Business Cycle Properties and Macro Forecasting of the Australian Economy - Case Study Example

Business Cycle Properties and Macro Forecasting of the Australian Economy Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 16th September 2012 Outline I. Executive Summary II. Introduction III. Analysis IV. Conclusion V. References Executive Summary The Australian economy has various indicators. These are variables that are used to measure economic performance. For the purpose of this re[port, the variables used are real GDP, inflation rate, nominal exchange rate, money supply, gross fixed investment, private final consumption, inventory investment, unemployment rate, labour productivity and trade credit. Some of the sources of this data are World Bank statistics, the Australian Bureau of Statistics, Reserve Bank of Australia and other statistical websites. This data has been arranged in tables for each of the variables. These tables are in form of excel sheets available as a separate attachment. During the rest of this paper, this data has been analysed and used in decision making and forecasting. Introduction Statistical analysis is necessary in order to make meaningful economic decisions. Australia’s economic data has been collected, classified and analysed for purposes of decision making and forecasting. This data has been tabulated for ease of analysis. GDP is one of the variables used in this analysis. It refers to revenue from consumption expenditure, exports and taxes minus imports. On the other hand inflation rate is the rise in living costs and drop in the value of a country’s currency. Unemployment is the percentage of the jobless population in relationship to the entire workforce. Labour productivity is the level of labour output towards the economy’s entire GDP. Current account balance is the total of net exports, transfers, goods and services within a given period of time. Money supply (M3) is the total availability of money and its equivalents including non-currency deposits held by foreign banks. Short term and long term interest rates are the rates of borrowing overnight cash and bonds respectively. Inventory investment is the level of investment by the private and public farming and non-farming sectors. The aim of this paper is to analyses the relationship between these variables in order to determine their effect on output (GDP). Analysis Australia is one of the ever growing economies in the world. The variables used to measure this growth are in the attached excel sheets. Correlation with output: correlation describes linear relationships between one variable and another. It describes if two variables move together in the same direction, if they move in opposite directions, or if they don't move in any related way at all. It also describes how strong the linear relationships are between one variable and another (Correlation and Covariance 2012). The correlation coefficient is usually between --1.0 and +1.0. When the correlation coefficient is near +1.0, it means that the two variables have a strong positive linear relationship. Therefore, when variable x increases, variable y increases (pro-cyclical). On the other hand, when the correlation coefficient is near -1.0, it means that the two variables have a strong negative linear relationship. Therefore, when variable x increases, variable y decreases (counter-cyclical). Additionally, the more close to zero a correlation is, the less the linear relationship between variable x and y (uncorrelated) (Correlation between Variables 2012). For instance, the correlation between Australia’s inflation rate and output between 1996 and 2012 is -0.56. This means that there is a negative relationship between the two variables (counter cyclical). Therefore, when inflation rate increases, output decreases. The correlation between nominal exchange rate and output is -0.25. This shows that the two variables have less linear relationship (uncorrelated). Therefore, there is no relationship between the two variables. The correlation between private final consumption and output is 0.72 which means that the two variables have a strong positive linear relationship (pro-cyclical). Therefore, when private final consumption increases, the level of output also increases. The correlation between gross fixed investment and output is -0.26 which means that the two variables have a weak linear relationship. Therefore, when one variable rises, the other variable drops slightly. Inventory investment and output have a correlation of 0.34 (pro-cyclical). This is a positive linear relationship that shows that when inventory investment rises, output also rises. Unemployment rate and output have a weak positive correlation. Therefore, when the level of unemployment rises, the level of output rises slightly. Labour productivity and output have a negative correlation of -0.56 (counter-cyclical). This means that in Australia, labour productivity has been rising as output reduces. On the other hand, short term and long term interest rates and output have a positive