Activity Variation with Business Cycle

Resource Use

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 of this, companies may reduce production. Consequently, 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 alternatively eliminate 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 prices of goods and services.

These low prices consequently cause consumers to buy more of the goods and services leading to an increase in aggregate demand. The business cycle then moves into the expansion stage. Here, the economy may experience shortages because the demand is higher than the supply. During this period, the riskiest assets, such as growth stocks, will experience high increases in prices.

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

Housing Sector

The housing sector is strongly correlated with interest rates. The construction and subsequent purchasing of homes depend on the mortgage rates at which the homebuyers are able to finance their mortgages. Therefore, when the interest rate is low, consumers are encouraged to purchase more real estate.

Apart from interest rates, the housing sector also closely follows the trends of the business cycle, as has been seen in the financial crisis of 2008. When home prices are low as 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 other currencies. This 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 which favors 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 17 LOS 17b:

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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