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Understanding the Economic Cycle

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

Introduction

All countries experience regular ups and downs in the growth of output, jobs, income and spending. These fluctuations form what is known as the economic or business cycle.

Boom

A boom occurs when real national output is rising at a rate faster than the trend rate of growth. Some of the characteristics of a boom include:

  • A fast growth of consumption helped by rising real incomes, strong confidence and a surge in house prices and other forms of personal wealth
  • A pick up in the demand for capital goods as businesses invest in extra capacity to meet rising demand and to make higher profits
  • More jobs and falling unemployment and higher real wages for people in work
  • High demand for imports which may cause the economy to run a larger trade deficit because it cannot supply all of the goods and services that consumers are buying
  • Government tax revenues will be rising as people earn and spend more and companies are making larger profits – this gives the government money to increase spending in priority areas such as education, the environment, health and transport
  • An increase in inflationary pressures if the economy overheats and has a positive output gap.

The UK enjoyed sustained growth over the last fifteen from 1993 through to the end of 2008 but for better examples of booming countries we have to look overseas. The obvious example is China whose growth has been astonishing. And many other emerging market countries have experienced a decade or more of phenomenally rapid increases in the size of their economies. The BRIC countries have interested economists interested in understanding their fast rates of growth and development. In addition to China, the BRIC nations include Brazil, Russia and India.

Slowdown

Recession

Recession and rising unemployment

“There is a risk is that productive capacity in the UK economy could be permanently lost, as temporary job losses morph into long-term unemployment due to job-seekers losing skills and dropping out of the labour market”

Source: IMF Blog, August 2011


A recession means a fall in the level of national output i.e. a period when growth is negative, leading to a contraction in employment , incomes and profits .

  • The simple definition:
    • A fall in real GDP for two consecutive quarters i.e. six months
  • The more detailed definition:
    • A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

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

  • A fall in purchases of components and raw materials from supply-chain businesses
  • Rising unemployment and fewer job vacancies
  • A rise in the number of business failures including high profile names such as Woolworths
  • A decline in consumer and business confidence
  • A contraction in consumer spending & a rise in the percentage of income saved
  • A drop in the value of exports and imports of goods and services
  • Deep price discounts offered by businesses in a bid to sell excess stocks
  • Heavy de-stocking as businesses look to cut unsold stocks when demand is weak
  • Government tax revenues are falling and welfare spending is rising
  • The budget (fiscal) deficit is rising quickly

The difference between a recession and a depression

  • A slump or a depression is a prolonged and deep recession leading to a significant fall in output and average living standards
  • A depression is where real GDP falls by more than 10% from the peak of the cycle to the trough.

What are the main causes of a recession?

  • Recessions are unusual. To some economists they are an inevitable feature of a market economy because of the cyclical nature of output, demand and employment.
  • Every recession is different! It is undeniable that the global credit crunch has been hugely significant in causing the downturn even though macroeconomic policy has tried hard to prevent it.

The 2009 recession was the result of a combination of domestic and external economic factors and forces:

  • The collapse of the British property boom – falling house prices hit wealth and led to a large contraction in new house building
  • Reductions in real disposable incomes due to wages rising less quickly than prices
  • A sharp fall in consumer confidence – made worse by rising unemployment – leading to an increase in household saving – Keynes called this the ‘paradox of thrift.’ (see the chapter on Keynesian economics)
  • External events – such as recession in the UK’s major trading partners including the USA (which accounts for 15% of UK trade) and the Euro Area (which has 55% of UK trade)
  • UK exports declined because of recession in major trading partners and this hit manufacturing industry and other businesses that supply export firms
  • Cut-backs in production have led to a negative multiplier effect causing a decline in demand for consumer services and lower sales and profits for supply-chain businesses
  • The credit crunch caused the supply of credit to dry up affecting many businesses and home-owners
  • Falling profits and weaker demand has caused a fall in business sector capital investment – known as the negative accelerator effect.
  • Unemployment has started to rise early in the downturn – a reflection of our flexible labour market and sticky wages

An important evaluation point is that, in a recession, some businesses are affected more than others.

The extent of the effects will depend on the type of business, the market it operates in and the nature of the product sold

When real incomes are falling, we would expect to see a decline in demand for products with a high income elasticity of demand – typically these goods and services are regarded as luxury items by consumers, things that they might choose to do without when the economy is having a bad time.

