is strong to the point of being
unsustainable, the RBA may wish to tighten interest rates to limit the effect of world growth on
the domestic economy.
The role of fiscal policy in response to the international business cycle.
Fiscal policy involves the use of the government’s budget to influence the level of economic activity and
the achievement of objectives such as internal and external balance and economic growth. Fiscal policy can
be used to counteract large variation in the international business cycle. When world growth is slowing or
in recession, the government may use an expansionary fiscal policy stance by handing down a smaller
surplus or larger deficit. If world and domestic growth is becoming unsustainable, a deficit may be used
which has a contractionary effect.
Conclusion
As economies become more globalised, the international business cycle will continue to have a significant
effect on domestic economic growth, performance and policy settings. As the cycle effects key economic
indicators such as unemployment, inflation and external stability, the government seeks to maintain a
degree of control that allows fluctuations in the cycle to be a benefit and not a hindrance.