correlation of 0.35 and 0.31 consecutively (pro-cyclical). Therefore, when short term and long term interest rates rise, the level of GDP also rises. Money supply and output have a positive correlation of 0.18 (pro-cyclical). Therefore, when the level of money supply rises, the level of output also rises. There is a negative correlation of -0.56 between trade balance and output. Some of the relationships are not standard because it depends on the performance of a particular economy. Cross correlations with output (t‐i and t+i, where i=1, 2, 3, 4, 5) Cross correlation is a measure of lag or lead of one variable against another over a given period of time. When one variable lags behind another, it means that one variable has to occur in order for the other to act. On the other hand, a lead refers to the variable that makes the first move before the others. For example, inflation rate lags behind GDP growth which means that whenever GDP rises, inflation rate has to be low. This is similar to the nominal exchange rate which has to be favourable in order to allow GDP to rise. Private final consumption has a cross correlation of 1.04 with GDP. This means that it leads GDP. Therefore, as it rises, GDP also follows suit. Gross fixed investment, also lags behind GDP. Inventory investment, unemployment rate, money supply and interest rates lead GDP. Therefore, as they rise, GDP drops. These factors show that one effect in the economy cannot contribute to growth. There is a coordinated set of variables that have to perform in a given manner in order to allow GDP to rise or to fall (Australia Investment (gross fixed) 2012). Indicator properties (leading, lagging or coincident indicators) An indicator is anything used to forecast financial or economic trends. Some of the indicators used in this case are inflation rate, unemployment rate, labour productivity, GDP, inventory investment, trade balance and money supply. These indicators should meet several established criterion. The indicators are grouped according to the types of predictions that they make. For instance, leading indicators signal future occasions. For example, Australia’s fluctuating inflation rate is an indicator of unstable GDP. Therefore, since the inflation rate has been rising and dropping over time, the level of real GDP is expected to remain unstable. Additionally, the gross fixed investment has been on the rise. This means that the level of GDP contributed by gross fixed investment is expected to rise steadily. Lagging indicators follow events. They have the ability to confirm that a pattern is taking place or about to take place. Unemployment rate is a lagging indicator because it shows that GDP is dropping. Additionally, money supply is a lagging indicator of improved economy. Coincident indicators appear almost at the same time as the conditions that they signify. Therefore, they change concurrently with the economy or stock market. For example, high interest rates are coincident indicators of high money supply. Additionally, trade balance is a coincident indicator of high money supply (Leading, lagging and coincident indicators 2007). Brief forecasts for each of the following variables Real GDP growth for 2012 Quarter IV and 2013 Quarter I. GDP is income from exports, consumer expenditure, government expenditure, taxes minus imports and subsidies. However, depreciation, depletion and degradation of assets and natural resources are not part of this GDP. The annual real GDP used in this case is based on an aggregate of 2000 U.S. dollars. Real GDP for Quarter IV of 2012 is expected to be 2.50%. This is because the first two quarters had an average real GDP of 2.15%. Therefore, the economy is expected to grow above this level during the next quarters. On the other hand, Quarter 1 of 2013 is expected to have an annual GDP of 3.0%. These rising projections are highly expected in Australia because most of the sectors of the economy have stabilized (World Bank: Working for a World Free of Poverty 2012). Additionally, there are favourable government policies such as subsidies and tax holidays which encourage investment. The inflation rate measured as the growth rate in the implicit GDP price deflator (the GDP Price Index) or CPI for 2012 Quarter IV and 2013 Quarter I. Inflation can be measured by consumer prices or GDP deflator. In this case, inflation rate has been measured using GDP deflator. Inflation rate using GDP deflator shows rate in price change in the entire Australian economy. The rate of inflation is a measure of rise in general prices against a standard purchasing power. Inflation rate is expected to fall to 0.7% during Quarter IV. This is an average of the inflation rate for each of the first two quarters of the year. This rate is however expected to rise to approximately 1.0% during Quarter 1 of 2013 as the economy still tries to stabilize (Financial Forecast Center: Independent, Objective, Accurate 2012). Will the RBA change the cash rate at the Reserve Bank Board meeting on Tuesday, November 6, 2012 and by how much? RBA