ECO120 Macroeconomics
Rod Duncan
Lecture 5- The business cycle, or
why we do well in some years and
worse in others
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!
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
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
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.
The big picture
P, Wealth, H/h Expectations,
H/h Taxes
C
P, i, Business Expectations,
Business Taxes
I
AE
Government policy, and?
P, and?
G
NX
AD
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).
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”.
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.
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.
Ford as a car assembler
• Ford is more of a car-assembler than a carmaker. 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.
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.
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.
Sep-07
Sep-04
Sep-01
Sep-98
Sep-95
Sep-92
Sep-89
Sep-86
Sep-83
Sep-80
Sep-77
Sep-74
Sep-71
Sep-68
Sep-65
Sep-62
Sep-59
Long-run view of GDP
Australian GDP 1959-2008
300000
250000
200000
150000
100000
50000
0
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Short-run view of GDP
Australian GDP 1980-1983
113000
112000
111000
110000
109000
108000
107000
106000
105000
104000
103000
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?
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.
ChangeinGDP  GDPtoday  GDPlast
Growth 
ChangeinGDP
GDPlast
Calculating growth
GDP in $
Change in
GDP in $
Quarterly
Growth in
(%)
Annual
Growth in
(%)
Mar 2007
251380
Jun 2007
254401
3021
1.2
Sept 2007
256934
2533
1.0
Dec 2007
259037
2103
0.82
Mar 2008
260792
1755
0.68
3.74
Growth in GDP
Quarterly growth in Australian GDP
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Oct-1959
-0.5
-1.0
-1.5
Mar1965
Sep1970
Mar1976
Aug1981
Feb1987
Aug1992
Jan1998
Jul-2003
Growth in GDP
• 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.
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.
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The business cycle
Australian GDP 1980-1983
113000
112000
111000
110000
109000
108000
107000
106000
105000
104000
103000
Parts of the business cycle
Real
GDP
Actual GDP
Peak
Trend GDP or
Full-employment
GDP
Trough
1993
2006
Year