the economic cycle and trend growth

Introduction

The Government's central economic objective is to achieve high and stable levels of growth and employment. Even small changes in the rate of growth can have large effects if sustained over a number of years. For this reason, the Government aims to raise the long-term non-inflationary growth performance of the economy (ie the economy's trend growth rate). It aims to do this by increasing employment opportunity and by raising productivity through promoting economic stability and through its wider economic policy agenda

Treasury Budget Statement 1999

Sustained Improvements in Prosperity
The Labour Government’s current macroeconomic strategy seeks to achieve sustainable improvements in prosperity and rising employment opportunity for all. Clearly the continuation of the current phase of economic growth is vital in meeting these twin objectives, but we know that every economy experiences short term fluctuations in the growth of income, output, spending and employment.

The Short Run Business Cycle

The economic cycle (or business or trade cycle) shows short-term fluctuations in macroeconomic activity, for example the annual rate of growth of real national output (GDP). The depth and volatility of the economic cycle varies from country to country and over time, the length of the cycle can also vary. Since the last recession ended in autumn 1992, the British economy has enjoyed a decade of almost uninterrupted growth. The value of real GDP (measured at constant 1995 prices) has expanded from £659 billion in 1990 to just under £846 billion in 2001. The chart below shows the annual rate of growth of real GDP since 1981. There have been two full-scale recessions in the last twenty years but the current expansionary phase is the longest period of sustained growth for over 30 years.

Economic growth in 2001 came in at 1.9%, just a shade below the long-term trend growth rate (i.e. the average achieved over 30 years) of 2.5% per annum.

Trend Economic Growth

Trend economic growth refers to the smooth path of long run output. Measuring the trend requires a very long-run series of macroeconomic data in order to identify the different stages of the cycle and derive average growth rates from peak to peak or trough to trough. The Treasury has undertaken several studies of the underlying rate of growth for the British economy in part so that they can base their projections for government spending and tax revenues so that government finances do not swing wildly out of line with what can be afforded.

This summary statement provides an overview of the Treasury’s latest research on underlying growth

Many factors influence the rate of economic growth. Some factors, such as changes in consumer and business confidence, aggregate demand conditions in the UK’s trading partners, and the stance of monetary and fiscal policy, tend to have a mainly temporary effect on growth. Other factors, such as the rates of population and productivity growth, have more enduring effects, and help to determine the economy's average growth rate over long periods of time.

The long-run sustainable rate of growth depends on improvements in the supply-side of the economy. Supply-side factors, such as capital investment, education and training and technological change are likely to determine the underlying trend rate of economic growth in the long run. The trend rate of growth is determined by the supply-side capacity of a country – i.e. the extent to which LRAS increases year-on-year to meet a higher level of aggregate demand.

Potential output in the long run depends on the following factors

• The trend growth of the working population i.e. the size of the active labour supply (e.g. those people able available and willing to find paid employment)
• The growth of the nation’s stock of capital – driven by the level of investment
• The trend rate of growth of factor productivity (including labour productivity) – a measure of gains in factor efficiency
• Technological improvements which reduce the real costs of supplying goods and services and which lead to an outward shift in a country’s production possibility frontier

Long Run Aggregate Supply and the Trend Rate of Growth

The effects of an increase in long run aggregate supply are traced in the diagram below. An increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading to sustained increases in real national output.

A lot of economic research has gone into analyzing the economic conditions under which a country might raise its trend growth rate. Fundamentally, annual increases in potential output are driven by higher labour and capital productivity and by an increase in the stock of capital and the available supply of labour. Over the last twenty years, government of different political persuasions, have put in place policies which they expect will be successful in raising investment, encouraging entrepreneurship and improving incentives to work.

Potential output in the long run depends on the following factors

(1) The trend growth of the working population i.e. the size of the active labour supply (e.g. those people able available and willing to find paid employment). If the government can successfully increase the number of people of working age willing and able to actively seek paid employment, then the employment rate can rise and the total stock of labour available to produce an output of goods and services can increase. The Government has invested heavily in a number of special employment schemes designed to raise employment potential in the economy (including New Deal and the Working Families Tax Credit). Other changes in the income tax and benefits system might also have an impact on the percentage of the population of working age who are active in the labour market. The current assumption is that the population of working age will grow by approximately 0.4% per year for the next few years. But changes in the age structure of the population will inevitably affect the total number of people seeking work.

(2) The growth of the nation’s stock of capital – driven by the level of fixed capital investment. A rise in investment adds directly to GDP in the sense that capital goods have to be designed, produced, marketed and delivered and an increase in capital intensity provides workers with more capital to work with. New capital also tends to embody technological improvements which providing workers have sufficient skills and training to make full and efficient use of their new capital inputs, should lead to a higher level of productivity

(3) The trend rate of growth of factor productivity (including labour productivity) – a measure of gains in factor efficiency. For most countries it is the annual rate of growth of productivity that drives the long-term rate of economic growth. But of more interest and importance is where gains in productivity come from. The macroeconomic data on productivity is simply the aggregation of productivity performance at a microeconomic level throughout every industry and market in the economy. Although we often focus on the overall productivity data, the root causes of improved efficiency come from making individual markets work better and achieving better productivity within individual plants. Increased investment in the human capital of the workforce is widely seen as essential if the UK is to improve its long run productivity performance.

(4) Technological improvements which reduce the real costs of supplying goods and services and which lead to an outward shift in a country’s production possibility frontier
Despite this, the underlying trend rate of growth has barely moved. The consensus remains that the British economy can sustain a rate of growth of output of only 2.5% per year over the long term. Even the rapid expansion of ICT over the last decade, and a welcome rise in the share of national output allocated to business investment has done little to improve Britain’s sluggish productivity record compared to other leading industrialized nations.

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