4.11.1 - Economic Growth and the Economic Cycle

Question 1

What is the difference between the definition and measurement of economic growth?

Answer 1

Definition - An increase in the potential level of real output the economy can produce.
Measurement - The annual change in real GDP

Question 2

How does an economy grow in the short-run?

Answer 2

By using spare capacity in the economy (i.e. economic recovery).

Question 3

What is the demand side?

Answer 3

Relates to the impact of changes in AD on the economy. (Tends to be Keynesian)

Question 4

How can you increase AD?

Answer 4

Following the equation:

AD = C + I + G + (X - M)

If consumption, investment, government spending or exports increase or if imports fall, AD will increase.

Question 5

Explain what will happen to the economy when AD shifts from AD₁ to AD₂?

Answer 5

Real output of the economy will increase from Y₁ to Y₂ with no increase on the price level (i.e. no inflation) because the SRAS curve is horizontal at low levels of output.

Question 6

What will happen to the economy from when AD shifts from AD₂ to AD₃?

Answer 6

The real national output will rise from Y₂ to Y₃. However, the price level will rise from P₂ to P₃, so the short-run economic growth has also been met with higher rates of inflation.

Question 7

How can the economy grow when real national output is at Y₅?

Answer 7

The short-run economic growth must give way to long-run economic growth to push the LRAS outwards to allow more growth.

Question 8

What is the supply-side?

Answer 8

Relates to changes in the potential output of the economy, which is affected by the available factors of production (i.e. changes in labour force, productivity etc.)

Question 9

What is the trend growth rate?

Answer 9

The rate at which output can grow, on a sustained basis, without putting upward or downward pressure on inflation. Refects the annual average percentage increase in the productive capacity in the economy.

Question 10

What is the economic cycle?

Answer 10

The upswing and downswing in economic activity taking place over 4 to 12 years.

Question 11

What policies allow the economy to grow in the long-run?

Answer 11

Supply-side policies.

Question 12

What is the UK’s trend growth rate?

Answer 12

Less than 2% since 2008.

Question 13

What are the two main economic growth theories?

Answer 13

• Neoclassical growth theory
• New growth theory

Question 14

How does the neoclassical growth theory work?

Answer 14

A sustained increase in investment will increase the economy’s growth rate, but only up to a certain point.

As depreciation of capital goods increase, investment will increase to match it but only to a certain point. This point is called the steady-state level of capital where investment = depreciation. All other factors being equal, as capital stock does not grow, nothing grows. This therefore means we have also reached the steady-stage level of output.

As investment is a percentage of savings, if savings increase, then a new steady-state level of output will arise. Growth will continue for some time, but will again only be temporary.

Question 15

Where does the flaw in neoclassical growth lie?

Answer 15

It assumes that technological progress will occur, but does not explain why.

The causes of economic growth (i.e. capital investment) are exogenous to the theory and therefore fails to provide a complete explanation of economic growth.

Question 16

What is new growth theory (aka endogenous growth theory)?

Answer 16

The unlimited wants of people will foster ever-increasing productivity and economic growth as ideas are generated to improve productivity in an economy.

Technological change does not happen by chance, but is directly proportional to the amount of firms and people looking for improvement. Knowledge and ideas are central to the new growth theory and technological improvement.

Question 17

What are the main sources of technological progress in the new growth theory?

Answer 17

• Profit-seeking research
  There is a ‘capital stock’ of ideas, and adding to this capital stock will allow technological improvement. Arguments involve ‘over-fishing’ against ‘standing on the shoulders’ - i.e. too many researchers damages technological progress or more researchers allowing faster technological improvement rates respectively.
• Openness to foreign ideas
  Technological progress is dependent on three factors: the rate at which tech is adopted from abroad, proportion of foreign technologies can be adopted and the rate at which they can be adopted. If a country is more open to foreign ideas, they can progress technologically.
• Accumulation of human capital
  By educating and training the indigenous population and migration from other countries, human capital is accumulated and improved. Technological change requires workers who possess skills to operate new technology, so training is important to facilitate technological progress.

