The business cycle is an economic model showing increases and decreases in a nation’s real GDP over time, oscillating around a long term upward growth trend line.

As we have seen the basic economic problem is one of scarcity. There are insufficient resources, globally, nationally and personally to meet all our needs and wants. Priorities need to be determined and choices made.

Economics is the study of how and why we make those choices. Logically, we all seek to maximize our satisfaction by choosing a combination of goods and services that provides us with the most ‘utility‘ or usefulness.

No matter what we choose, there are costs associated with those choices – both monetary and non monetary. In fact the ‘real’ cost of any choice you make to consume (by definition, the satisfaction of a want or need) is the opportunity foregone. In other words, what you gave up to have the good or service you decided on.

The amount of goods and services available for consumption determines the level of satisfaction or ‘standard of living‘ for an economy. A growing economy, where more goods and services are produced and more people are employed, implies a more satisfactory answer to the economic problem. This is a macro view, not individual. How better off individuals are depends on how the goods and services are distributed.

In a highly specialized economy, income determines your ability to consume and incomes (and ‘wealth’ – a store of income in the form of assets) are unevenly distributed.

Australia is a modified free enterprise economy.

The market system is efficient; the interaction of supply and demand allocates goods and services highly effectively through the rationing device, we know as the price.

In a perfectly operating market, as demand for a certain good rises, supply expands to meet the demand. If supply cannot meet the rising demand, prices rise to ration the available stock. The reverse is also true. If demand for a good or service falls, producers will run down their inventories and cut back on production, perhaps even cease production and prices may fall. resources then are free to flow into the production of other goods and services.

This is however a simplistic,textbook version of the economy. In reality a number of factors come into play that may inhibit the free operation of the market. Supply is not always perfectly ‘elastic‘ or responsive to the increased demand for a certain good – rather than increased supply, we may simply end up with higher prices for the same good or service. If this happens in a general and consistent way, we simply get inflation and our buying capacity is eroded.

Similarly, the factor of production labour may not be able to flow from one industry to another seamlessly as demand patterns change. As the size of the economy expands, demand for labour rises and as it contracts, demand for labour falls. The inability of the economy to absorb the labour or to redeploy the factors to other industries results in unemployment. (or under-employment, a situation where people cannot work as much as they would like or need to)

So, while the market system may be efficient, it is not necessarily equitable, nor is it self correcting!

Modern economies, like Australia’s are subject to market failure.

Government in Australia (and to varying degrees in other countries around the world) manages the economy through a combination of macroeconomic policies designed to smooth out the worst extremes of the business cycle – the regular periods of instability accompanied by inflation at it’s peak and unemployment at its trough.

Fiscal Policy is designed to influence the economy through budgetary and taxation measures. When the economy is slowing, and unemployment is rising, the government can inject money into the economy by running a budget deficit = spending greater than revenue.

When the economy is overheating, and inflation is rising, a surplus budget will dampen demand and put downward pressure on prices.

Remember that every policy decision has trade-offs and even unintended side effects.

Running a surplus may reduce inflation, but it may also mean the loss of jobs. Running a deficit may employ more people but at the cost of higher prices.

Nothing is simple or straightforward!

Remember the circular flow of income model or the ‘above ground pool’ analogy ? The size of the pool and therefore the number of people who can get in and get wet depends on the balance between leakages and injections. In the national income equation Y= C + I + G + (X-M)


The government also uses Monetary Policy to help smooth out the ups and downs in the business cycles.

The Reserve Bank is responsible for Australia’s monetary policy. Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. In determining monetary policy, the RBA has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term.

Interest rates are eased to encourage spending and growth and therefore employment and tightened to control inflation.

Through a combination of monetary policy and fiscal policy, governments aim to smooth out the extremes of the business cycle. They can also use fiscal policy to redistribute incomes,and incentivise participation and enterprise and encourage self sufficiency.