Transcript the business cycle

MACRO-ECONOMICS
The Business Cycle
IB ECONOMICS – A COURSE
COMPANION 2007 – OXFORD
UNIVERSITY PRESS
THE BUSINESS CYCLE
• In most developed country economies we can
generally see a pattern where there are
periods of rising growth, followed by periods
of slowing growth, and even fallen growth.
• This is known as the business cycle or trade
cycle.
• The business cycle is the periodic fluctuations
in economic activity measured by changes in
real GDP.
Phases of the Business Cycle
The phases of the business cycle
are known as:
• Boom
• Recession
• Trough
• Recovery
While fluctuations are in practice highly irregular, the most common illustration shows
a standard periodic cycle.
BUSINESS CYCLE
Recovery Phase
• In the recovery phase, there is increased
aggregate demand and an economic expansion.
• Consumption and investment rise, resulting in
higher levels of GDP.
• To meet increased aggregate demand, firms take
on more workers so that unemployment falls.
• The newly employed workers spend their new
incomes on durable goods and the process
repeats itself.
BUSINESS CYCLE
Boom
• GDP will reach its highest level at the peak of
the cycle.. BUT problems soon emerge....
• Capacity constraints in the economy are likely
to slow down further increases in GDP and
lead to inflationary pressures.
• Demand for money for investment is likely to
increase interest rates.
BUSINESS CYCLE
Recession
• The boom period results in higher inflation
and higher interest rates, which ultimately
leads to a fall in consumption and investment.
• This is beginning of the recession phase of the
cycle.
What is a the technical definition of a recession?
• A recession is defined as two consecutive quarters
of negative GDP growth, not just a decline in GDP
growth. In other words, GDP growth goes
backwards.
BUSINESS CYCLE
The Conditions of a Recession
• During a recession, consumption and
investment falls.
• Falling aggregate demand will lead to firms to
lay off workers, so unemployment rises.
• If more people are unemployed, then there
will be even less consumption.
• Low levels of demand result in lower rates of
inflation, or even deflation.
BUSINESS CYCLE
Trough
• At some point the contraction and recession will come
to an end.
• This is known as the trough.
• Output cannot continue to fall for ever, as there will
always be some people with jobs to maintain a given
level of consumption, foreigners will demand exports,
governments will continue to spend by running budget
deficits and people will be able to use savings to
finance consumption.
• Additionally the low demand for money for investment
will result in lower interest rates.
• Thus aggregate demand will pick up, the economy will
enter the recovery phase and the cycle will pick up.
The difference between actual
output and potential output is
known as the output gap. A
point A, there is a negative
output gap. The economy is
producing below its potential
output and unemployment is
likely to be a problem. At
point B, there is a positive
output gap. The economy is
producing above its potential
(eg: beyond capacity) and
inflation is likely to be a
problem.
As this diagram shows, the second recovery is at a higher level of real GDP than the
first and each boom is higher than the last. This illustrates the important point that
economies tend to go through periodic fluctuations in real GDP around their long
term growth trend, or long term potential output. The periodic fluctuations in
growth are shown as the actual output line while the economy’s long term potential
is shown as a steady increase in output. This represents the growth rate the
economy can sustain over time, but is not sustainable development.
The Short Run “Trade-off” between
Unemployment and Inflation
• When operating below potential ,
unemployment will be a problem, while
operating above potential will result in
inflationary pressure (rising rate of inflation.)
The causes of Business Cycles
• Economists have long studied the causes of
the business cycles and often hypothesised
about the length and magnitude of a “typical”
cycle.
• However, there are no straight answers to
these questions.
• One theory (of many) is that a country’s
business cycle may be linked to its electoral
cycle
Elections and the Business Cycle
• A government will stimulate an economy with
expansionary policies to create a boom and lower
unemployment just before an election, and then
put into place less popular contractionary policies
after it has been elected.
• A criticism of such policies is that they can widen
the magnitude of the cycle, with higher levels of
unemployment and inflation than there would be
if the economy were left on its own.
Expansionary Phase of GDP
Increased demand for imports
• During an expansionary phases, where national
income is rising, an economy tends to purchase
more imports of goods and services.
• As income rises, so does consumption and much
of what consumers buy is likely to be imported.
• Even if the final products consumed are produced
domestically, it is quite possible that they will be
made up of some imported components.
Expansionary Phase of GDP
Inflation and Exports
• As inflationary pressure builds during an
expansion, the prices of the country’s exported
goods and services will also rise.
• This will makes its exports less competitive on
world markets and may lead to lower export
revenues.
• During an expansion, import expenditure rises
and export revenue may fall, thus worsening the
country’s balance of trade in goods and services.
• This is known as its current account balance.
Contractionary Phase of GDP
Impact on Exports/Imports
• Import spending may as people can afford
fewer imported goods and services.
• Exports prices may become more competitive
internationally and this may result in greater
export revenues.
• Thus the current account balance may
improve.
Business Cycle and
Macroeconomic Objectives
GOAL
EXPANSION OF GDP
CONTRACTION OF GDP
Economic Growth
Achieved – GDP rises
Not Achieved – GDP falls
Low Unemployment
Achieved – more workers
are needed to produce the
growing output
Not achieved as workers
are laid off when less
output is demanded.
Low and Stable Rate of
Inflation
Not achieved – Inflationary
pressure builds.
Achieved-inflation falls
Favourable Balance of
payments position
Not achieved = as the
current account worsens
Achieved – the current
account improves.