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02 the economic cycle
 

02 the economic cycle

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    02 the economic cycle 02 the economic cycle Document Transcript

    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle THE ECONOMIC CYCLE National output (GDP) in the British economy does not rise or fall at a uniform rate. Our economy experiences a regular trade, business or economic cycle where the rate of growth of production, incomes and spending fluctuates over time. Statisticians calculate annual and quarterly movements in national output and these are then tracked to measure the cyclical movement of the economy as can been seen above. ECONOMIC CYCLE Refers to fluctuations in the level of real GDP over time over four stages: boom, recession, slump and recovery. When real GDP (or national output) is rising the economy is said to be experiencing economic growth or recovery. As GDP rises above the trend rate of growth the economy is said to be in boom. A good example of this was the economic boom in the late 1980s. ECONOMIC GROWTH ECONOMIC RECOVERY ECONOMIC BOOM Refers to an increase in a country's output of goods and services. It is usually measured by changes in real GDP. A recovery occurs when real national output picks up from the trough reached at the low point of the recession. A boom occurs when real national output is rising at a rate faster than the estimated trend rate of growth. 1 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle LONG RUN TREND OF GDP Describes the country’s maximum potential output over time. When the growth of output is below its long run trend rate of GDP but is not yet negative - then an economic slowdown exists. If the growth becomes negative then a recession is said to be occurring. There have been four recessions since the early 1970s. The last major recession before the recession that we are just pulling out of, occurred just under a two decades ago when national output fell throughout 1991 and for most of 1992. ECONOMIC SLOWDOWN ECONOMIC RECESSION A slowdown occurs when the rate of growth decelerates – but national output is still rising. A period of negative economic growth. In the UK it is defined as two successive quarters of negative economic growth. Since the 1991/1992 and before 2008/2009 the British economy had enjoyed a period of sustained economic growth. Indeed that upturn in the economic cycle was the longest period of economic growth for over thirty years. The chart above shows the percentage rate of growth of UK real national output over the last 40 years. SUSTAINED GROWTH A period of growth in output that is sustained for several years in succession. STAGES OF THE ECONOMIC CYCLE BOOM A boom occurs when national output is rising strongly at a rate faster than the trend rate of growth (or long-term growth rate) of about 2.5% per year. In boom conditions, output and employment are both expanding and the level of aggregate demand for goods and services is very high. Typically, businesses use the opportunity of a boom to raise output and also widen their profit margins. Characteristics of an economic boom: • Strong and rising level of aggregate demand - often driven by fast growth of consumption • Rising employment and real wages • High demand for imported goods & services • Government tax revenues will be rising quickly • Company profits and investment increase • Increased utilization rate of existing resources • Danger of demand-pull and cost-push inflation if the economy overheats 2 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle AGGREGATE DEMAND CONSUMPTION DEMAND-PULL INFLATION COST-PUSH INFLATION Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. Consumption is the use of a good or a service by consumers (households) to satisfy a want or a need. Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply. Inflation that is caused by an increase in production costs, such as wages or oil prices. SLOWDOWN OR DOWNTURN A slowdown occurs when the rate of growth decelerates - but GDP is still rising. If the economy continues to grow (albeit at a slower rate) without falling into outright recession, this is known as a soft-landing. The Bank of England has tried to engineer a soft-landing for Britain on at least two occasions since it was given independence in the setting of interest rates in May 1997. Interest rates were raised from 6% to 7.5% between the summer of 1997 and the spring of 1998; and the Bank raised interest rates again during the latter half of 1999 in a bid to reduce the rate of growth of demand. 