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 CYCLERecession

• 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 CYCLEThe 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 CYCLETrough

• 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.

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 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.

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 GDPIncreased 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 GDPInflation 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 GDPImpact 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.