The Trade (Business) Cycle and the Output Gap
EdExcel AS Economics 2.5.3
Economic Cycle Concepts
Boom A period when the rate of growth of real GDP is fast and higher than the long-term trend
Business cycle Short-run fluctuations of national output (real GDP) around its long-term trend.
National income Everything produced, earned and spent in a country.
Slowdown A weakening of the rate of growth, real GDP is still rising but increasing at a slower rate
RecessionA period of at least six months when an economy suffers a fall in output. Or a broadly-based contraction in output, employment, investment and confidence
Recovery A phase of the cycle, after a recession, during which real GDP starts to increase and unemployment begins to fall
Depression A prolonged downturn in the economy and where a nation’s GDP falls by at least 10 per cent
Real GDP Growth in the UK Economy
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
GDP
grow
th ra
te c
ompa
red
to p
revi
ous y
ear
The chart shows real GDP growth for the UK from 2010-2014. Data for 2015 onwards shows forecast growth using data from the International Monetary Fund (IMF)
UK GDP growth of 3% in 2014 placed it at the top of the G7 league table
Revised GDP increased by 3.0% in 2014 the highest annual increase since 2006
Identifying Stages of the Economic Cycle
Boom
SlowdownRecession
Recovery
A cycle is when GDP growth fluctuates around the trend (or underlying) growth
Make sure you are clear about the different stages of an economic cycle and apply them to the specific country.
Economic Recovery and the PPF Diagram
During an economic recovery, aggregate demand will be rising. This
leads to an increase in real national
output and a fall in the amount of
spare capacity i.e. we move closer to the PPF boundary
from E to F
Capital goods
Consumer goods
PPF
A
B
C D
E
F
Mining, oil, etc
Finance/insurance
Electricity & gas
Agriculture
Water & waste
Manufacturing
Other services
Construction
Hotels & restaurants
Property services
Transport & comms
Retail & wholesale
Prof & business services
-8% -6% -4% -2% 0% 2% 4% 6% 8%
Output Growth in Different Sectors of the UK Economy
Since the end of the last recession, there has been a wide variation in output growth in different industries. This is shown in the chart above.
% per annum increase in output, Q3 2009 – Q1 2015
Actual and Forecast Real GDP for the UK EconomyThis chart is taken from the May 2015 Bank of England Inflation Report
The economic cycle can be seen by the path of actual national output. The last UK recession began in 2008.
Source: Bank of England, May 2015
Problems in Forecasting Real GDP Growth
No macroeconomic model can deal fully with the volatility of key indicators such as price and cost inflation, exchange rates and global commodity prices. This
makes forecasting GDP growth difficult
Uncertain business
confidence levels
Fluctuations in exchange rate
External events e.g.
volatile oil and gas prices
Uncertain reactions to macro policy
changes
Rate of business job creation is
hard to forecast
Forecast growth for UK from the Bank of England (May 2015 Inflation Report)
Source: Bank of England, May 2015
Spare Capacity – Measuring The Output Gap
The output gap is the difference between the
actual level of GDP and its estimated potential level. It
is usually expressed as a percentage of the level of
potential output.
General Price Level
Real GDP
GPL1
AS
Y1
AD
Yp
LAS
In the diagram on the left, the equilibrium level of
national income (GDP) is less than long run potential
output – therefore the output gap is negative
The Estimated Output Gap for the UK Economy
The chart shows the estimated output gap for the UK economy. Note that there is a range of estimates from different economic forecasters.
Negative output gap – i.e. economy has large marginal of spare capacity
Stronger growth in 2014-15 bring a reduction in the negative output gap
Negative and Positive Output Gaps
Negative Output Gap
When the level of actual GDP is less than potential GDP
Some factor resources are under-utilized e.g. demand-
deficient unemployment
Main problem is likely to be higher unemployment and
possible deflation risk
Positive Output Gap
Actual GDP is greater than the estimated potential GDP
Some resources working beyond usual capacity (shift
work & overtime)
Main problem is rising demand-pull and cost-push
inflationary pressures
Problems in Measuring the Output Gap
• The output gap is a measure of the difference between the actual output of an economy and its potential output.
