Economic CyclesEconomic Cycles

The economic cycleThe economic cycle A term used to describe the tendency of A term used to describe the tendency of

economic activity to cycle along its trend patheconomic activity to cycle along its trend path Real GDP shows a series of peaks and troughs Real GDP shows a series of peaks and troughs

along trend, characterising booms, along trend, characterising booms, slowdowns, recessions and recoveriesslowdowns, recessions and recoveries

All countries experience economic cyclesAll countries experience economic cycles

Key ConceptsKey Concepts

Key ConceptsKey Concepts

Cycles vary in terms ofCycles vary in terms of (i) Their volatility(i) Their volatility (ii) Their duration(ii) Their duration

There are several models of the cycleThere are several models of the cycle Cycles caused by internal changes in Cycles caused by internal changes in

output and pricesoutput and prices Cycles affected by external economic Cycles affected by external economic

shocksshocks

The UK Economic CycleThe UK Economic CycleAnnual percentage change in GDP at constant prices

Growth of National Output for the UK

ar 4 quartersSource: Reuters EcoWin

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Perc

ent

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

The recession of the early The recession of the early 1990s1990s

Data on the last recession Data on the last recession (1)(1)

Annual percentage change in GDP at constant pricesGrowth of National Output for the UK

ar 4 quartersSource: Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q389 90 91 92 93 94

Per

cent

-3

-2

-1

0

1

2

3

4

5

Data on the last recession Data on the last recession (2)(2)

Percentage change from previous period, at Constant Prices

UK Household Consumption

Source: Reuters EcoWin

88 89 90 91 92 93

Per

cent

-2

-1

0

1

2

3

4

5

6

7

8

Data on the last recession Data on the last recession (3)(3)

Output Gap (Difference between actual and potential GDP), Unemployment - claimant count measureThe Output Gap and Unemployment in the UK

Output gap of the total economy Unemployment, Rate, Claimant count, SASource: Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q390 91 92 93

Per

cen

t

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Unemployment

Output gap

The Need for Macroeconomic The Need for Macroeconomic StabilityStability

Large fluctuations in output, employment Large fluctuations in output, employment and inflation add to uncertainty for and inflation add to uncertainty for businesses and consumers, and can reduce businesses and consumers, and can reduce the economy's long-term growth potentialthe economy's long-term growth potential

Stability allows businesses, individuals and Stability allows businesses, individuals and the Government to plan more effectively for the Government to plan more effectively for the long term, improving the quality and the long term, improving the quality and quantity of investment in physical and quantity of investment in physical and human capital and helping to raise human capital and helping to raise productivityproductivity Adapted from the Budget Statement, April 2003Adapted from the Budget Statement, April 2003

UK and Global Economic UK and Global Economic FluctuationsFluctuations

Demand-side shocksDemand-side shocks Growth of income & demand in OECD economiesGrowth of income & demand in OECD economies

E.g. an recession in the United States E.g. an recession in the United States Asian economic downturn / financial turbulenceAsian economic downturn / financial turbulence

Interest rates decisions in Europe and in the USA Interest rates decisions in Europe and in the USA Performance of global stock markets - particularly Performance of global stock markets - particularly

in the USAin the USA Foreign capital investment decisions of global Foreign capital investment decisions of global

multinationalsmultinationals Supply-side shocksSupply-side shocks

Fluctuations in international commodity prices Fluctuations in international commodity prices such as oil, copper and other essential raw such as oil, copper and other essential raw materialsmaterials

