Business Cycle - Q&A

(a)          What is meant by stock market boom?

Stock market boom is the sustained periods of rising real stock prices and asset prices. Stock market booms tend to occur during periods of above-average growth of real output, and below-average and falling inflation. Stock Market booms are associated with the business cycle, arising when the output or Real GDP growth is above average which means during periods of expansion or recovery, ending when Real GDP slows or declines.

(b)          Why may a boom be accompanied by a widening current account deficit?

Current account deficit occurs when a nation’s total import of goods, services and transfers is greater than the nation’s total export of goods, services and transfers. It reflects a surge in investment spending caused by accelerating productivity. But producing more goods and services in the future requires current investment. Thus, the increase in productivity raises domestic investment spending, causing total domestic spending to exceed domestic production in the short run and to cover the excess of domestic spending over production, the country imports more goods and services than it exports. In particular, the surge in investment may increase the demand for imported capital goods.

(c)          Describe the features of an economic boom.

Economic boom is the period that follows recovery phase in a standard economic cycle. It is an upturn in the business cycle during which real GDP rises. Hence, the following features are observed during the stage of economic boom:

—  GDP Growth faster than the regular trend

—  Rising Aggregate Demand

—  Increase in employment, Real Wages and Disposable Income

—  Increase in Government Revenue

—  Threat of Demand pull and Cost Push Inflation

(d)          Which phase follows the boom?

The boom-bust cycle is an episode which is characterized by a sustained rise in several macroeconomic indicators and followed by a sharp and rapid contraction. After the economic boom, there is an increase in credit prices and the value of assets prices might collapse which ultimately causes a considerable reduction in investment and fall in consumption and then, lead to a recession. Thus, recession is the phase after boom.

(e)          Why might an economic boom not be accompanied by inflation?

Economic boom is not likely to be accompanied by inflation as increase in money supply increases aggregate demand. However, shrinking the money supply may keep the inflation under check but, it increases the cost of borrowing which is supported by the stimulation of supply side factors, i.e. cutting taxes on capital investment which would foster job creation or employment. Also, it may bring the increase in labor productivity (output per worker) through investment in capital goods, technological breakthroughs etc.

(f)           Explain what is likely to bring an economic boom to an end?

Usually the demand pull inflation and cost push inflation causes the economic boom to come to an end. When the AD exceeds the SRAS for a prolonged period of time, the inflation rises to above the normal rate forcing the value of money to decline often explained by the increased burden on the limited resources regardless of the economic growth and capability of a nation. This results in government intervention and government controls the supply of money which ultimately tightens the money deposit in the market and thus decreases the credit creation. And when the money supply is decreased, the investment rate also decreases along with decrease in consumption which ultimately forces the economy to go on a depression.

(g)          Explain how strong exchange rates suppress inflationary symptoms.

Exchange Rate is the external value of a nation’s money in terms of how much of the other currency it can buy. When the exchanges rates become stronger, the value of the currency of a country compared to other country rises which results in the foreign good being cheaper since their money value is less. Now the domestically produced goods will be valued higher than the imported goods, so more imported goods are likely to be bought which causes the demand for domestically produced goods to decrease which will force the domestic producers to cut down their prices by lowering their cost in order generate customers. When the prices are lowered by the domestic producers, inflation is suppressed. Hence a strong exchange rates suppresses inflation.