Demand for products with negative income elasticity (i.e. inferior goods) might rise during a recession!

Slow Recovery for the UK

The British economy which contracted 6.4pc in the downturn, has rebounded 2.5pc, and is still 3.9pc below its peak. This recovery is taking longer to take root than from any 20th Century recession bar the Great Depression

Source: News reports, August 2011

Recovery

  • A recovery occurs when real national output picks up from the trough reached at the low point of the recession.
  • The pace of recovery depends on how quickly AD starts to rise after a downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a rise in demand
  • The state of business confidence plays a key role here. Any recovery might be subdued if businesses anticipate that a recovery will be temporary or weak in scale.

A recovery might follow a deliberate attempt to stimulate demand. In the UK a number of strategies have been used to boost confidence and demand and prevent the recession turning into a damaging depression:

  • Cuts in interest rates – the policy interest rate fell to 0.5% in the Autumn of 2008 and they have stayed at this low level ever since (0.5% at the time of writing in August 2012)
  • A rise in government borrowing – the budget deficit rose above £150bn in 2009 and government borrowing is likely to remain high for some time to come despite attempts to cut it
  • A policy of quantitative easing (QE) by the Bank of England to pump more money into the banking system in a bid to increase the supply of loans – now worth more than £325 billion.
  • A temporary cut in the rate of VAT from 17.5% to 15% (now reversed – VAT rose to 20% in 2011)
  • The launch of a car scrappage scheme for older cars worth up to £2000 per car and a consumer subsidy for households replacing their old boilers.


Why has the economic recovery in the UK economy been so weak?
The year 2009 saw the UK economy suffer a deep recession with a fall in real GDP of 4.4% and a steep rise in the unemployment rate. There was an encouraging recovery in national output in 2009 with real GDP growing close to the estimated trend rate of growth.

Since then however the pace of expansion in the UK economy has slowed down with growth of only 0.7% in 2011 and even weaker growth forecast for 2012. Indeed in the 2nd quarter of 2012, data showed that the British economy had fallen into a second recession – known as a double-dip.

The level of real GDP remains well below the peak reached at the end of the last economic cycle. Many commentators are forecasting that recovery will continue to be slow in the next couple of years and this poses big risks for households, businesses and the government.


Key economics indicators for the United Kingdom

2007

2008

2009

2010

2011

2012

Real GDP (% change)

3.5

-1.1

-4.4

2.1

0.7

0.5

Consumer spending (% change)

2.7

-1.5

-3.5

1.2

-1.2

0.8

Government spending (% change)

0.6

1.6

-0.1

1.5

0.1

-0.7

Capital investment spending (% change)

8.1

-4.8

-13.4

3.1

-1.2

-0.9

Exports of goods and services (% change)

-1.3

1.3

-9.5

7.4

4.6

1.9

Imports of goods and services (% change)

-0.9

-1.2

-12.2

8.6

1.2

1.5

Unemployment rate (% of labour force)

5.4

5.7

7.6

7.9

8.1

8.6

Government fiscal balance (% of GDP)

-2.8

-5.0

-11.0

-10.3

-8.4

-7.7

Short-term interest rate (per cent)

6.0

5.5

1.2

0.7

0.9

1.0

Consumer price index (% change)

2.3

3.6

2.2

3.3

4.5

2.6

Balance of Payments, current account balance (% of GDP)

-2.5

-1.4

-1.5

-3.3

-1.9

-2.1

 

Source: OECD World Economic Outlook, May 2012. Data for 2012 is a forecast

Why is the UK finding it hard to achieve a decent recovery in output and jobs? As always when we study macroeconomics, there are many factors at work. The UK is an open economy and our fortunes are affected not just by domestic events and policies but also what is happening in the global system.

Why is GDP growth so difficult to forecast?

Why is GDP growth so difficult to forecast?

When economists make forecasts about the future path for an economy they have to accept the inevitability of forecast errors. Conditions in the economy are always changing and no macroeconomic model can hope to cope with the fluctuations and volatility of indicators such as inflation, exchange rates and global commodity prices. GDP growth is hard to forecast – the chart above is the one produced by the Bank of England when they publish their quarterly Inflation Report. The projection area is their forecast, notice how the uncertainty grows as we move further from the present. In 2014, the range of probabilities for real GDP growth in the UK stretches from -1% (recession) to over 5% (very strong growth). The graph above is a probability fan chart, the darker the area, the higher is the probability attached to the outcome.

 




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