Chapter 5
The macroeconomic
environment
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Learning objectives
• Describe the business cycle — the periodic
fluctuations in output, employment and price
levels that have characterised our economy
• Examine unemployment in detail — its definition and
measurement, and the structure of unemployment
• Discuss the economic and social problems
associated with unemployment
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Learning objectives (cont.)
• Understand the causes and consequences
of inflation, a problem that plagued us through
the 1970s and 1980s
• Discuss the history and changes in structure
of Australia’s balance of payments, with emphasis on
the current account of the balance of payments
• Discuss the relationship between the current account
balance and the level of national savings
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The business cycle
• The recurrent, somewhat cyclical, increases
and decreases in the level or rate of growth
in economic activity that typify the pattern of
progress of our economy’s real GDP over time
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The Australian business cycle & rate of
inflation
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Phases of the business cycle
• Peak
– Temporary maximum economic activity
• Recession
– Decline in output and employment to low or
negative levels
– A depression is a severe and prolonged recession
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Phases of the business cycle
(cont.)
• Trough
– Output and employment bottom out at their lowest
levels
• Recovery
– Output and employment expand towards the fullemployment level or capacity level
• Secular/growth trend
– The average (or trend) rate of expansion or
contraction
of an economy over the long term (25, 50 or 100
years)
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The business cycle
Level of business activity
Peak
Peak
Peak
Trough
Trough
Time
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Causes of business cycle
Variety of explanations/theories:
• Innovation
• Political events
• Random events
• Purely monetary phenomenon
• Immediate determinant — aggregate expenditure
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Business cycle
Non-cyclical fluctuations
• Seasonal variations in business activity are
regular fluctuations in the tempo of business activity
that are independent of the business
cycle and occur particularly in the retail industry
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Business cycle
• Cyclical impact: durables and non-durables
– Capital goods and consumer durables most greatly
affected by business cycles
– Consumer non-durables least affected
• Postponability
• Monopoly power
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Growth in motor vehicles registrations, new
dwellings approved and retails sales in Australia
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Types of unemployment
• Frictional
– Workers ‘between jobs’, temporarily laid off due
to seasonality and new entrants
– Allows movement of labour from low to high
productivity
– Inevitable and partly desirable
• Structural
– Mismatch in skills and geographic location
– Not employable without additional training,
education
and geographical movement
– Arises due to changes in labour demand caused
by changes in consumer demand and technology
• Cyclical
– Unemployment caused by the business cycle, or
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Full employment
• The full-employment rate of unemployment
is called the ‘natural rate of unemployment’
– Equals the sum of frictional and structural
unemployment
– Cyclical unemployment = zero
• Domestic output consistent with the natural rate
of unemployment is potential output or GDP
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Australia: unemployment rate
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Measuring unemployment
• Part-time employment
– Underemployed workers, prefer more hours of work
• Discouraged workers or the ‘hidden unemployed’
– Those who become discouraged and drop out
of the labour force but would return if a suitable
job prospect arose
• Discouraged workers, participation rate and
the unemployment rate
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Cost of unemployment
Economic costs
• Output forgone, measured in terms of the
GDP gap
– The amount by which the actual level of GDP
falls short of the potential GDP
• Okun’s law shows the relationship between
the unemployment rate and the GDP gap
• Unequal burdens
– Unemployment is borne more heavily by some
groups than others
Non-economic costs
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Inflation
• Inflation is a continuous rise in the general
price level
• The inflation rate is measured as follows:
Inflation
rate
=
Current year index – Previous
year index
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× 100
Previous year index
5-18
Theories of inflation
Two general theories of inflation:
• Demand-pull inflation
– Caused by excess demand for output
• Cost-push inflation
– Rise in prices arising from increased cost
of production due to:
 Wage push
 Profit push
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The price level and the level of
unemployment
Range 3
Price level
P
Range 1
Fullemployment
output
Q
Output and employment
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Inflation & redistribution
• Most severe when inflation is unanticipated
• Fixed-nominal-income receivers
– Inflation penalises people living on fixed nominal
income
• Savers
– The value of savings will decline if inflation is higher
than the interest rate
• Debtors and creditors
– Inflation tend to benefit borrowers at the expense
of the lenders
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Anticipated inflation
• Real interest rate
– The percentage increase in the purchasing power
that a lender receives from a borrower in exchange
for the borrower’s use of the lender’s funds
• Nominal interest rate
– The percentage increase in money that the lender
receives from the borrower
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Output effects of inflation
• Stimulus of demand-pull inflation
– High level of spending required for higher output and
lower unemployment also causes some inflation
• Cost-push inflation and unemployment
– Hyperinflation
– Wage-price inflationary spiral
 A continuous cycle of money wage and price rises
that feed on each other
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Australia’s current account
problem
• Three factors
– Gradual deterioration in the terms of trade
– High freight and transport costs
– Dependence on large levels of capital inflow
• Current account problems in the 1970s, 1980s,
1990s and into the 2000s
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Components of the current account
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The capital and financial account balance
1959–60 to 2001–02
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National savings
• National savings represents savings from
national income
• Used to finance gross capital formation
• Continuous fall in household savings in Australia
in recent years:
– Increases in household wealth
– Replacement of direct savings with alternatives
such as superannuation
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Australia: net national savings, 1959–60
to 2004–05
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5-28