Economic Cycle

Understanding the Economic Cycle

All countries experience regular ups and downs in the growth of output, jobs, income and spending.

UK Real GDP

Explaining the economic 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 share prices
• A pick up in demand for capital goods as businesses invest in extra capacity to meet strong demand and to make higher profits
• More jobs created and falling unemployment and higher real wages
• High demand for imports which may cause the economy to run a larger trade deficitbecause 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 areas such as education, the environment, health and transport
• An increase in inflationary pressures if the economy overheats and has a positive output gap

Slowdown

• A slowdown occurs when the rate of growth decelerates – but national output is still rising
• If the economy grows without falling into recession, this is called a soft-landing

Recession

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

A simple definition:

• A fall in real GDP for two consecutive quarters i.e. six months

A 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 retail sales.

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

1. A fall in purchases of components and raw materials (i.e. intermediate products)
2. Rising unemployment and fewer job vacancies available for people looking for work
3. A rise in the number of business failures and businesses announcing lower profits and investment
4. A decline in consumer and business confidence
5. A contraction in consumer spending & a rise in the percentage of income saved
6. A drop in the value of exports and imports of goods and services
7. Large price discounts offered by businesses in a bid to sell their excess stocks
8. Heavy de-stocking as businesses look to cut back when demand is weak – causes lower output
9. Government tax revenues are falling and welfare benefit spending is rising
10. 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
• An example of a country that has suffered a depression in recent years is Greece. National output has fallen in six successive years and real GDP is more than 25% lower than at the peak of the cycle

Recession and depression

Recovery

• This occurs when real GDP picks up from the trough reached at the low point of the recession.
• The state of business confidence plays a key role here. Any recovery might be subdued if businesses anticipate that it will be temporary or weak in scale.
• A recovery might follow a deliberate attempt to stimulate demand. In the UK we have seen

1. 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 since then
2. A rise in government borrowing
3. 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 £375 billion.

Why is GDP growth difficult to forecast?

When economists make forecasts about the future path for an economy they have to accept the inevitability of forecast errors. No macroeconomic model can hope to cope with the fluctuations and volatility of indicators such as inflation, exchange rates and global commodity prices.

• Uncertain business confidence levels
• Fluctuations in exchange rate
• External events e.g. volatile oil and gas prices
• Uncertain reactions to macro policy changes
• Rate of business job creation hard to forecast

MEASURES TO RAISE THE PROPENSITY TO CONSUME

Measures to Raise the Propensity to Consume

In the short period due to psychological and institutional factors, it is very difficult to stimulate consumption function which possible in long-run measures to raise propensity to consume in long run are as follows:

1. Income Redistribution:

Propensity to consume of poor people is higher than propensity to consume of rich people. Therefore, redistribution of income helps to raise propensity to consume if redistribution of income favours poor. Thus, propensity to consume can be raised transferring income from the rich to poor.

2. Social security:

Various type of social security measures raise propensity to consume in long run. For example provision for unemployment compensation, old age allowance, widow allowance, etc., remove uncertainties in future. Therefore, tendency to save is reduced and people start to consume more.

(3)  Wage policy:

Wage rates are considered measure to raise consumption in both short-run and long-run point of view. But in short run, labour productivity can’t be increased more will harm the labours more than benefit because increased wages will increase cost which may lead to unemployment. Thus in long-run, if wage rate and productivity of labour both are increased in same way then it will tend to raise level of consumption in economy.

(4)  Easy credit facilities:

Consumption function shifts upward by the help of cheap and easy credit facilities.

(5)  Advertisement and publicity:

In modern time, advertisement and publicity, propaganda and salesmanship are effective tools to attract consumers towards commodities because these make the consumers familiar with use of product. It raises consumption function of people.

(6)  Development of infrastructures:

            Development of infrastructures like transport, communication, hydropower, etc., helps to shift consumption function upward.

(7)  Urbanization:

In urban areas people are highly influenced by the demonstration effect. This shifts the consumption function upward.