is likely to change the cash rate. The rate is expected to be reviewed downwards in order to encourage borrowing and investment. This rate is expected to be 3.30% which is lower than the current cash rate of 3.63%. Low interest rates encourage investment, consumer expenditure and subsequently high GDP. However, it can cause increased inflation when the money supply exceeds the normal capacity. As a result, this new rate needs to be reviewed in order to get the desired level of money supply. As the rates reduce, it is also important to control the level of foreign investment. This can be done by establishing higher rates for foreign investors. As a result, the local industry can be safe from unhealthy competition. The average exchange rate between the Australian dollar and the US Dollar to prevail from November 1, 2012 to June 30, 2013 The exchange between the Australian and the USA dollar has been fairly constant. The average exchange rate in 2011 and the first quarters of 2012 has been 1.03. This rate has been the highest average annual rate over the last 10 years. This is an indicator of stable economy. This rate is likely to remain constant from November 1, 2012 to June 30, 2013. This is because some of the sectors of the Australian economy are still recovering from the effects of previous recession. However, there will be no drop in the current rate. The year‐over‐year percentage change in Australian House Price Indexes in Q4 2012 (relative to Q4 2011) as measured by the Australian Bureau of Statistics 6416.0 ‐ According to the Australian Bureau of Statistics, the following are the expected changes in home prices during Q4 of 2012. Established house prices Mar Qtr 12 to Jun Qtr 12 (% change) Jun Qtr 11 to Jun Qtr 12 (% change) Weighted average of eight capital cities 0.5 -2.1 Sydney 1.4 -0.9 Melbourne -0.4 -4.8 Brisbane 0.1 -2.7 Adelaide 0.5 -1.3 Perth 0.6 1.1 Hobart -0.4 -3.2 Darwin 5.1 12.3 Canberra -1.3 -2.6 (Australian Bureau of Statistics: Australian Economic Indicators, 2012) From the table it is clear that the average change in house prices in the eight capital cities will be -2.1%. In Sydney, the average house price will change by -0.9%, -4.8% in Melbourne, -2.7% in Brisbane, -1.3% in Adelaide, 1.1% in Perth, -3.2% in Hobart, 12.3% in Darwin and -2.6% change in Canberra. The highest change is seen in Darwin while the lowest is seen in Melbourne. The slow drop in house prices is also affecting savings, investment and consumer expenditure in these major cities. Therefore, the government needs to lower the lending rates in order to increase expenditure on other commodities. Another means of encouraging investments and savings is reduction in consumer prices, This way, consumers will have some money left for investments. Conclusion (how the forecast on GDP growth and inflation relates to the forecast on government policies, long‐term interest rates and exchange rates) GDP growth is expected to rise to 2.5% or more because Australia’s government policies on subsidies, tariffs, discounts, and taxation are expected to be favourable. As a result, consumer expenditure and investment are likely to rise. Additionally, government policies on inflation are expected to favour drop in inflation rate. This involves regulation of money supply. On the other hand, the long term interest rates are expected to drop to 2.9%. This is a slight change given that aimed at encouraging borrowing. This will also cause GDP growth. However, it will cause raise the inflation rate marginally as consumers will have easier access to money. The improved exchange rate means that the level of exports is rising above the level of imports. As a result, the value of the Australian dollar is rising against the foreign currency. This has reduced the consumer prices in the market and consequently it will lead to a rise in GDP. Additionally, this will reduce the inflation rate as the demand for the Australian dollar drops. Correlation and cross correlation show the relationship between two variables. The relationships can either be pro-cyclical, counter cyclical or uncorrelated. There is a possibility of rise in GDP and fall in inflation and interest rates in the last quarter of 2012 and the first quarter of 2012. The cost of housing is expected to vary across the major cities in Australia. Favourable interest rates and will reduce expenditure on housing and will increase consumer expenditure and savings. The banks should therefore aim at reducing lending rates during the scheduled November meeting. References Australia Investment (gross fixed), viewed 16 September 2012, Australian Bureau of Statistics: Australian Economic Indicators, viewed 16 September 2012, . Correlation and Covariance, viewed 16 September 2012, . Correlation between Variables, viewed 16 September 2012, . Financial Forecast Center: Independent, Objective, Accurate, viewed 16 September 2012 . Leading, lagging and coincident indicators, viewed 16 September 2012, . World Bank: Working for a World Free of Poverty, viewed 15 September 2012, . Read More