Lesson 2 of 8
We will now learn about resource use fluctuation, housing sector activity and external trade in the context of the phases of the business cycle.
During the build-up to peak phase, production is high. Firms will keep inventory that is enough to meet the demand. They will not keep more as it will lock their capital. At the peak though, sales will slow down and a slow build-up of inventory will take place.
Once the recession phase starts, sales slow down drastically. Companies stop holding inventory, which further leads to a slowdown in the economy. In the recession stage companies keep low inventory. Once the cycle reaches trough stage, the next stage is an upward trend in the economy. Sales begin to improve and there is increased demand. This means the sales-inventory ratio will be low. Firms will start increasing inventory to meet growing demand and the sales-inventory levels will move back to normal.
Labour and capital in the context of business cycles can be adjusted theoretically. In real terms though it is impractical to reduce and increase workers and machinery during the varying stages of the business cycle. Instead companies will modulate the time both these factors are used. In the high demand phase workers and machines will work overtime and vice-versa in periods of low demand. In the case of machines, lesser maintenance and replacement will be done to reduce costs in times of low demand. Only in the case of a protracted downturn will workers be laid off.
The housing sector is a big source of demand and behaves differently during the various stages of the business cycle. The housing market does well during the early phase of the business cycle. A growth in housing harbingers a further growth in the economy. Low interest rates stimulate growth in the housing market, while high interest rates reduce demand in the housing market.
In the recovery stage or growth stage of the economy when incomes are increasing, there is growth in the demand for housing as well. In the recession or trough stages there is a fall in the demand for housing and therefore a fall in construction related activity as well.
While housing boosts economic growth, by itself it does not result in the growth of the economy. In the upward movement to the peak, the demand for housing is high. With increase in prices, investors may seek to park their funds in housing, leading to a further increase in growth of the housing sector. As in the case of Ireland people borrowed from banks to invest in housing. Construction increases manifold – a pile up of inventory occurs. As the economy becomes sluggish there is a fall in prices and speculation in the housing sector ends. The housing bubble burst in Ireland resulted in banks sitting on a pile of bad debt. In Ireland’s case the housing activity was not real demand, but fuelled by speculative gains.
Another factor affecting housing activity is the demographic profile of the population. Growing economies, with high rural to city migration has resulted in an increase in demand for housing. Economies of populations with increasing numbers in the 25-40 age group also shows an increase in housing activity, as this age group seeks out housing options.
The determinants of external trade sector activity during business cycles are currency rates, domestic GDP growth and the GDP of trading partners.
If the currency value of a country increases with respect to other currencies, this will lead to an increase in imports and decrease in exports. If the currency value decreases vis-a-vis others currencies, then imports will decrease and exports will increase. In these scenarios we are referring to continued trends rather than gains and losses in the currencies in the short term.
The GDP on the other hand usually reacts to a set of variables and behaves differently during different phases of the business cycles.
In the expansion stage the GDP growth rate increases. Unemployment reduces due to more recruitments; Inflation may be on the increase and investments particularly in housing and capital equipment increases. Imports will reduce.
In the peak stage the GDP starts slowing down. Investments start getting sluggish as does recruitment, though unemployment continues to stay low. Inflation continues to increase.
In the contraction state, growth rates fall to negative levels, unemployment increases; Imports fall as does consumer investments and purchases. Inflation starts falling.
In the trough stage the GDP growth rate climbs back to positive; unemployment continues to stay high with increased usage of contract labourers. Inflation starts to reduce. There is a spurt in consumer activity.