the economic cycle Flashcards
what does economic cycle refer to?
An economic (or business) cycle refers to the changes in real GDP that occur in an economy over time
This is the actual growth
what will the real GDP do ?
The real GDP will fluctuate above and below the long-term trend rate of growth
what does the long term trend rate of growth refer to and represent
The long-term trend rate of growth refers to the average or long-term rate at which an economy expands over time
It represents the underlying, sustainable rate of growth that an economy can achieve over the long run, after accounting for fluctuations caused by the economic cycle
draw the economic cycle diagram
digram analysis
A positive output gap is identified as growth of real GDP that is above the trend
A negative output gap is identified as growth of GDP that is below the trend
There is often a natural flow through the different stages, from boom to slowdown to recession to recovery
This flow of real GDP can be moderated by government intervention
E.g. Increasing taxes in a boom period or increasing spending in a recession will help the economy stay closer to the long term trend
characteristics of a recession
Two consecutive quarters (6 months) or more of negative economic growth
Increasing/high unemployment
Increasing negative output gap and spare production capacity
Low confidence for firms and households
Usually, low inflation
what are the characteristics of a boom ?
Increasing/high rates of economic growth
Decreasing unemployment and increasing job vacancies
Reduction of the negative output gap or creation of a positive gap. Spare capacity is reduced or eliminated
High confidence and more risky decisions taken
Increasing rate of inflation - usually demand pull
An improvement in the government budget as tax revenues rise and expenditures fall
exam tip on characteristics of the economic cycle
You will often be examined on the characteristics of the economic cycle. Remember to demonstrate critical thinking around the assumptions of the model. For example, some firms may thrive during a recession as consumers switch to purchasing inferior goods (Poundland).
Additionally, the components of aggregate demand do not rise/fall at the same rate. For example, during a recovery, consumption may increase well ahead of investment by firms.
An economy may also experience some fundamental restructuring during a prolonged recession, and the composition of real GDP growth may be significantly different to what is was before the recession.
why is it difficult to measure output gaps?
It is difficult to measure output gaps accurately
This is because it is hard to know exactly what the maximum productive potential of an economy is
Rapidly rising prices can indicate a positive gap is developing
Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing
when does a negative output gap occur?
A negative output gap occurs when the economy is operating below its full potential
draw a negative output gap on a AS/AD diagram
diagram analysis
The potential output of this economy is at YFE
The economy is in a short-run equilibrium at AP1Y1
A negative output gap exists at Y1 - YFE
This effectively gives the economy spare capacity in the short-term
One cause of this may be that the AD has recently decreased due to a fall in consumption
The Classical view is that the output will return to YFE in the long-run, but at a lower average price level
The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time
when does a positive output gap occur
A positive output gap occurs when the economy is operating beyond its full potential
draw a positive output gap on a AS/AD diagram
diagram analysis
A positive output gap occurs when the economy is operating beyond its full potential
causes of changes in phases of economic cycles - Excessive growth in credit and levels of debt
High levels of borrowing and spending occur during an economic boom
The period leading up to the 2008 financial crisis saw a surge in mortgage lending and high levels of household debt
Which in turn led to economic downturn (recession) when the level of debt became unsustainable
causes of changes in phases of economic cycles - asset price bubbles
Rapid increases in asset prices, such as real estate or stocks, occur during the expansion phase when consumer confidence is high
This is often driven by access to low interest loans
The housing market boom in the UK in the early 2000s resulted in inflated property values
The housing bubble burst in 2008, signalling an onset of a recession
causes of changes in phases of economic cycles-Animal spirit / herding
Keynes coined the term animal spirits to describe how investment prices rise/fall based on human emotion rather than intrinsic value
Herd behaviour occurs when individuals mimic the actions of others, assuming that a collective decision is more accurate or rational than an individual one, in financial markets
