1. 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?
ECON2: The National Economy

2. The concept of the economic cycle
2.2 What you need to know
The concept of the economic cycle
The different phases of the economic cycle
How 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

3. 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

4. The Economic Cycle: A Definition
“Variations in the level of productive capacity of an economy over time.”
Key Questions
What 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.

5. 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

6. The Economic Cycle: A Diagram
The level of economic activity fluctuates over time, this pattern is referred to as the economic cycle
Economic activity is measured by GDP
GDP is the total value of a country’s output in a year
Real 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:
Trend rate of economic growth
Boom
Boom
Real GDP
Recovery
Recovery
Recession
Recession
Slump
Slump
Time 6

7. The Economic Cycle: A Diagram
GDP
Time
Actual GDP
Trend line
The Economic Cycle is also known as the Business Cycle or Trade Cycle.
Mark on the diagram the following 4 points:
a) Boom
b) Recession
c) Slump
d) Recovery

8. 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. 8

9. 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 worst recession in the Eurozone.
1979 saw the start of Britain’s decline into a recession – mirrored in the music of the day
Ghost Town The Specials.
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. 9

10. 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? 10

11. 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? 11

12. The Economic Cycle in the UK: Recent History
Source:
BBC News Website
Can you spot a clear economic cycle within the data?
What do you think is meant by the term “double-dip recession”?
UK double-dip recession revised away.

13. Positive and Negative Output Gaps
An output gap is the difference between actual GDP and potential GDP.
Actual GDP
Trend line
GDP
= Positive Output Gap
= Negative Output Gap
Which is which?
Does the UK currently have a positive or negative output gap?
Time

14. 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
Inflation
Investment
Wage Rates
Consumption
House Prices

15. Demand Side Shocks
You need to be able to identify what might cause unexpected changes in the economic cycle
This can be split into demand-side and supply-side
Demand-Side:
This refers to unexpected changes in the economy that directly impact on aggregate demand
Example:
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.

16. Supply Side Shocks Supply-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 , 1979 and 1999 substantial oil price increases occurred. These price changes shifted the short-term aggregate supply curve upwards and to the left.

17. 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

18. Multiple Choice 1
Which one of the following is most likely to occur in the boom phase of an economic cycle?
Rising national income, falling unemployment and a negative output gap
Rising imports, rising profits and a positive output gap
Rising consumption and investment expenditure and a negative output gap
Excess demand, falling employment and a positive output gap
Can you explain your answer? B

19. Multiple Choice 2 In an economy with a positive output gap
There is spare capacity
Actual output is less than potential output
There is cyclical unemployment
Demand-pull inflationary pressure exists
Can you explain your answer? D

20. Multiple Choice 3
An economy’s output gap moves from being positive to negative. The most likely reason for this is that?
Taxes have increased
Interest rates have been cut
Unemployment has fallen
Taxes have been cut
Can you explain your answer? A

21. Multiple Choice 4
Which one of the following is most likely to result in a demand-side shock to the UK economy? A large rise in
World commodity prices
UK wages due to a wave of strikes
UK interest rates
The price of imported semi-manufactured goods
Can you explain your answer? C

22. Multiple Choice 5 Can you explain your answer?
GDP
Time
Actual GDP
Trend line
If the economy is operating at point A, which one of the following policies is most likely to be employed by the government
An increase in unemployment benefit
Higher interest rates
A reduction in income tax
Cutting the education budget A B
Can you explain your answer?

23. 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