3 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle ECONOMIC RECESSION A recession means a fall in the level of real national output (i.e. a period when the rate of economic growth is negative). During this time national output declines, leading to a contraction in employment, incomes and profits. When real GDP reaches a low point at the end of the recession, the economy has reached the trough - economic recovery is imminent. An economic slump is a prolonged and deep recession leading to a significant fall in output and average living standards. Characteristics of an economic recession: • Declining aggregate demand for UK output • Contracting employment / rising unemployment • Sharp fall in business confidence & profits and a decrease in capital investment spending • De-stocking and heavy price discounting • Reduced inflationary pressure and falling demand for imports • Increased government borrowing • Lower interest rates from central bank LIVING STANDARDS BUSINESS CONFIDENCE CAPITAL INVESTMENT Standard of living is generally measured by standards such as real income per person and the poverty rate. Other measures such as access and quality of health care, income growth inequality and educational standards are also used. The degree of optimism on the state of the economy that businesses are expressing through their activities. Monies invested by a business in its manufacturing plant or equipment. The process of reducing inventory or of stocking less. DE-STOCKING GOVERNMENT DEBT Government debt (also known as public debt or national debt) is money (or credit) owed by any level of government. ECONOMIC RECOVERY A recovery occurs when real national output picks up from the trough reached at the low point of the recession. The pace of recovery depends in part on how quickly aggregate demand starts to rise after the economic downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a rise in demand. The last recession that we have fully recovered from in the UK ended in the autumn of 1992. A much lower exchange rate (stimulating export sales) following sterling's departure from the exchange rate mechanism, plus a sharp fall in interest rates provided a big stimulus to demand. 4 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle National output grew by more than 3% in 1993 and over 4% in 1994 - a vigorous rebound from the effects of the 1990-92 recession. EXCHANGE RATE MECHANISM A mechanism established in 1979 to regulate currency exchange rates in the European Union. Member currencies were permitted to fluctuate in value only within a narrow margin. OUTPUT GAPS The economic cycle can also be described in terms of both positive and negative output gaps. Output gaps occur when there is a difference between the actual rate of growth (determined by AD, i.e. total demand in the economy) and the long-run trend of GDP (determined by the long run aggregate supply LRAS). The LRAS determines the trend rate of growth as it defines the country’s maximum potential output. If the country’s maximum potential output is growing then this allows a greater level of aggregate demand to be met in the economy without causing inflationary pressure. LONG-RUN AGGREGATE SUPPLY It is a measure of a country’s potential output. POSITIVE OUTPUT GAPS - A positive gap is when the actual rate of growth exceeds the long-run trend of GDP. In a boom demand in the economy (AD) is growing faster than the economies ability to meet that demand (LRAS). Due to this positive output gaps can be considered as potentially inflationary as AD > LRAS. In other words there is a trade-off between economic growth and inflation. Resources including labour are likely to be in great demand and thus are being stretched beyond their normal capacity as demand for them increases. The main problem is likely to be an acceleration of demand-pull and cost-push inflation as shortages of factors of production put upward pressure on factor rewards increasing costs for businesses and factor income in the economy which in turn increases AD. POSITIVE OUTPUT GAP NEGATIVE OUTPUT GAP Occurs when actual GDP is above the productive potential of the economy. Occurs when actual GDP is below the productive potential of the economy. NEGATIVE OUTPUT GAPS - In recession unemployment increases as actual GDP is below the productive potential of the economy, i.e. LRAS > AD. With AD being below what the economy can potentially supply it means that some resources become unused. In simple terms, current output and spending is well below what the economy could normally sustain and thus in this situation there is spare capacity in the economy. The main problem is likely to be higher than average unemployment. As resources become unused there is downward pressure on factor rewards thus reducing factor income in the economy and thus AD. Due to this negative output 5 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle gaps can also cause a collapse in investment as planned capital investment by business is normally positively correlated to the rate of economic growth and if growth falls investment will fall exaggerating the initial fall in growth. This is known as the accelerator effect. SOLUTIONS TO ECONOMIC CYCLE FLUCTUATION Wild fluctuations in economic activity can be damaging, not only because booms can cause inflation and recessions unemployment, but also because such fluctuations can be damaging to the long-term