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Economic Cycles

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

Britain has just suffered one of the deepest slumps in her post-1945 history; the Euro Area economies have struggled to climb out of recession amid unprecedented levels of financial turbulence and the crippling effects of high private and public sector debts

Many of the world’s richest countries have witnessed damaging contractions in activity since 2008. Few nations have escaped – although countries such as Australia, Poland, Norway and Canada seem to have emerged from the global financial crisis (GFC) in relatively good shape.

There are major doubts about the likely pace of growth for advanced nations. The new normal growth rate may be lower than in the last twenty years with important consequences for living standards and the ability of sovereign governments to extract them from the debt crisis.

We have had three recessions in the UK since the early 1980s, the most recent started in the spring of 2008 and real GDP fell by more than 4.5% in 2009 and - from peak to trough – the recession led to a 6% fall in national output.

In contrast, between 1993 and 2008 Britain enjoyed a period of sustained growth combined with low inflation and falling unemployment – an era once dubbed by the Governor of the Bank of England, Mervyn King as the ‘NICE’ decade, NICE standing for ‘non-inflationary continuous expansion’. This came to an abrupt halt in 2007 when global inflationary pressures soared and the world economy was shocked by the sub-prime crisis and the ensuing credit crunch and downturn.

What causes the economic cycle?

For A2 it is important to grasp the dynamic causes of different stages of the cycle. And to understand how macro developments in one country/region impact on other economies through trade, capital and other resource flows.  When looking at the causes of cyclical changes in production, incomes and jobs there are two main approaches:

  • Endogenous models explain cyclical fluctuations in terms of internal events or policies i.e. changes which lie within the economic system
  • Exogenous models argue that turning points in an economic cycle happen because of external demand-side or supply-side ‘shocks’ from beyond the economic system. These shocks create a disequilibrium for an economy and lead output and prices to deviate from a forecast path

Endogenous Models

The Stock Cycle

The stock cycle helps to explain changes in national output because all businesses hold stocks (inventories) of finished products or raw materials and components as a way of balancing changes in demand.

  • When demand is strong and running ahead of supply, stocks fall and this is a signal either to raise prices and/or to expand production. Re-stocking can be a way out of a recession.
  • Consider the car-scrappage scheme in the UK which was introduced as a way of boosting demand for new vehicles during the recession. This £2,000 cash incentive lead to a spike in demand some of which was met by selling vehicles stuck in vast car parks adjacent to the assembly plants.
  • Some of the extra spending on new vehicles will have necessitated a rise in demand for components used in making a new car – there was a positive impact on supply-chain businesses and a rise in demand for stocks leading to an injection of extra incomes in the vehicle industry.

In the early stages of a recession, any slump in consumer demand will cause businesses to cut back on output so as to reduce the volume of stocks. We saw this effect at work in 2008-09 as the UK recession became a reality – consider the evidence from the chart below.

The chart shows “de-stocking”, in the 1st quarter of 2009, the reduction in the value of stocks amounted to more than £5bn. As British-based carmakers produced fewer cars and house-builders cut back on the number of new homes being built, so the derived demand for cement, bricks, glass, steel, rubber and other raw materials and component parts suffered.

Key point: Changes in the stock cycle have important multiplier effects on supply-chain industries.
The use of ‘just-in-time’ (JIT) stock delivery systems in manufacturing has reduced the need for businesses to hold high stocks of intermediate products. It is now easier for supply to match changes in demand. For example, stocks tend to be less important in the service sector, which now accounts for more than 75 per cent of UK national output.

2. Fluctuations in one or more components of aggregate demand (AD)Movements in real GDP in the short term are mainly due to changes in the components of AD and shifts in short-run aggregate supply (SRAS).  

As with most of the advanced economies, UK household consumption is the largest element accounting for over 65% of spending on goods and services.

Here is a way of breaking down the aggregate demand calculation:

  1. Domestic demand                           = C + I + G
  2. External demand                             = X-M (also known as net trade)
  3. GDP (Aggregate demand)            = C+I+G+X-M

For some countries domestic demand is a high % of total spending (e.g. the USA). In contrast in China, the economy has been driven forward by high trade and current account surpluses and domestic spending has been  lower – the Chinese government wishes to boost consumer spending and rely less on exports in order to sustain here fast rate of economic growth in the years ahead.

