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

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

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

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.

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.” http://www.bbc.co.uk/news/business-13200758 What is GDP?: BBC

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

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

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

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. http://www.youtube.com/watch?v=1WhhSBgd3KI http://www.bbc.co.uk/news/business-23704700 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

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? http://www.bbc.co.uk/news/business-23886149 10

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? http://www.bbc.co.uk/news/business-23143587 11

The Economic Cycle in the UK: Recent History Source: BBC News Website http://www.bbc.co.uk/news/business-23090725 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.

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

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

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.

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 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? 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

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

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

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

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?

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