Economic Cycles

In AS economics you will have been introduced to the concept of the economic (or business) cycle a time period where the growth of production, incomes and spending fluctuates over time. The potential volatility of economic cycles for countries around the world has been headline news in the last couple of years. Britain has just suffered one of the deepest slumps in her post-1945 history; the Euro Zone economies have struggled to climb out of recession amid unprecedented levels of financial turbulence. Indeed many of the worlds richest countries have witnessed damaging contractions in economic activity since 2008. Few nations have escaped although countries such as Australia, Norway and Canada seem to have emerged from the global financial crisis (GFC) in relatively good shape.

The Economic Cycle - Growth in UK National Output

Annual percentage change in GDP at constant prices

6 5 4 3 2 1
Percent

6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6

0 -1 -2 -3 -4 -5 -6 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: UK Statistics Commission

We have had three recessions in the UK since the early 1980s, the most recent started in the spring of 2008 and is thought to have ended (perhaps temporarily) in the spring of 2010. Real GDP fell by more than 4.5% in 2009 and - from peak to trough the recession led to a 6% fall in the value of national output. In contrast, between the years 1993 and 2008 Britain enjoyed a period of sustained growth combined with low inflation and falling unemployment an era once dubbed by the Governor of the Bank of England, Mervyn King as the NICE decade, NICE standing for non-inflationary continuous expansion. This came to an abrupt halt in 2007 when global inflationary pressures soared and when the world economy was shocked by the sub-prime crisis and the ensuing credit crunch and widespread downturn. What causes the economic cycle? For A2 it is important to have a good grasp of the dynamic causes of different stages of the cycle. And crucially to understand how macro developments in one country or region impact on other economies through trade, capital and other resource flow. When looking at the causes of cyclical changes in production, incomes and jobs there are two main approaches:

Endogenous models to explain cyclical fluctuations in terms of internal events or policies i.e. changes which lie within the economic system Exogenous models argue that turning points in an economic cycle happen because of external demand-side or supply-side shocks from beyond the economic system.

Endogenous Models 1. The Stock Cycle The stock cycle helps to explain changes in national output because nearly all businesses hold stocks of finished products or raw materials and components as a way of balancing changes in demand. When demand is strong and running ahead of supply, stocks fall and this is a signal either to raise prices and/or to expand production. Re-stocking by increasing production can be a way out of a recession. Consider for example the impact of the car-scrappage scheme in the UK which was introduced as a way of boosting demand for new vehicles during the recession. This 2,000 cash incentive did lead to a spike in demand some of which was met by selling vehicles stuck in vast car parks adjacent to the assembly plants. But some of the extra spending on new vehicles will have necessitated a rise in demand for all of the different components used in making a new passenger car there was a positive impact on supply-chain businesses and a rise in demand for stocks leading to a injection of extra production and incomes in the vehicle industry. In the early stages of a recession, any slump in consumer demand will cause businesses to cut back on output so as to reduce the volume of stocks. We saw this effect at work in 2008-09 as the UK recession became a reality consider the evidence from the chart below. The chart shows de-stocking, in the 1st quarter of 2009, the reduction in the value of stocks amounted to more than 5bn. As British-based carmakers produced fewer cars and house-builders cut back on the number of new homes being built, so the derived demand for cement, bricks, glass, steel, rubber and other raw materials and component parts suffered. Key point: Changes in the stock cycle have important multiplier effects on supply-chain industries. The use of just-in-time (JIT) stock delivery systems in industries such as motorcar manufacturing has reduced the need for businesses to hold high levels of stocks of intermediate products. It is now easier for supply to match changes in demand. For example, stocks tend to be less important in the service sector, which now accounts for more than 75 per cent of UK national output.

Changes in stocks and the UK economic cycle

Evidence for the stock cycle in the UK 4 3 2 1 0 -1 -2 -3 -4 -5 -6 4 3 2 1 0 -1 -2 -3 -4 -5 04 05 06 07 08 09 10
Source: Reuters EcoWin

Percent

Real GDP Growth

4 3 2 1 0 -1 -2 -3 -4 -5 -6 4 3 2 1 0 -1 -2 -3 -4 -5

(billions)

Change in the value of stocks

2. Fluctuations in one or more components of aggregate demand (AD) You will have become familiar with the make-up of aggregate demand during your AS course. No study of economic cycles is complete without a quick focus on the components of AD because movements in real GDP for any country in the short term are mainly due to changes in the components of AD and shifts in short-run aggregate supply (SRAS). Changes in the components of demand for the UK are shown in the chart below. As with most of the advanced economies, household consumption is the largest element accounting for over 65% of spending on goods and services.