Recap on the main Stages of the Cycle

Boom

A boom happens when real GDP grows faster than the trend growth rateover a number of years. In a boom phase, AD is high and businesses expand output and employment and may also raise profit margins by increasing prices - causing cost-push and demand-pull inflation. The main characteristics of a boom are:

  • A tightening of the labour market: Measured by the rate of unemployment or the number of unfilled job vacancies.
  • High demand for imports: Demand increases due to a high marginal propensity to import.
  • Public finances: An expansion provides a “fiscal dividend” to the government because tax revenues will be rising as people are earning and spending more. Business profits will be increasing and state spending on welfare tends to fall. A boom can lead to a ‘fiscal drag’ effect with tax revenues rising more quickly than the economy is growing.
  • Strong company profits and investment: An upturn leads to higher profits & investment – this is known as the accelerator effect and you will have covered this at AS level.
  • Cyclical boost to productivity: An expanding economy is good news for productivity because businesses are using labour resources more intensively. Productivity growth tends to be pro-cyclical.
  • A risk of higher inflation: Demand-pull and cost-push inflation can occur if AD exceeds potential GDP over time leading an economy to operate with a positive output gap.

Slowdown

A slowdown occurs when real GDP expands but at a reduced pace – e.g. the UK economy in 2008

Recession

  • The standard definition of a recession is ‘two consecutive quarters of negative GDP growth’ but a more inclusive definition is “a significant decline in activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators.”
  • A depression is a persistent downturn in output and jobs with an economy operating well below its productive potential and where there can be powerful deflationary forces at work. As a rule of thumb, a depression occurs when there is a fall in real GDP of more than 10 per cent from the peak of the cycle to the trough.

Symptoms of a recession

There are many symptoms of a recession – here is a selection of key indicators:

  1. A fall in purchases of components and raw materials from supply-chain businesses
  2. Rising unemployment and fewer job vacancies for those looking for work
  3. A rise in the number of business failures
  4. A contraction in consumer spending & a rise in the percentage of income saved (savings ratio)
  5. Falling private sector capital spending due to weak demand, deteriorating animal spirits, low profits and rising spare capacity
  6. A drop in the value of exports and imports of goods and services especially for countries with many industries exposed to changing demand in the world economy
  7. Price discounts offered by businesses and de-stocking as businesses look to cut unsold stocks
  8. Government tax revenues fall and the budget (fiscal) deficit and government debt grows quickly

The UK recession of 2008-10 was a result of a mix of internal and external factors – among them:

  • The end of the property boom – falling house prices hit wealth and led to a large contraction in new house building, many thousands of jobs were lost in the construction industry
  • Reductions in real disposable incomes due to wages rising less quickly than prices
  • The lagged effects of rising interest rates in 2007-08 (a tightening of monetary policy caused by rising food and energy prices and inflation above target)
  • A sharp fall in consumer confidence – made worse by the rise in unemployment
  • External events – such as recession in trading partners including the USA (which accounts for 15% of UK trade) and the Euro Area (55% of UK trade). Falling exports hit manufacturing industry hard
  • Cut-backs in production led to a negative multiplier effect causing a decline in sales and profits for supply-chain businesses. This has contributed to rising unemployment.
  • The credit crunch caused the supply of credit to dry up affecting many businesses and home-owners. And falling profits and weaker demand has caused a fall in capital investment – known as the negative accelerator effect. There are few signs of a large recovery in bank lending especially to small and medium sized enterprises (SMEs)

The Output Gap

How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? Has the recession had a permanent effect on our ability to supply goods and services? These sorts of questions link to an important concept – the output gap.

The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output.

Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium. If actual GDP is less than potential GDP there is a negative output gap. Factor resources such as labour and capital machinery are under-utilised and the main problem is higher than average unemployment.
More people out of work indicate an excess supply of labour, which means there is downward pressure on real wages. In the next time period, a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP then there is a positive output gap. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of demand-pull and cost-push inflation. Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.

Recession and the output gap

  • The UK will operate with a large negative output gap for some time.  But much depends on whether the recession will do long-term damage to our productive capacity.
  • This might arise from a rise in business failures and people leaving the labour market if they suffer long periods out of work (long term structural unemployment). This is known as a hysteresis effect

When a business is operating at less than 100% capacity, it is said to have “spare capacity”.
Demand factors:

  • Lower demand due to a decline in consumption or demand for raw materials
  • Loss of market share due to poor marketing or competitors introducing better products
  • Seasonal variations in demand - i.e. temporary spare capacity during off-peak times

Supply factors:

  • Increase in capacity not yet matched by increased demand
  • Because new technology has been introduced in anticipation of higher demand
  • Improvements in productivity mean capacity increases for a given level of demand

Spare capacity allows businesses to respond to an unexpected increase in demand, when there is productive slack, i.e. supply is price elastic. It also provides time for maintenance, repairs and employee training.

But it can also lead to inefficiency, which makes a business less competitive - and operating below capacity means higher unit costs because fixed costs are being spread over a reduced volume of output. This implies lower profitability than could be achieved.





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