The Economic Cycle

The Economic Cycle

Also known as the business cycle, it shows how the economy fluctuates above and below its trend rate of growth.

When the economy is performing above its trend rate of growth, there is a positive output gap. During a positive output gap, the economy is in a boom whereby growth is high and unemployment is low.

When the economy is producing below its trend rate of growth, there is a negative output gap. The economy is said to be in a recession where growth is very low or even negative, along with high unemployment.

Reasons for these fluctuations

There are many theories devised to help explain fluctuations in the economic cycle. In the exam, it is important to prioritise your arguments, thus I have ordered the following according to my opinion, of course you may think otherwise:

1. Outside shocks

Outside shocks can be classified by demand shocks and supply shocks. Demand shocks affect AD in the economy, and can lead to a recession or downturn. For example, e-coli in German cucumbers supposedly sourcing from Spain led to AD for Spanish (and other European grown) vegetables, see article, to fall (from Russia in particular). 

A supply side shock affects AS within the economy. Examples include conflict in the Middle East affecting oil supplies and the Japanese earthquake affecting supply chains of manufactured goods, see article. Other evidence for this is, if you take a look at this website, you will see that Japan is currently experiencing negative growth, due to the earthquake.

2. Speculative bubbles

Rapid growth of asset prices (gold, property, shares…) leads to a bubble because people will speculate that the price will continue to rise and buy the asset. When the price is above the real value of the asset, people will start to sell and the bubble bursts. Speculation can destroy business and consumer confidence. People will stop spending, leading to a recession. This contributed to the UK recession (2008) when house prices plummeted, see article.

3. Changes in technology on the supply side of the economy

Technical progress can increase the rate of growth of total factor productivity (TFP). A change in TFP measures the change in total output when all the factors of production are changed in the economic long run. Technical progress measures how much more productive the factors of production have become over a period of time. Technology has inevitably increased the rate of economic growth in some developing countries where it is much needed, e.g. mobile phones in Uganda, and it has also led to the growth of developed countries thus creating the world’s most powerful economies, e.g. Japan.

4. Changes in inventory

Firms invest in stocks of raw materials and finished goods to smooth production and cope with changes to demand. However sometimes firms can over-anticipate demand leading to unsold stock, which can lead to a cut in current production and a slow down in the economy. Recessions in the UK and USA are made worse due to changes in inventory.

5. Political business cycle theory

Governments tend to cut taxes or implement new policies to give people more money before elections as a way a ‘buy votes’. People have more money, thus increasing spending leading to a boom period. After the election, governments deflate aggregate demand to prevent the economy from over-heating.

6. The multiplier and the accelerator

An increase in investment increases AD and leads to an increase in national income. This is known as the multiplier. Higher income leads to more investment (increasing AS), known as the accelerator. The extent to which the multiplier increases AD is down to:

a)     The marginal tax rate

b)    Marginal propensity to import

c)     Savings

Therefore this isn’t top in my list because, for the UK, the multiplier is not large since all of the above are reasonably large (the multiplier is calculated by 1 divided by the above). If the values for all of the above are high, there will be lower investment.

7. Climatic factors

El Nino/La Nina and sun spots (or lack of) can create extreme conditions resulting in   changes to harvest, affecting the agriculture market. The price of the grain and the quality of food can be damaged, leading to a fall in output in the producer country. This can lead to a fall in business confidence and thus a recession. El Nino Southern Oscillation is an event that occurs every 2 to 7 years and last 1 to 2 years. Cold water is suppressed in the Pacific Ocean, causing warm, dry weather over Southern Asia (India, Philippines…) and Oceania (Australia, New Zealand…) and increased rainfall over the America’s. El Nino can also affect the fishing industry. Sun spots can increase surface temperatures, causing warmer and drier weather.