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AS Macro Revision Aspects of the Economic Cycle
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AS Macro Revision Aspects of the Economic Cycle

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  • 1. AS Macro Revision Aspects of the Economic Cycle Spring 2014
  • 2. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u www.tutor2u.net/blog/index.php/economics/categories/C59
  • 3. Identifying Stages of the Economic Cycle Cycle is when GDP growth fluctuates around the trend (or underlying) growth Recession Slowdown Recovery Boom
  • 4. Explaining the Stages of the Economic Cycle Boom A period when the rate of growth of real GDP is fast and higher than its long-term trend Slowdown A weakening of the rate of growth, real GDP is still rising but increasing at a slower rate Recession A 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 or depression, 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
  • 5. The Output Gap General Price Level LAS AS GPL1 AD Y1 Yp Real GDP The output gap is the difference between the actual level of GDP and its (estimated) potential level and is usually expressed as a percentage of the level of potential output. In the example on the left, the equilibrium level of national income (GDP) is less than long run potential output – therefore the output gap is negative
  • 6. Negative and Positive Output Gaps Negative Output Gap Positive Output Gap When actual GDP is less than potential GDP Actual GDP is greater than potential GDP Some factor resources are under-utilized Some resources working beyond usual capacity (shift work & overtime) Main problem is likely to be higher unemployment Main problem is rising inflationary pressures
  • 7. Evidence for the Output Gap in the UK Economy Positive output gap after several years of strong growth Recession Recession causes negative output gap
  • 8. Identifying Some 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
  • 9. External Shocks to Aggregate Demand Many unexpected events cause changes in the level of demand, output and employment. These events are called “shocks”. Some of the causes of AD shocks are as follows A large rise or fall in the exchange rate A recession or boom in one or more main trading partner countries A slump in the housing market or a change in the level of share prices An event such as the global financial crisis which caused a fall in the supply of credit
  • 10. UK Economic Growth in Recent Years Forecast A long period of strong, sustained growth with rising real GDP and incomes Two years of recession followed by a slow recovery
  • 11. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u www.tutor2u.net/blog/index.php/economics/categories/C59
  • 12. Short Term Economic Effects of a Recession Effects of recession depend in part on its causes and how long it lasts Business profits and investment • Falling demand can cause more businesses to fail and profits fall • Planned investment declines – hitting industries that make the capital goods Unemployment • The drop 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 Inflation • Many business offer price discounts to off-load excess stocks • A deep recession risks causing a period of price deflation (negative inflation)
  • 13. Longer Term Economic & Social Effects of a Recession Effects of recession depend in part on its causes and how long it lasts Long Term Economic Consequences Long Term Social Consequences Rising structural longterm unemployment Falling real wages hits living standards Low investment can reduce the capital stock Widening inequality of income and wealth Persistent budget deficit and rising national debt Social costs from rising relative poverty
  • 14. Legacy of Recession: Hysteresis v Creative Destruction Here are two competing views about the effects of a recession Hysteresis When an economy is disabled by recession – big risk of permanent loss of national output Creative Destruction Recessions can cast a dark shadow but capitalist economies usually bounce back Loss of productive capacity due to low investment / business closures Recessions prompt emergence of new business models and an increase in start-ups High rates of longterm structural unemployment – shrinking labour force New technologies can act as a catalyst for renewed growth and investment
  • 15. 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 • In Greece, real GDP has fallen in seven successive years and real GDP is more than 25% lower than at the peak of the cycle
  • 16. Why has the UK Economic Recovery been weak? Domestic demand-side factors: Weak consumer demand, low business capital investment, cuts in real level of government spending Domestic supply-side factors: Low supply of bank credit to businesses, falling labour productivity (output per worker) + high energy prices, External demand-side factors: Weak growth in key overseas markets, hitting UK export sales e.g. Euro Area, too few exports to Asian region External supply-side factors: Rising world food and energy prices, keeping UK inflation high and squeezing real disposable incomes
  • 17. Problems in Forecasting Real GDP Growth No macroeconomic model can hope to cope with the volatility of indicators such as inflation, exchange rates and global commodity prices. This makes forecasting GDP growth difficult Uncertain business confidence levels Rate of business job creation hard to forecast Uncertain reactions to macro policy changes Forecast growth for UK (source: BoE) Fluctuations in exchange rate External events e.g. volatile oil and gas prices
  • 18. Real Incomes and Economic Activity Real income measures the purchasing power of a given amount of nominal (money) income – i.e. nominal income adjusted for inflation Year 2008 2009 2010 2011 2012 2013 Earnings Consumer (Wages, Bonuses Price Index and Overtime) % annual % annual change change 4.7 3.0 1.9 2.3 2.1 3.7 0.4 4.5 1.6 3.0 2.2 2.4 Real incomes Rising Falling Falling Falling Falling Falling Year of recession In each of the last five years, the annual growth of earnings for people in work has been less than inflation – causing real incomes to fall
  • 19. How The Housing Market Affects AD • The construction sector employs about 10% of the UK workforce (over 2 million people) and contributes almost £90 billion to the UK economy each year • The recession of 2008-2010 caused a steep fall in new house building and led to hundreds of thousands of job losses – this was a factor causing unemployment to rise • House-building remains labour intensive so changes in demand and output have quite large multiplier effects • Changes in house prices affect the level of household wealth and this can affect consumer spending and saving decisions • Falling house prices often cause a fall in consumption • Since 2012, house prices have started to rise again but so too have housing rents – housing affordability is a big issue
  • 20. Costs & Benefits of High House Prices Benefits of rising prices Costs of rising prices • Increases wealth of home owners • Boosts consumer confidence • Stimulates an expansion of new house-building • Increases tax revenues from stamp duty • Improves the financial stability of the banks • Worsens affordability for first time buyers • Increases level of mortgage debt • Increases wealth inequality • Causes an increase in demand for and cost of renting property • Worsens geographical mobility of labour Evaluation Points Effects of rising house prices depends in part on: 1. The scale of the rise in prices 2. The volatility of the housing market 3. The extent to which homebuyers overextend themselves with high mortgages
  • 21. Get help on the AS macroeconomics course using twitter #econ2 @tutor2u_econ www.tutor2u.net