Components of aggregate demand for the UK economy Consumer Spending bn 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 691.5 713.5 739.8 762.8 787.5 805.3 819.6 837.4 842.2 813.2 General Govt Spending bn 244.4 250.2 258.9 267.8 275.9 281.3 285.2 288.8 293.5 297.1 Real GDP bn 1142.4 1170.5 1195.0 1228.6 1264.9 1292.3 1328.4 1364.0 1363.1 1296.4

Gross Capital Investment bn 184.6 189.3 196.2 198.4 208.5 213.6 227.2 245.1 232.8 197.8 bn 5.3 6.4 2.6 4.6 5.4 5.0 5.2 6.8 0.1 -15.4

Exports bn 283.5 292.0 294.9 300.3 315.4 340.3 378.0 368.3 372.1 332.7

Imports bn 299.1 313.4 328.7 335.8 359.1 384.5 419.6 416.3 411.1 360.2
th

Source: UK Economic Accounts, HM-Treasury, accessed 19 August 2010

billions

Here is a way of breaking down the aggregate demand calculation: 1. Domestic demand 2. External demand =C+I+G = X-M (also known as net trade)

3. GDP (Aggregate demand) = C+I+G+X-M For some countries domestic demand is a high % of total spending (e.g. the USA). In contrast in China, the economy has been driven forward by persistently high trade and current account surpluses and domestic spending has been relatively lower there are strong signs that the Chinese government wishes to boost consumer spending and rely less heavily on exports. Recap on the main Stages of the Cycle Boom A boom happens when real GDP grows faster than the trend growth rate over a number of years. In a boom phase, AD is high and businesses expand output and employment and they may also raise profit margins by increasing prices - this can lead to cost-push and demand-pull inflation. The main characteristics of a boom are: 1. A tightening of the labour market: The tightness of the labour market can be measured by the rate of unemployment or the number of unfilled job vacancies. A sustained boom may lead a country towards full-employment. 2. High demand for imports: During a consumer-led boom, demand for imports increases because of a high marginal propensity to import. 3. Public finances: An expansion provides a fiscal dividend to the government because tax revenues will be rising as people are earning and spending more. Business profits will be increasing and state spending on welfare tends to fall. A boom can lead to a fiscal drag effect with tax revenues rising more quickly than the economy is growing.

4. Strong company profits and investment: An upturn leads to higher profits & investment this is known as the accelerator effect and you will have covered this at AS level. 5. Cyclical boost to productivity: An expanding economy is good news for productivity because businesses are using their existing labour resources more intensively. Productivity growth tends to be pro-cyclical. 6. A risk of higher inflation: Demand-pull and cost-push inflation can occur if AD exceeds potential GDP over time leading an economy to operate with a positive output gap. Slowdown A slowdown occurs when real GDP expands but at a reduced pace. If a country can achieve growth without falling into a recession, this is termed a soft-landing. Recession The fashionable definition of a recession is two consecutive quarters of negative GDP growth but a broader and more inclusive definition is a significant decline in activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A depression is a persistent downturn in output and jobs where an economy operates well below its productive potential and where there can be powerful deflationary forces at work. As a rule of thumb, a depression occurs when there is a fall in real GDP of more than 10 per cent from the peak of the cycle to the trough. Symptoms of a recession There are many symptoms of a recession here is a selection of key indicators: 1. A fall in real national output (GDP) 2. A fall in purchases of components and raw materials from supply-chain businesses 3. Rising unemployment and fewer job vacancies for those looking for work 4. A rise in the number of business failures 5. A steep decline in both consumer and business confidence (sentiment) 6. A contraction in total consumer spending & a rise in the percentage of income saved 7. Falling business capital spending due to weak demand, low profits and rising spare capacity 8. A drop in the value of exports and imports of goods and services especially for countries with sizeable industries exposed to changing demand in the world economy 9. Price discounts offered by businesses and de-stocking as businesses look to cut unsold stocks 10. Government tax revenues are falling and the budget (fiscal) deficit is rising quickly

