The Economic Cycle

Question 1

Define trend rate of growth:

Answer 1

Short run changes in real GDP through changes in SRAS, AD or costs of production

Question 2

Define positive output gap:

Answer 2

When actual rate of growth exceeds the trend rate of growth

Question 3

Define negative output gap:

Answer 3

When actual rate of growth is lower that trend rate of growth

Question 4

What diagram can +ve/-ve output gaps be demonstrated on?

Answer 4

Keynesian, neoclassical or PPF

Question 5

How is the trend rate of growth shown on an AD/AS diagram?

Answer 5

Shift in LRAS (both neoclassical and Keynesian)

Question 6

Consequences of output gaps

Answer 6

Negative output gaps: unemployment and potential deflation

Positive output gaps: inflation, uncertainty, wage price spiral, reduced international competitiveness and declining real value of savings and loans

Question 7

What are the four stages of the economic cycle?

Answer 7

The peak: maximum level of growth possible

The recession: when the rate of economic growth falls

The trough: the floor of the recession when economic growth stops falling

The boom: when economic growth starts to rise again

Question 8

Use the multiplier/accelerator model and capital stock to explain the economic cycle:

Answer 8

This theory revolves around investment rates in capital stock.

There is then an accelerator which is the change in investment that comes from expected changes in demand. At the trough you reach a point where capital stock wears out and needs replacement. There is a small amount of capital replacement in the economy AD starts to rise slowly. A few more people now have jobs as they are employed to create new capital. Business confidence starts the increase as we are about to start the growth phase. Businesses want to invest now in order to have sufficient capacity for when demand increases. There is a stage in which the rate of business investment exceeds economic growth. This is the accelerator that causes AD to increase rapidly. This is the injection that activates the multiplier.

Question 9

Use the Neoclassical monetary argument to explain the economic cycle:

Answer 9

Neoclassical economists argue that the economic cycle is a product of access to ‘easy money’ during the trough and recoveries causing the resultant peak growth rate and boom. This creates inflation which leads to higher interest rates. At high interest rates there is less investment, loans are defaulted on and capital intensive production methods bought with cheap capital ceases to be profitable. This creates falls in consumer spending, reduction in investments and unemployment- all features associated with a recession, leading to a trough where low interest rates and access to easy money again stimulate spending, investment and growth.

Question 10

What does the length and severity of a recession depend on? (Monetary argument)

Answer 10

Bank losses and how long it takes them to recapitalise following a recession/crash.