growth of the economy as they create uncertainty and discourage firms from investing. It is for these reasons that the government seeks to stabilise the economy and smooth out these short-term fluctuations. To reduce the distance of output gaps the government uses Counter-Cyclical Policies: Boom Interest Rate Government Spending Taxation Up Down Up Recession Interest Rate Government Spending Taxation Down Up Down These policies though have time lags associated with them and it takes time for these policies to take effect. It is important to remember that while monetary and fiscal policy (i.e. demand-side policy) can be successful in bring the actual rate of growth in line with the long-run trend rate of growth they cannot change the long-run trend rate of growth itself. This is changed by LRAS policy. DEMAND-SIDE AND SUPPLY-SIDE SHOCKS Economic shocks can cause fluctuations in the business cycle in other words fluctuations in national income, output and employment particularly as countries become more globalised and integrated into the world economy as a whole. Economic shocks can cause unpredictable changes in aggregate demand and short run aggregate supply which causes changes in the level of GDP within a country. The unpredictable nature of these shocks creates a fluctuating rate of economic growth and may require some sort of macroeconomic policy response. EXTERNAL DEMAND SIDE SHOCKS An example of a demand shock could be a recession in a major trading partner. For example in the UK this could be the USA. If the USA is experiencing a recession, as happened in 2002 then the real disposable incomes of US consumers will fall and hence demand for imports will fall. Britain exports around 15% of its total exports to the US economy. Thus a recession in the US can have an important impact on our trading performance. A fall in exports will potentially lead to a decline in aggregate demand for UK produced goods and services. 6 of 7
    • THE MEASUREMENT OF MACROECONOMIC PERFORMANCE The Economic Cycle The current world-wide banking crisis can be considered a domestic demand-side shock as the reduction in the availability of loan capital that is has caused means that there has been a reduction in AD in the economy of consumers and firms both now find it harder to borrow funds. Another example of an external demand-side shock could be the sudden and significant rise or fall in the exchange rate – affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries. DOMESTIC DEMAND SIDE SHOCKS Demand shocks can also be caused by domestic shocks. One example of this was the fall in domestic demand caused by the significant fall in house prices that were seen in 1989 in the UK resulting in the 1990-91 recession. The fall in aggregate demand was brought about by a reverse wealth effect. Due to the fall in house prices consumers felt less ‘wealthy’ and therefore this caused them to cut back expenditure and increase their level of reducing the level of AD in the economy. This effect then led to a fall in the demand for labour and hence a rise in unemployment resulting in a fall in average disposable income. The result was a further fall in real consumer spending thus exaggerating the original fall in demand. This is known as the multiplier effect. Other domestic demand-side shocks that have occurred in the past have included the effect of a capital investment boom e.g. a boom in construction and the effects of a pre-election government spending spree aimed at gaining votes. The current UK banking crisis can be considered a domestic demand-side shock as the reduction in the availability of loan capital that is has caused means that there has been a reduction in AD in the economy of consumers and firms both now find it harder to borrow funds. SUPPLY SIDE SHOCKS An adverse supply side shock is an event that causes an unexpected increase in costs or disruption to production. A negative supply-side shock has been caused in the past by a rise in world oil prices. The rise in oil prices has causes an increase in the costs of firms for whom oil is an essential input into the production process. For this reason firms may seek to raise their prices to protect their profit margins. This will cause demand to contract and if the rise in oil costs affects sufficient industries across the economy, hence GDP will fall. A supply-side shock such as this has an inflationary effect on the general price level but causes real output to fall. The current world-wide banking crisis can be considered a supply-side shock as the reduction in the availability of loan capital that is has caused means that firms have less access to financial capital. This lack of access to funds directly affects the firms ability to supply and indeed reduces the level of LRAS in the economy. Other supply-side shocks that have occurred in the past have included severe weather, such as Hurricane Katrina in USA and the effects of declining productivity for example through general and prolonged strikes. 7 of 7