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

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

RecessionA 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

Real GDP Growth in the UK Economy

2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

GDP

grow

th ra

te c

ompa

red

to p

revi

ous y

ear

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

Identifying Stages of the Economic Cycle

Boom

SlowdownRecession

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.

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

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

-8% -6% -4% -2% 0% 2% 4% 6% 8%

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

Actual and Forecast Real GDP for the UK EconomyThis 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

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

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

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

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

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 migration2. Problems in accurately measuring productivity3. Surveys of producers about spare capacity may be inaccurate4. Gaps in knowledge about how much businesses are investing

and the potential output from new capital e.g. in digital sectors5. 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

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

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

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)

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

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

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

2010 2011 2012 2013 2014 2015*

2016*

2017*

2018*

2019*

2020*

0

5000

10000

15000

20000

25000

30000

GDP

per

cap

ita in

U.S

. dol

lars

Real Per Capita Income in Greece 2010-2020 (Source IMF)

The Trade (Business) Cycle and the Output Gap

EdExcel AS Economics 2.5.3