Question 18

What type of government intervention does new growth theory suggest?

Answer 18

Supply-side.

Creating:
* Conditions that encourage profit-seeking research
* Externalities which benefit private sector businesses
* Patent legislation and a judicial system to enforce contracts to create incentives for firms to innovate

Question 19

What are the costs of economic growth?

Answer 19

• Using up finite resources (i.e. oil, minerals etc.)
• Leading to pollution and other environmental degradation
• Destruction of local cultures and communities by widening the income gap
• Urbanisation which swallows up agricultural land
• Rapid growth in population (in early stages of economic growth)

Question 20

What are the benefits of economic growth?

Answer 20

• Increase standards of living
• May lead to more civilised communities
• Provides more environmentally friendly technologies
• Increasing the length of people’s lives
• Provides a route out of poverty
• Increased tax revenues to be spent to correct market issues

Question 21

What happens to individuals during periods of economic growth?

Answer 21

Rich individuals will experience higher welfare and incomes.

Some poor people will lose jobs due to automation, reducing demand for labour so they will lose their jobs.

Question 22

What happens to the economy during periods of economic growth?

Answer 22

Economic growth may have more costs than benefits, leading to an outcome where growth is unsustainable.

Question 23

How do fluctuations in economy activity occur?

Answer 23

• Seasonal fluctuations (i.e. during the Winter tourism will probably fall)
• Cyclical fluctuations (over a number of years)

Question 24

How long are economic cycles?

Answer 24

Between 4 and 12 years.

Question 25

What primarily causes economic cycles?

Answer 25

Fluctuations in AD.

(In recent times (ie. COVID), supply shocks have also caused cyclical fluctuations.)

Question 26

What is actual output?

Answer 26

The level of real output produced in the economy in a particular year.

Question 27

What are the principle explanations for the causes of the phases of the economic cycle?

Answer 27

• Fluctuations of AD
• Supply-side factors
• Speculative bubbles
• Political business cycle theory
• Outside shocks
• Multiplier / accelerator interaction

Question 28

How do fluctuations in AD explain changes in the phases of the economic cycle?

Answer 28

Consumer and business confidence give way to pessimism and vice-versa.

This is the prevailing view today.

Question 29

How do supply-side factors explain changes in the phases of the economic cycle?

Answer 29

Changes in technology on the supply-side of the economy might be as important as changes in AD to explain economic cycles.

Question 30

How do speculative bubbles explain changes in the phases of the economic cycle?

Answer 30

Rapid economic growth leads to a rapid rise in asset prices.

When people realise asset prices are far above the assets’ real values, asset selling replaces asset purchasing. Thic causes the bubble to burst, destroying consumer/business confidence.

Question 31

How does the political-business cycle theory explain changes in the phases of the economic cycle?

Answer 31

To gain election, the political party in power may attempt to ‘buy votes’ by engineering a pre-election boom.

This is then deflated by the following party to prevent the economy from overheating.

Question 32

How do external shocks explain changes in the phases of the economic cycle?

Answer 32

Large supply-side shocks such as a war in the Middle-East can lead to two things:

• Oil prices rising increasing business cost of production.
• A demand shock by reducing business/consumer confidence causing AD to fall.

Question 33

How does the multiplier/accelerator interaction explain changes in the phases of the economic cycle?

Answer 33

The multiplier process, through which an increase in investment leads to multiple increases in national income.

The accelerator process, where the increase in income induces a change in the level of investment.

Question 34

What is the output gap?

Answer 34

The level of actual real output in the economy either higher or lower than the trand output level.

Question 35

What is the positive output gap?

Answer 35

The level of actual real output in the economy is greater than the trend output level.

Question 36

What is the negative output gap?

Answer 36

The level of actual output in the economy is lower than the trend output level.

Question 37

How is a negative output gap denoted on this graph?

Answer 37

Between Y² and Yf.

Question 38

How is the positive output gap denoted on this graph?

Answer 38

Between Yf and Y¹.