UK Real National Output

Quarterly value of real GDP 350 350

325

325

300

300

275

275

GBP (billions)

250

250

225

225

200

200

175

175

150 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

150

Source: Reuters EcoWin

Understanding the causes of a recession Every recession is different. It is undeniable that the credit crunch and global financial crisis has been hugely significant in causing the most recent downturn even though macroeconomic policy has tried hard to prevent it through a range of stimulus policies. Key points 1. There has been a fall in several components of AD especially investment and exports 2. Recession has been deeper than expected because of a collective loss of confidence animal spirits and recovery cannot happen until confidence returns 3. A weak global economy (the lowest growth for over 60 years with world GDP contracting by 2% in 2009) and a contraction in world trade of 10% in 2009. 4. Countries that produce large volumes of cyclical goods such as capital goods and products linked to housing have tended to do worse in the downturn, for example Germany and Japan are suffering from this The UK recession is a result of a mix of internal and external factors among them: The end of the property boom falling house prices have 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 and rising unemployment The lagged effects of rising interest rates in 2007-08 (a tightening of monetary policy caused by rising food and energy prices and inflation above target) A sharp fall in consumer confidence made worse by the rise in unemployment leading to a rise in saving

billions

External events such as recession in major trading partners including the USA (account for 15% of UK trade) and the Euro Area (55% of UK trade). UK exports have declined and this has hit manufacturing industry hard

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. This has contributed to rising unemployment. The credit crunch has caused the supply of credit to dry up affecting many businesses and home-owners. And falling profits and weaker demand has caused a fall in business sector capital investment known as the negative accelerator effect.

The Output Gap How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? Will the current recession have a permanent effect on our ability to supply goods and services? These sorts of questions all link to an important concept the output gap. The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output. Negative output gap downward pressure on inflation The actual level of real GDP is given by the intersection of AD & SRAS the short run equilibrium. If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as labour and capital machinery are under-utilised and the main problem is likely to be higher than average unemployment. A rising number of people out of work indicate an excess supply of labour in the factor market, which means there is downward pressure on real wage rates. In the next time period, a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical assuming labour markets are flexible. Positive output gap upward pressure on inflation If actual GDP is greater than potential GDP then there is a positive output gap. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of demand-pull and cost-push inflation. Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical assuming labour markets are flexible. Recession and the output gap The latest forecasts from the OECD suggest that the UK will operate with a large negative output gap for some time to come. The gap between actual and potential GDP is estimated to widen to its greatest level since the recession of the early 1980s. Much depends on how long and how deep is the recession. There are some economists who argue that the fall out from the slump will have longterm damage to our productive capacity and that the UK economy may experience a permanent loss of output equivalent to between 4 and 5 per cent of GDP. This might arise from a sharp rise in the number of business failures together with a long-term loss of people from the labour market if they suffer extended periods out of work. This is known as a hysteresis effect. Many firms are responding to the recession by scaling back their capacity - from airlines to motor car manufacturers there are plenty of examples - check out some of the related articles listed below. In the short term, a negative output gap means that there is little risk of demand-pull inflation and this may influence the interest rate decisions of the Bank of England. That said, the size of the output gap has little bearing on cost-push inflationary pressures, except to the extent that a global economy operating well below potential may lead to lower commodity prices.

United Kingdom, Output gap of the total economy

Actual GDP - Potential GDP, measured as a percentage of potential GDP source: OECD

5 4 3 2
Percentage of potential GDP

5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7

1 0 -1 -2 -3 -4 -5 -6 -7 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Source: OECD World Economic Outlook

Spare Capacity When a business is operating at less than 100% capacity, it is said to have spare capacity. Demand factors: 1. Lower demand due to a decline in consumption or demand for raw materials 2. Loss of market share due to poor marketing or competitors introducing better products 3. Seasonal variations in demand - i.e. temporary spare capacity during off-peak times Supply factors: 1. Increase in capacity not yet matched by increased demand 2. Because new technology has been introduced in anticipation of higher demand 3. Improvements in productivity mean capacity increases for a given level of demand Spare capacity can be useful in that it allows businesses to respond to short-term or an unexpected increase in demand, when there is some productive slack, supply is price elastic. It also provides time for maintenance, repairs and employee training. But it can also lead to inefficiency, which makes a business less competitive - and operating below capacity implies higher unit costs than the competition because the fixed costs are being spread over a reduced volume of output. This implies lower profitability than could be achieved. There is also the risk of de-motivated employees. Factory workers who have been made redundant often say that they could see it coming because production had been quiet. And economists will always point to the opportunity cost of the spare capacity - i.e. the returns foregone from the cash invested

