Chapter 12 the Trade Cycle

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Chapter 12

The macroeconomic context 1 the trade

cycle

CHAPTER 12 THE TRADE CYCLE

136 www.studyinteractive.org

CHAPTER CONTENTS

LEARNING OUTCOMES ------------------------------------------------- 137

INTRODUCTION --------------------------------------------------------- 138

AGGREGATE DEMAND AND AGGREGATE SUPPLY -------------------- 139

THE CIRCULAR FLOW OF INCOME ------------------------------------ 140

STAGES IN THE TRADE CYCLE ----------------------------------------- 145

IMPACT OF THE TRADE CYCLE ON THE BUSINESS ENVIRONMENT ---------------------------------------------------- 146



LEARNING OUTCOMES

(a) Explain the determination of macroeconomic phenomena, including

equilibrium national income, growth in national income, price inflation,

unemployment, and trade deficits and surpluses.

(b) Explain the stages of the trade cycle, its causes and consequences for the

policy choices of government.

(c) Explain the consequences of the trade cycle for organisations.



INTRODUCTION

In macroeconomics we still examine demand and supply, but now look at the

economy as a whole. We now consider the total level of spending in the economy

and the total level of production in other words we examine aggregate demand

and aggregate supply.

The four corners of macroeconomic concern

Economic growth

A growing economy leads to more goods and services for people to consume,

raising living standards, education and life expectancy. A r

growth over two or more successive quarters.

Unemployment

UK unemployment currently stands at approx.7.8%. During the Great Depression

unemployment reached 23%.

Inflation

The general rise in prices throughout the economy, currently UK inflation is running

at approx. 2.8%!

Balance of payments / exchange rate

Measure of all transactions between residents of a country and the rest of the

world. If we spend more foreign currency than we earn this will lead to a balance of

payments deficit, conversely if we earn more than we spend this will lead to a

surplus in both instances there are wider economic implications.

Government policy

In broad terms, government policy focuses upon achieving -

o High / stable economic growth

o Low unemployment

o Low inflation

o Avoiding balance of payments deficits / fluctuating exchange rates.

Economic theory

Broad economic theory may be divided between free marketeers on the political

right and those that advocate market intervention on the political left.



AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate demand

The total value of demand for goods and services produced in the economy during

a year.

Aggregate supply

The maximum potential output of the economy during a year.

In relation to the above diagram students are expected to be able to identify

inflationary and deflationary gaps.

Inflationary gaps arise when planned aggregate demand exceeds the full

employment of national income.

Deflationary gaps arise when the planned level of aggregate demand is below the

level needed to assure full employment.

Yf

AS Prices

AD

Real national income

Y

P

At full employment prices rise as no

scope to increase real output



THE CIRCULAR FLOW OF INCOME

Closed economy

Characteristics of a closed economy include:

No government

No overseas sector

All income is spent on consumption

All production is sold to households.

Discussion 1

How would one calculate the level of gross domestic product within the above

closed economy?

Firms Households

Factor income paid by firms

Expenditure on goods and services

Productive resources

Goods and services



Open economy

With an open economy, the above diagram must take into consideration

withdrawals and injections, which comprise the following elements:

Withdrawals Injections

Savings (S) Investment (I)

Taxation (T) Government spending (G)

Imports (M) Exports (X)

Discussion 2

Adopting an expenditure approach, how would one measure GDP within an open

economy?

Illustration

Households Firms

Financial Sector

Government Sector

Foreign Sector

Withdrawals Injections



Marginal propensities to consume and withdraw

Figure 1 shows the consumption function for an economy, illustrating the way in

which planned consumption varies as income rises.

Marginal propensity to consume (MPC) measures the percentage of any

additional income that is spent on consumption.

MPC is calculated as follows:

Exercise 1

o $360, and household

consumption has increased from $260 to $290.

Consumption

Income

Y = C

Autonomous consumption

Figure 1

Consumption

C = a + bY



Marginal propensity to withdraw (MPW) comprises:

1. Marginal propensity to sale (MPS); plus

2. Marginal propensity to tax (MPT); plus

3. Marginal propensity to import (MPM).

Therefore

MPW = MPS + MPT + MPM

MPC + MPW = 1

The multiplier effect

each $1 injected into an economy. The question being whether national income

rises less than in proportion to, equal to, or by a greater extent than the initial

injection.

Exercise 2

Consider the following exercise with regard to a closed economy that experiences a

$100m injection, but with a MPC of 0.9.

Increase in expenditure

$m

Increase in savings $m

Income rises $100 -

90% consumed $90m $10m

If the exercise was continued, then

Total increase in income

The multiplier is calculated as follows:

In an open economy, withdrawals will include taxation and imports, as well as

savings. Therefore the calculation may be written as follows:



Determinants of injections

As noted previously, injections comprise: investment (I), government spending (G)

and exports (X).

Consider three explanations that may bring about an increase in each:

1. Investment

2. Government spending

3. Exports



STAGES IN THE TRADE CYCLE

Trade cycles refer to periods of accelerated growth in national income followed by

a slow-down in growth resulting in a drop in national income, referred to as a

recession.

Label the phases of the trade cycle:

o A

o B

o C

o D

Output

Time

Actual output

A

Trend in output

B C

D



IMPACT OF THE TRADE CYCLE ON THE BUSINESS

ENVIRONMENT

The recovery and boom phase:

Due to high levels of demand in the economy, the direct impact on business:

Need to expand capacity;

Resource shortages, in terms of both staffing and materials;

New entrants into the market seeking a share of the high profits;

Acquisition activity as firms look to consolidate their position in the market;

Inflation;

Exchange rate depreciation.

Secondary effects of the trade cycle include:

Government may increase interest rates to deal with inflation;

Government may look to increase taxation;

Government may cut back on expenditure.

The recession and depression phases:

During these phases, demand is falling, along with low levels of business and

consumer confidence in the economy. The direct impacts of which include:

Firms will need to cut back focusing primarily on core activities, this may

involve cutting back on staffing numbers.

Firms with excess levels of stock will look to off-load at lower prices. With less

cash to spend, a fall in demand will also place downward pressure on prices.

Investor pressure shareholders and other key investors will look to maintain

profits, forcing firms to make wholesale cut-backs across the business.

Secondary effects of the above, insofar as government policies may include:

Banks will look to reduce interest rates so as to encourage borrowing and

discourage savings.

Government may commence large public sector projects so as to inject cash

into the economy.

Government may consider targeted tax reductions so as to stimulate

business activity in certain sections of the economy.

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Chapter 12 the Trade Cycle

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