Activity Variation with Business Cycle

Resource Use

Resources required for the production of goods and services evolve around 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 inventories. 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 with more aggression, 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, the low prices cause companies and consumers to buy more of the goods and services leading to an increase in aggregate demand. This leads to a turning point in the business cycle.

The business cycle then moves to the boom stage. Here, the economy may experience shortages because the demand is higher than the supply. This is an expansion phase, during this period, the riskiest assets will have the highest increase in prices i.e. growth stocks.

The boom phase is then followed by the peak of the business cycle and subsequently the contraction phase. It is characterized by high energy prices, high unemployment, and credit crises.

Housing Sector

The housing sector is most responsive to interest rates. Construction and purchasing of homes consequently depend on the mortgage rates as they expand with low mortgage rates and contract with high mortgage rates.

Apart from interest rates, the housing sector also follows the trends in a business cycle. When home prices are low as compared to average income, the cost of owning a house reduces and the demand rises. The cycle expands with an increase in mortgage rates and high prices of houses. These high prices then cause a downturn in sales and subsequently reduced construction. Individuals will then buy houses because of an expected rise in prices and cause an upward movement.

External Trade Sector

External trade relevance varies extremely from one economy to the other. Since 1970, external trade has grown globally. With this growth, business cycles of huge economies can without difficulty be spread to other economies.

Imports increase as demand for goods and services increases for goods bought from abroad. Hence, imports are dependent on domestic cycles. On the other hand, exports depend on external business cycles. Thus, they will still grow with a decline in the internal economy.

When there is appreciation in a country’s currency, the currency strengthens in comparison to other currencies. This appreciation makes exports expensive as well and leads to reduced exports. This then depreciates the currency’s power.

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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