Businesses operating at full capacity

Source: The British Chambers of Commerce, Full capacity survey data, quarterly data

50

50

45 Services

45

40
Net balance

40

35

35

30 Manufacturing

30

25

25

20
00 01 02 03 04 05 06 07 08 09 10

20

Source: Reuters EcoWin

Output gaps in the world economy % of potential GDP 2000 High income countries Developing countries 1.39 0.91 2005 -0.81 -0.48 2009 -8.24 -3.85 2010* -9.22 -6.00

* forecast, source: World Bank The depth of the downturn in richer nations means that on average GDP will be nearly 10% less than potential GDP in 2010. The world economy has a huge amount of excess capacity and this will have deflationary effects on prices, output, profits and jobs.

2010 Update: The Global Economic Cycle The global economy experienced a recession in 2009. Real GDP grew by 3.1% in 2008 but contracted by 0.5% in 2009. It is expected to recover strongly in 2010 by 4.3% but much of this growth will come from emerging economies (growth of 6.6% is forecast) whereas the rate of increase in real GDP for the developed world is only 2.0% - barely enough to create enough new jobs to bring unemployment down.

The Output Gap and Unemployment in the UK

Output Gap, Unemployment - claimant count measure

10.0 8.0 6.0 4.0

Per cent
Output gap Unemployment

10.0 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0

2.0 0.0 -2.0 -4.0 -6.0 -8.0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Reuters EcoWin

1. If actual GDP is less than potential GDP there is a negative output gap. Some factor resources are under-utilised and the main macroeconomic problem is likely to be higher than average unemployment and also weak business profits and investment. 2. A second possible consequence from an economy operating with a large negative output gap is that there is deflationary pressure on prices and wages. Businesses left with unsold goods and services and a large margin of productive slack might choose to engage in heavy price discounts, or look to squeeze their costs including prices paid to suppliers and wages paid to their employees. 3. A rising number of people out of work indicate an excess supply of labour, which means there is downward pressure on real wage rates. 4. A negative output gap also causes a worsening of government finances we have seen in the current recession how badly tax revenues have been affected by the slump in demand, profits and the subsequent rise in unemployment. The British Treasury estimates that this credit-crunch recession may have led to a permanent fall in real national output of perhaps 5% of GDP. 5. One benefit of an economy operating below capacity is that the demand for imports is highly likely to fall leading to an improvement in the trade balance. Longer term effects of a recession hysteresis effects A recession means that output in the short term is below potential and the economy is under-utilising its resources. At AS level you might have illustrated this using a production possibility frontier diagram. But what if the downturn creates longer-term problems? What if the recession leads to a permanent loss of output and productive capacity? That is the danger if an economy suffers from hysteresis effects. Consider the article below that relates to the EU economy.

Europe at risk of permanent loss of output

Euro Zone and UK Unemployment

Percentage of the labour force, seasonally adjusted; 2011 forecast is from the OECD

11 Euro Zone average 10

11

10

PERCENT

UK unemployment rate

4 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Reuters EcoWin

The recession and financial crisis may lead to a permanent loss in potential economic output and a slower trend rate of growth in the future according to a new study by the European Commission. The fall in potential GDP will be an example of hysteresis effects across the European economy and the cyclical downturn in output and jobs creates long-term damage. At the heart of the hysteresis argument is that the economic slump will lead to * A steep rise in business failures * A rise in structural unemployment together with people leaving the labour market permanently * Sharp falls in capital investment * Lower research and development with consequences for innovation * A freeze on finance available for new business start-ups * A squeeze on government spending as politicians take steps to reduce their borrowing and debts The EU report finds that Empirical evidence of the effect of past crises shows that the economy will not return to its pre-crisis expansion path but will shift to a lower one. In other words, the crisis will entail a permanent loss in the level of potential output. Longer term demographic pressures will add to worries about the potential for economic growth - the welfare state of Europes member nations must grapple with the issues arising from rising life expectancy, low fertility rates and a shrinking working-age population. Source: Tutor2u economics blog, July 2009