• Estimating the output gap is difficult because we cannot observe directly the supply potential of an economy directly
• Problems in estimating the output gap include:1. Inaccurate data on the labour force for example difficulties in
measuring the scale of net inward labour migration2. Problems in accurately measuring productivity3. Surveys of producers about spare capacity may be inaccurate4. Gaps in knowledge about how much businesses are investing
and the potential output from new capital e.g. in digital sectors5. Uncertainties about the number of people who may have left
the labour market as “discouraged workers”6. Hard to measure the amount of under-employment in the
labour market at different stages of the economic cycle
Examples of Demand and Supply-Side Shocks
Demand-side Shocks
Economic downturn in a trading partner
Unexpected tax increases
Financial crisis causing bank lending to fall
Bigger than expected rise in unemployment
Supply-side Shocks
Steep rise in oil and gas prices or other commodities
Political turmoil / strikes
Natural disasters causing sharp fall in production
Unexpected breakthroughs in production technology
Identifying Possible Causes of a Recession
External events• A recession in a trading partner e.g. the European Union or the USA• A sharp rise in global commodity prices e.g. rising oil and gas prices
Tightening of macro policy• Higher interest rates leading to more expensive loans • A rise in taxation or a cut in government spending
Fall in asset prices or supply of credit• Steep decline in the level of share or house prices• A collapse in the supply of credit (e.g. Global financial crisis)
Drop in business and consumer confidence• Lower business confidence cuts investment and may lead to job losses• Declining consumer confidence leads to less spending and more saving
Short Term Economic Effects of a Recession
Impact of a recession depends in part on causes and how long it lasts
Business profits and capital investment• Falling demand can cause more businesses to fail and profits fall• Planned investment declines – hitting industries that make the capital goods
Unemployment• A steep decline in aggregate demand causes a fall in the demand for labour• This causes a contraction in employment and a rise in cyclical unemployment
Government finances• Recession causes a decline in tax revenues and more welfare spending• The result is usually an increase in the budget deficit and a rising national debt
Inflation• Many business offer price discounts to off-load excess unsold stocks• A deep recession risks causing a period of sustained deflation (negative inflation)
Longer Term Economic & Social Effects of a Recession
A deep recession / depression can having economic and social costs
Long Term Economic Effects
Rising structural long-term unemployment and regional decline
Low rates of investment can reduce the size of the capital stock
Persistent budget (fiscal) deficits and a rising national debt leads to
austerity (cut in public services)
Long Term Social Effects
Falling real wages hits average living standards and reduces demand
Widening inequality of income and wealth leading to rising poverty
Social costs such as loss of social cohesion and threats to democracy
Legacy of Recession: Hysteresis v Creative Destruction
Here are two competing views about the effects of a recession
When an economy is disabled by recession there is a big risk of a permanent loss of national output
Loss of productive capacity due to low capital investment + many business closures
High rates of structural unemployment may cause a shrinking labour force perhaps through outward migration
Hysteresis Recessions can cast a dark shadow but capitalist market economies usually bounce back eventually
Recessions prompt the emergence of new business models and an increase in start-ups
New technologies can act as a catalyst for renewed economic growth and investment
Creative Destruction
The Difference between Recession and Depression
• A depression is a prolonged slump where real GDP falls by more than 10% from the peak of the cycle to the trough
2010 2011 2012 2013 2014 2015*
2016*
2017*
2018*
2019*
2020*
0
5000
10000
15000
20000
25000
30000
GDP
per
cap
ita in
U.S
. dol
lars
Real Per Capita Income in Greece 2010-2020 (Source IMF)
The Trade (Business) Cycle and the Output Gap
EdExcel AS Economics 2.5.3
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