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Activity Variation With Business Cycle

Activity Variation With Business Cycle

Resource Use During a Recession

Resources required for the production of goods and services are closely related to the business cycle. Aggregate demand reduces with the beginning of a downturn resulting in the accumulation of inventories. As a result, companies may reduce production. Further, they may stop ordering new equipment and replenishing their inventory. During this downturn, companies do not necessarily need to reduce the number of workers. They could, instead, freeze overtime to reduce costs since the slowing of the economy is temporary.

If the severity of the downturn increases, companies will continue cutting down on costs more aggressively, especially those that are not essential.  At this point, the economic downward spiral continues. The decrease in aggregate demand lowers the prices of goods and services.

Resource Use During an Expansion

The low prices that characterise the recession and trough phases of the business cycle prompt consumers to buy more goods and services. This leads to an increase in aggregate demand. The business cycle then moves into the expansion stage. Here, the economy may experience shortages because demand is higher than supply. During this period, the riskiest assets, such as growth stocks, will experience high increments in prices.

The expansion phase is then followed by the peak of the business cycle and subsequently, the contraction phase.

Housing Sector

There is a strong correlation between the housing sector and interest rates. This is because the construction and subsequent purchasing of homes depends on the mortgage rates at which the homebuyers can finance their mortgages. Therefore, when interest rate is low, consumers are encouraged to purchase more real estate.

Apart from interest rates, the housing sector also closely follows the business cycle trends. This was evident in the financial crisis of 2008. When home prices are low compared to average income, the cost of owning a house reduces, and the demand rises.

The External Trade Sector

Imports increase as demand for foreign goods and services increases. Hence, imports are highly dependent on domestic cycles.

However, exports also depend on external business cycles. When a country’s economy is booming, its currency strengthens in comparison to foreign currencies. This currency value appreciation makes exports expensive in comparison. This leads to reduced exports and thus reduced production output. This effect then subsequently depreciates the currency’s power, thereby favouring exports.

Question

In general, imports respond to:

A. The domestic industrial policy

B. Domestic GDP growth rate

C. Level of exports

Solution

The correct answer is B.

Imports show the domestic needs for imported goods and change with domestic growth.

On the other hand, exports most likely depend on external business cycles.

Reading 15 LOS 15b:

Describe how resource use, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle

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