key exam knowledge: implications of the business cycle

Economic Booms

Introduction

An economic boom occurs when real GDP grows faster than the trend rate of economic growth (in the UK, the trend rate is around 2.5% per year).

Economic Boom

In a boom aggregate demand is high. Typically, businesses respond to this by increasing production and employment and they may also opt to widen profit margins by raising prices.

Economic Boom

The increase in output eventually puts pressure on scarce factor resources and can lead to demand-pull inflation. This depends on how much spare capacity is available to meet demand.

Characteristics of an Economic Boom:

A strong and rising level of aggregate demand – nearly always driven by household consumption but government spending, fixed investment and exports can also add to final demand. Exports might be boosted by a more rapid growth of world trade or a fall in the exchange rate which increases the competitiveness of the UK traded goods sector

Rising employment and real wages As the labour market “tightens,” this will lead to falling unemployment and higher real incomes for those in work. The tightness of the labour market can be measured in various ways for example the rate of unemployment; the percentage of the labour force in work; the number of unfilled job vacancies and surveys of labour shortages in specific industries and occupations.

Rising employment and real wages

Real incomes for those people in work tend to rise quickly during a boom because of rising labour demand and the opportunity to boost earnings from overtime and productivity-related pay

Increased demand for imported goods & services

The UK has a high marginal propensity to import. This can lead to an increase in the UK trade deficit (this has been true for the UK since the late 1990s).

Strong and rising level of aggregate demand

Rising aggregate demand is nearly always driven by household consumption. Government spending, fixed investment and exports can also add to final demand. Exports might be boosted by a more rapid growth of world trade or a fall in the exchange rate which increases the competitiveness of the UK traded goods sector

Government tax revenues can be expected to rise during and economic boomRising employment levels will reduce the amount of benefits which the government has to pay out.Income rise may be expected to rise during a boom leading to an improvement in government finances as tax receipts increase (the so-called “fiscal dividend” arising from a sustained expansion). This rise in government receipts can lead to a budget surplus which might be used to reduce government debt, or finance an increase in government spending on public goods and services

Company profits and investment increase Increasing company profits may lead to a higher level of fixed capital investment - the link between the strength of demand and planned investment is often explained using the accelerator theory of investment. The extent to which a sustained expansion of national output leads to rising profits depends in part on what is happening to the exchange rate. For example when the exchange rate is falling, the profitability of exporting goods and services increases leading to a rise in profit margins and higher export orders and output at the same time

Company profits and investment increase

For example when the exchange rate is falling, the profitability of exporting goods and services increases leading to a rise in profit margins and higher export orders and output at the same time.

Rising productivity

A cyclical boom is good for labour productivity because businesses are working capacity hard to meet extra demand by using their existing labour resources more intensively

The risk of demand-pull and cost-push inflation

If AD exceeds SRAS over a prolonged period inflationary pressure is likely to build up in the economy.

Economic Downturn• Rising costs associated with continuing growth will, over

time, discourage continuing growth.

• Profitability may fall as costs rise

• Government may act in order to damp down the economy

• Interest rate may increase

Impact of higher interest ratesExplain the likely impact of higher interest rates on:

• Consumers

• producers

Economic DownturnDemand for all types of goods will fall.

The construction industry will be particularly badly hurt because .. …………

Builders will respond by …………………

RecessionIn a recession you are likely to observe:

• Business complaining of falling demand• Cuts in output• Rising unemployment• Few job opportunities• Gloomy expectations• Low levels of capacity utilisation• Falling levels of investment• Many businesses making losses• Some businesses closing down

What is likely to happen to the following in a recession?

SlumpIn a slump, what is likely to happen to:

investment, employment,Interest rates, andinflation

Recovery• When it comes, recovery may be hesitant. Businesses

may be unsure that the improvement in demand will be sustained. This will influence corporate strategies.

• Firms may be reluctant to invest and be reluctant to take on more workers.

• Under utilised resources mean that production can be increased quite quickly.

Questions

• How is the business cycle likely to affect the decisions of people engaged in human resource management?

• Describe the conditions likely to confront a manufacturer of washing machines during a recession

Questions

• What types of business are most likely to survive a recession?• What types of business re least likely to survive a

recession?• How might cutting interest rates help to ‘stave off’

recession?• In what phase of the business cycle would firms

‘destock?’

key exam knowledge: implications of the business cycle

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