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A2 Macroeconomics / International Economy

Nature and Causes of Fluctuations in Economic Activity

The economic cycle

All countries experience business cycles (sometimes known as trade cycles) where the rate of growth of production, incomes and spending fluctuates over a period of time. The length and volatility of each of these cycles tends to change over time partly because the structure of an economy evolves. Often, as economists, we find that previously observed theoretical relationships between different variables, for example between unemployment and inflation, appear to have changed. This can make life difficult for policy-makers when they are trying to manage the economy and meet their objectives. We will tend to focus on what has been happening to the UK economy over recent years. But bear in mind that many of the ideas here can be applied and tested with other countries many of whom will be at different stages of their economic development.

Short term economic growth for the UK

The annual growth of UK real GDP between 1986 and 2006 is shown in the next chart. The data shows the annual percentage changes in national output at constant prices, in other words the figures have been adjusted to take into account changes in the general level of prices.

The business cycle for the UK over the last twenty-five years

The UK last experienced a recession in 1990-92 during which over three million people became unemployed. Since 1993, the UK has enjoyed over thirteen years of sustained growth. The strongest years during the current cycle came in 1997 (3.3%) and in 2000 when real GDP expanded by nearly 4%. Taken as a whole, the UK economy has now enjoyed its longest period of sustained growth for over forty years whereas other countries have experienced recessions or very slow growth in the last few years, including the United States, Germany, France and Japan.

Theories of the Economic Cycle

In this section we consider some theories about the economic cycle and in particular how a country moves from one stage of a cycle to another. Business cycle models are often divided into two groups:
Endogenous models of the cycle try to explain cyclical fluctuations in terms of factors which lie within the economic system suggesting that, even if there were no shocks to an economy, there would still be variations in the growth of income, spending and output

Exogenous models of the cycle argue that cycles can be started by demand-side or supply-side shocks to the economic system. We will return to the idea of shocks a little later on

Endogenous models of the business cycle

1. The Stock Cycle

The stock cycle helps to explain some of the changes in national output. To see this we will look at what happened the last time that the economy had a recession. In 1989-90 the rate of growth in the economy slowed right down at the end of what had been a very strong consumer boom.

During the recession businesses cut back on production and tried to off-load stocks

Consider the effects of such a fall in consumer demand which initially (in the first half of 1989) caused an increase in stocks of goods and raw materials held by firms. Because holding stocks can be a drain on a company’s finances (they must be stored somewhere and may have a limited product or shelf life), an unexpected rise in unsold stocks acted as a signal to firms to cut back production - leading to a fall in demand for intermediate products such as components. This process of de-stocking then worked its way through the supply-chain. So for example, companies providing raw materials and other supplies also suffered a downturn in demand. The result was a fall in production and the laying off of workers. Throughout 1991, 1992 and for most of 1993, businesses in the UK economy were seeking to reduce their stock levels because of weak demand and low profits. One way of doing this is to try to sell unsold products at discounted prices; this is indeed what happened in the UK at the time, the effect being a fall in the rate of inflation.
The British economy started to come out of the recession in 1993 and growth strengthened considerably in 1994 partly on the back of a boom in exports overseas.
Theory tells us that when AD starts to pick up at the start of a recovery and stock levels dip, this is a signal for firms to step up production to re-build inventories and meet an increase in consumer demand. Notice how, in the second half of 1994, stock levels started to rise quite strongly. The very act of increasing production to rebuild stocks helps to bring the economy further away from the low point of the recession.

Is there evidence in this chart for the sort of stock cycle explained in the previous section?

Is the stock cycle becoming less important in helping us to explain the economic cycle? Some economists believe that the answer is yes because improvements in information technology have changed the nature and importance of the stock cycle in most developed countries. For example, the use of ‘just-in-time’ stock delivery systems common place in industries such as motor car manufacturing and widespread improvements in stock control has reduced the need for businesses to hold high levels of stocks of intermediate products. It is now easier for supply to match changes in demand in the short term.
The stock cycle is not irrelevant, but we need to have other theories to be able to explain cyclical fluctuations in an economy.

2. Changes in aggregate demand

At AS level, you will have been introduced to the concept of aggregate demand (AD) – i.e. the total demand for goods and services produced within the domestic economy. The reality is that changes in the growth of real GDP in the short term are indeed mainly caused by changes in the components of aggregate demand.

The annual rates of growth of the components of demand are shown in the table below

The key features of the above table to consider are:

Strong consumption: Consumer spending has been the driving force behind the growth of the British economy over recent years. In the short term this has had beneficial effects – it has helped to absorb some of the weakness of the investment and export sectors. But there has been a price to pay because the consumer boom has been driven by rising house prices and an strong level of demand for credit and the risk is that strong consumer demand has led to an unbalanced economy and an unsustainable “debt mountain”. By the spring and early summer of 2005 it was becoming clear that the consumer boom was coming to an end as people started to save more and there was a downturn in retail sales. Indeed in 2005 the annual growth of consumption was just 1.3%, the weakest growth since the last recession.