Demand-side shocksDemand-side shocksGeneral

Price Level

National Income

AD1SRAS

Pe

Ye

LRAS

Yfc

AD2

Y2

P2

Supply-side ShocksSupply-side ShocksGeneral

Price Level

National Income

AD

SRAS1

P1

Y1

LRAS

Yfc

SRAS2

P2

Y2

SRAS3

Y3

Characteristics of an Economic Characteristics of an Economic BoomBoom

Strong and rising level of ADStrong and rising level of AD Often driven by fast growth of consumptionOften driven by fast growth of consumption Rising employment and real wagesRising employment and real wages High demand for imported goods & servicesHigh demand for imported goods & services Government tax revenues will be rising quicklyGovernment tax revenues will be rising quickly Company profits and investment increaseCompany profits and investment increase Increased utilisation rate of existing resourcesIncreased utilisation rate of existing resources Danger of demand-pull and cost-push inflation Danger of demand-pull and cost-push inflation

if the economy overheatsif the economy overheats

Characteristics of an Economic Characteristics of an Economic RecessionRecession

Declining aggregate demand for UK output Declining aggregate demand for UK output Contracting employment / rising Contracting employment / rising

unemploymentunemployment Sharp fall in business confidence & profits Sharp fall in business confidence & profits Decrease in fixed capital investment spendingDecrease in fixed capital investment spending Reduced inflationary pressureReduced inflationary pressure Falling demand for importsFalling demand for imports Increased government borrowing Increased government borrowing Lower interest rates from central bankLower interest rates from central bank

The Multiplier EffectThe Multiplier Effect

An initial change in aggregate demand / An initial change in aggregate demand / output can have a much greater final output can have a much greater final impact on equilibrium national incomeimpact on equilibrium national income

Injections of demand stimulate further Injections of demand stimulate further rounds of spending rounds of spending

The key to the final size of the multiplier The key to the final size of the multiplier effect is the propensity to consume effect is the propensity to consume (demand) out of extra income(demand) out of extra income

Construction projects and the Construction projects and the multiplier effectmultiplier effect

Major construction projects such Major construction projects such as the new Terminal 5 building as the new Terminal 5 building at Heathrow can have big at Heathrow can have big multiplier effectsmultiplier effects Thousands of people are Thousands of people are

employed within the employed within the projectproject

Their incomes are re-Their incomes are re-injected into the circular injected into the circular flow flow

Companies supplying to Companies supplying to the project will also the project will also increase their own increase their own spendingspending

Accelerator EffectAccelerator Effect

Planned capital investment spending is Planned capital investment spending is linked to the growth of demand for goods linked to the growth of demand for goods and servicesand services

When demand is rising strongly, When demand is rising strongly, businesses may increase investment to businesses may increase investment to expand their production capacityexpand their production capacity

But a slowdown in demand creates excess But a slowdown in demand creates excess capacity and may lead to a fall in planned capacity and may lead to a fall in planned investment demandinvestment demand

Consider the links between the UK and the Consider the links between the UK and the USA economyUSA economy

15% of UK exports go to the USA15% of UK exports go to the USA There are large flows of foreign There are large flows of foreign

investment between the two countriesinvestment between the two countries Many international commodities are priced Many international commodities are priced

in US dollars – so movements in the dollar in US dollars – so movements in the dollar exchange rate can be importantexchange rate can be important

What would happen if there was a What would happen if there was a recession in the USA?recession in the USA?

Inter-relationships between Inter-relationships between countriescountries

US Economic Growth in recent US Economic Growth in recent yearsyears

Annual Percentage Change in National Output at Constant PricesUSA Gross Domestic Product

ar 1 year

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Perc

ent

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

The UK and the Euro ZoneThe UK and the Euro Zone

Over half of our trade in goods and Over half of our trade in goods and services is with countries inside the Euro services is with countries inside the Euro ZoneZone

It represents our biggest export marketIt represents our biggest export market In recent years the Euro Zone countries In recent years the Euro Zone countries

have experienced fairly slow growth of have experienced fairly slow growth of GDPGDP

This has made it harder for UK exporters This has made it harder for UK exporters to sell into European marketsto sell into European markets

Euro Zone GDP growth in Euro Zone GDP growth in recent yearsrecent yearsAnnual percentage change in real national output

Euro Zone and UK Economic Growth

Euro Zone [ar 4 quarters] United Kingdom [ar 4 quarters]

Source: Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q399 00 01 02 03 04 05 06

Per

cent

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Euro Zone

UK

Euro Zone