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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
Busi...
Real GDP Growth in the UK Economy
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019...
Identifying Stages of the Economic Cycle
Boom
Slowdown
Recession
Recovery
A cycle is when GDP growth fluctuates around the...
Economic Recovery and the PPF Diagram
During an
economic recovery,
aggregate demand
will be rising. This
leads to an
incre...
-8% -6% -4% -2% 0% 2% 4% 6% 8%
Mining, oil, etc
Finance/insurance
Electricity & gas
Agriculture
Water & waste
Manufacturin...
Actual and Forecast Real GDP for the UK Economy
This chart is taken from the May 2015 Bank of England Inflation Report
The...
Problems in Forecasting Real GDP Growth
No macroeconomic model can deal fully with the volatility of key indicators such
a...
Spare Capacity – Measuring The Output Gap
The output gap is the
difference between the
actual level of GDP and its
estimat...
The Estimated Output Gap for the UK Economy
The chart shows the estimated output gap for the UK economy. Note that
there i...
Negative and Positive Output Gaps
Negative Output Gap
When the level of actual GDP
is less than potential GDP
Some factor ...
Problems in Measuring the Output Gap
• The output gap is a measure of the difference between the
actual output of an econo...
Examples of Demand and Supply-Side Shocks
Demand-side
Shocks
Economic downturn in a
trading partner
Unexpected tax increas...
Identifying Possible Causes of a Recession
External events
• A recession in a trading partner e.g. the European Union or t...
Short Term Economic Effects of a Recession
Impact of a recession depends in part on causes and how long it lasts
Business ...
Longer Term Economic & Social Effects of a Recession
A deep recession / depression can having economic and social costs
Lo...
Legacy of Recession: Hysteresis v Creative Destruction
Here are two competing views about the effects of a recession
When ...
The Difference between Recession and Depression
• A depression is a prolonged slump where real GDP falls by more
than 10% ...
The Trade (Business) Cycle and the
Output Gap
EdExcel AS Economics 2.5.3
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Trade cycle output_gaps

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Trade cycle output_gaps

  1. 1. The Trade (Business) Cycle and the Output Gap EdExcel AS Economics 2.5.3
  2. 2. 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 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, 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
  3. 3. Real GDP Growth in the UK Economy 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020* GDPgrowthratecomparedtopreviousyear 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
  4. 4. Identifying Stages of the Economic Cycle Boom Slowdown Recession 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.
  5. 5. 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
  6. 6. -8% -6% -4% -2% 0% 2% 4% 6% 8% 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 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
  7. 7. Actual and Forecast Real GDP for the UK Economy This 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
  8. 8. 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
  9. 9. 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
  10. 10. 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
  11. 11. 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
  12. 12. 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 migration 2. Problems in accurately measuring productivity 3. Surveys of producers about spare capacity may be inaccurate 4. Gaps in knowledge about how much businesses are investing and the potential output from new capital e.g. in digital sectors 5. 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
  13. 13. 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
  14. 14. 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
  15. 15. 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)
  16. 16. 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
  17. 17. 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
  18. 18. 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 0 5000 10000 15000 20000 25000 30000 2010 2011 2012 2013 2014 2015*2016*2017*2018*2019*2020* GDPpercapitainU.S.dollars Real Per Capita Income in Greece 2010-2020 (Source IMF)
  19. 19. The Trade (Business) Cycle and the Output Gap EdExcel AS Economics 2.5.3

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