Weak investment: Capital investment on new plant & machinery and buildings has been relatively weaker although there was a pick up in 2004 with investment rising by six per cent. Over seventy five per cent of capital spending is done by private sector businesses and within this total the majority of new investment comes from the service sector which accounts for nearly seventy per cent of total GDP. Some major infrastructural projects such as the new Wembley Stadium, Terminal 5 at Heathrow and the National Health Service building programme have contributed to a faster growth of investment demand.

High demand for imports: Import growth has exceeded exports in Britain in recent times leading to a further increase in the trade deficit which reached a record level in 2005. Import demand has been strong because of the high exchange rate and household spending. 2005 was the first year since 2000 that the volume of exports of goods and services grew faster than the volume of imported products coming into the country.

Different stages of the economic cycle

Economic Boom

A boom occurs when real GDP grows much faster than the trend growth rate of about 2.5% per year. In a boom phase, AD is high and typically, businesses respond by increasing production and employment. They may also opt to widen their profit margins by raising prices and this can lead to cost-push and demand-pull inflation. The main characteristics of a boom are as follows:

High aggregate demand: A boom in demand in the UK is nearly always driven by consumer spending. But government spending, an increase in capital investment and a surge in exports can also add to demand for goods and services. Exports might be boosted by a rapid growth of world trade or a fall in the exchange rate.

A tightening of the labour market: An expanding economy should lead to higher employment and an increase in real incomes of people in work.  The ‘tightness of the labour market’ can be measured in various ways for example the rate of unemployment or the number of unfilled job vacancies. Surveys of labour shortages also provide information about the balance of supply and demand in the labour market. If labour shortages become severe, the risk is that wage inflation will accelerate leading to a rise in unit labour costs feeding through to higher retail prices. The possible trade-off between unemployment and inflation is explored in the later chapters on the Phillips Curve and the NAIRU.

High demand for imports and a wider trade deficit: A common feature of a boom is that the demand for imports increases because of a high marginal propensity to import among consumers. Unless the growth of UK exports can match this surge in import demand, the trade deficit will widen.

Impact on government finances: An economic boom provides a “fiscal dividend” to the government because tax revenues will be rising quickly as more people are in work and they are earning and spending more money. An expanding economy also helps to reduce state spending on welfare payments.

Strong company profits and investment: A cyclical upturn normally leads to a strong growth in profits and an increase in investment. The link between demand and planned investment can be explained using the accelerator theory of investment.

Cyclical boost to productivity: An expanding economy is good news for labour productivity because businesses are stretching to supply the extra demand by using their existing labour resources more intensively and making more efficient use of existing capacity. The rise in productivity helps to keep unit labour costs under control. To use the current jargon – productivity growth tends to be pro-cyclical – i.e. it picks up speed when the economy is strong, but can falter when demand and production weakens.

A risk of a pick-up in inflation: Both demand-pull and cost-push inflation can occur if AD exceeds potential GDP over a prolonged period. An excellent example of this was the boom of the late 1980s that led to rising inflation and several years of very high interest rates. It is the job of monetary and fiscal policy to make sure that a strong cyclical upturn does not get out of control.

Since the early 1990s the UK economy has enjoyed stable inflation and continuous growth

As the chart above shows, in the late 1980s, there was a sharp rise in inflation as a result of an overheating economy during the mid-late 1980s. The economy then went into recession which helped to bring down inflation. Since the early 1990s, we have seen a favourable combination of steady growth and low, stable inflation. Indeed for nearly all of period baring a short phase during 2005, the rate of growth of real GDP has exceeded the rate of growth of consumer prices. In other words, there has been an improvement in the trade off between economic growth and inflation.

Showing economic growth using an AD-AS framework

In the following diagram we see an outward shift in AD. Equilibrium national income rises from Y1 to Y2 and takes real national output closer to potential output (shown at level Yfc). If AD were to rise further beyond AD2, this risks creating excess demand (i.e. a positive output gap). At this stage of the business cycle, short run aggregate supply is drawn as inelastic and there is growing pressure on factor resources which might trigger an increase in commodity prices and wages putting upward pressure on inflation.

In the diagram below the outward shift of AD had taken the economy beyond potential GDP leading to a positive output gap measured by the distance AB. This may then cause higher wages and a rise in labour costs and also the prices of other factor inputs leading to an inward shift in SRAS. This takes the economy towards full-capacity output but with a higher price level (P3).

Economic Slowdown

A slowdown occurs when real GDP continues to expand but at a reduced pace. If a country can achieve growth without falling into a recession, this is termed a “soft-landing” whereas (maintaining the aeronautic analogy) a full recession is coined a “hard-landing”.

Economic Recession

A recession means an actual fall in real national output and a contraction in employment, incomes and profits. In technical terms a recession is a period of two quarters (i.e. six months) when real GDP declines. An alternative interpretation of the term recession is that it occurs when the economy is operating persistently with a level of real national output below its potential and that the gap between actual and potential GDP continues to widen.

The output gap has remained within around 1% or -1% of GDP since 1996

We can see the output gap in the chart above. Can you see the effects of the recession in 1990-92? – this left the economy with a large negative output gap, i.e. national output was well below its estimated potential. The recovery during the mid 1990s caused the output gap to narrow and by 1997 the UK had reached potential GDP. Since then, although there have been cyclical variations, the output gap itself has remained very small – ranging between +1% and -1% of GDP. This is one of the reasons that the British economy has managed to continue its current growth phase.