ECON2: The National Economy

2.2 The Economic Cycle

Why does the productive capacity of the economy change over time?How can we tell when or how this is happening?

2.2 What you need to know

The concept of the economic cycleThe different phases of the economic cycleHow to use a range of different economic

indicators to identify the various phases of the economic cycle

The difference between demand-side and supply-side shocks

The concept of positive and negative output gaps in the economic cycle

2.2 You should be able to:Understand and illustrate the concept of the

economic cycle on a diagramUse economic indicators such as GDP, the rate of

inflation, unemployment and investment to identify the various phases of the economic cycle

Show the impact that demand-side and supply-side shocks might have on the economic cycle

Explain the likely state of the economy using economic indicators during periods of positive and negative output gaps

The Economic Cycle: A Definition

“Variations in the level of productive capacity of an economy over time.”

Key QuestionsWhat do we mean by ‘variations’?What do we mean by ‘productive capacity’?What do we mean by ‘over time’?

Productive capacity (or potential) is the maximum amount of goods and services that we can produce with the resources

we have available.

Gross Domestic Product: A Definition

In order to understand the economic cycle it is important that we understand Gross Domestic Product (GDP). This is defined as:

“The value of goods and services produced in the economy over a period of time.”

What is GDP?: BBC

The Economic Cycle: A DiagramThe level of economic activity fluctuates over time,

this pattern is referred to as the economic cycleEconomic activity is measured by GDP GDP is the total value of a country’s output in a yearReal GDP takes into account inflation. If GDP growth

is 5% and inflation 2% real GDP growth will be 3%. There are four main stages to the Economic Cycle:

Real GDP

Time

Boom

Recovery

Recession

Slump

Trend rate of economic growth

Boom

Slump

Recovery

Recession

The Economic Cycle: A Diagram

GDP

Time

Actual GDP

Trend line

Mark on the diagram the

following 4 points:a) Boomb) Recessionc) Slumpd) Recovery

The Economic Cycle is also known as the

Business Cycle or Trade Cycle.

Economic Cycle - Boom A period of high levels of economic activity

Characterised by:

High rate of economic growth

High demand

Low unemployment

Inflationary pressure

Labour skills shortages

High confidence in the economy

Capital Investment is high

Once you have studied each of the economic variables in turn you

may wish to revisit the economic cycle to

discuss why some of the characteristics of a

boom lead to a recession.

Economic Cycle - Recession The rate of economic growth starts to fall in a downturn

If real GDP falls for 6 months then this is known as a recession

Characterised by:

Demand falls

Unemployment begins to rise

Some firms will go out of business

Confidence in the economy is low and most firms will reduce investment

The Government state that recession is officially two quarters of negative economic growth. However, it is often regarded as a period of low economic

growth.

The worst recession in the Eurozone.

1979 saw the start of Britain’s decline into a recession – mirrored

in the music of the dayGhost Town The

Specials.

Economic Cycle - Slump The bottom of the business cycle which

represents a period of serious economic decline

Characterised by:

Low or negative growth

Demand and inflation are low

Unemployment is high

Confidence in the economy is low

High rate of bankruptcy

Why is the housing market frequently quoted as a key

indicator of economic activity?

Economic Cycle - Recovery When there are signs that economic growth is

starting to rise, often referred to as the ‘green shoots of recovery’

Economic growth starts to rise

Demand increases

Unemployment falls

Inflation starts to rise

Confidence in the economy increases

Capital Investment increases

Why is business confidence so

important for a recovery?

The Economic Cycle in the UK: Recent History

Can you spot a clear economic cycle within the data? What do you think is meant by the term “double-dip recession”?

Source:BBC News Website

UK double-dip recession revised away.

Positive and Negative Output Gaps

GDP

Time

Actual GDP

Trend line

= Positive Output Gap

= Negative Output Gap

Does the UK currently have a

positive or negative output gap?

An output gap is the difference between actual GDP and potential GDP.

Which is which?

Economic Indicators over the Cycle

What do you think is likely to be happening to the following indicators during a positive and negative output gap?

Indicator Positive Output Gap

Negative Output Gap

Unemployment Rising or Falling Rising or Falling

Inflation Rising or Falling Rising or Falling

Investment Rising or Falling Rising or Falling

Wage Rates Rising or Falling Rising or Falling

Consumption Rising or Falling Rising or Falling

House Prices Rising or Falling Rising or Falling

Demand Side ShocksYou need to be able to identify what might cause

unexpected changes in the economic cycleThis can be split into demand-side and supply-sideDemand-Side:This refers to unexpected changes in the economy that

directly impact on aggregate demandExample: The Eurozone crisis occurred due to some states e.g. Spain, Italy and Greece borrowing beyond their means when interest rates were cheap. As rates rose these states struggled to pay back their debts. The consequent fall in demand impacted on trading partners such as the UK.

Supply Side ShocksSupply-Side:This refers to unexpected changes in the

economy that directly impact on aggregate supply

This will often refer to the size and productivity of the workforce, and firms’ ability to produce goods and services

Example: Over the years oil prices have seen dramatic increases that have had a short-term impact on the supply of goods and services as many businesses use oil directly or indirectly in the production process. In 1973-74, 1979 and 1999 substantial oil price increases occurred. These price changes shifted the short-term aggregate supply curve upwards and to the left.

For each of the following, decide whether the impact is demand-side or supply-side, AND if the impact might improve or worsen the economic cycle

Impact Demand-Side or

Supply Side?

Improvement or Worsening of Economic Cycle?

The Bank of England raise interest rates

Larger budgets given to schools for education

A cut in the main rate of income tax

Tax given to businesses to encourage investment

An unexpected 10% increase in the price of oil

Consumer confidence rises

Multiple Choice 1

Which one of the following is most likely to occur in the boom phase of an economic cycle?

a)Rising national income, falling unemployment and a negative output gapb)Rising imports, rising profits and a positive output gapc) Rising consumption and investment expenditure and a negative output

gapd)Excess demand, falling employment and a positive output gap

Can you explain your answer?

Multiple Choice 2In an economy with a positive output gap

a) There is spare capacityb) Actual output is less than potential outputc) There is cyclical unemploymentd) Demand-pull inflationary pressure exists

Can you explain your answer?

Multiple Choice 3An economy’s output gap moves from being

positive to negative. The most likely reason for this is that?a) Taxes have increasedb) Interest rates have been cutc) Unemployment has fallend) Taxes have been cut

Can you explain your answer?

Multiple Choice 4Which one of the following is most likely to

result in a demand-side shock to the UK economy? A large rise ina) World commodity pricesb) UK wages due to a wave of strikesc) UK interest ratesd) The price of imported semi-manufactured goods

Can you explain your answer?

Multiple Choice 5

If the economy is operating at point A, which one of the following policies is most likely to be employed by the governmenta) An increase in unemployment benefitb) Higher interest ratesc) A reduction in income taxd) Cutting the education budget

GDP

Time

Actual GDP

Trend line

A

Can you explain your answer?

2.2 You should be able to:

Understand and illustrate the concept of the economic cycle on a diagram

Use economic indicators such as GDP, the rate of inflation, unemployment and investment to identify the various phases of the economic cycle

Show the impact that demand-side and supply-side shocks might have on the economic cycle

Explain the likely state of the economy using economic indicators during periods of positive and negative output gaps