the-economic-cycle

The Economic Cycle

• An economic (or business) cycle refers to the changes in real GDP that occur in an economy over time

  • This is the actual growth 

• The real GDP will fluctuate above and below the long-term trend rate of growth

  • The long-term trend rate of growth refers to the average or long-term rate at which an economy expands over time

  • It represents the underlying, sustainable rate of growth that an economy can achieve over the long run, after accounting for fluctuations caused by the economic cycle 

• There are four recognisable points in the cycle

  • Peak/boom; slowdown/downturn; recession, recovery

Diagram: The Economic Cycle

Diagram analysis

• A positive output gap is identified as growth of real GDP that is above the trend

• A negative output gap is identified as growth of GDP that is below the trend

• There is often a natural flow through the different stages, from boom to slowdown to recession to recovery

• This flow of real GDP can be moderated by government intervention

  • E.g. Increasing taxes in a boom period or increasing spending in a recession will help the economy stay closer to the long term trend

A Table Explaining the Characteristics of a Boom & Recession

The Difference Between Positive & Negative Output Gaps

• It is difficult to measure output gaps accurately

  • This is because it is hard to know exactly what the maximum productive potential of an economy is

  • Rapidly rising prices can indicate a positive gap is developing

  • Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing

Negative Output Gap on an AD/AS Diagram

• A negative output gap occurs when the economy is operating below its full potential

Diagram: Negative Output Gap

Diagram analysis

• The potential output of this economy is at Y_FE

• The economy is in a short-run equilibrium at AP₁Y₁

  • A negative output gap exists at Y₁ – Y_FE

    • This effectively gives the economy spare capacity in the short-term

  • One cause of this may be that the AD has recently decreased due to a fall in consumption

  • The Classical view is that the output will return to Y_FE in the long-run, but at a lower average price level

  • The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time

Positive Output Gap on an AD/AS Diagram

• A positive output gap occurs when the economy is operating beyond its full potential

Diagram: Positive Output Gap

Diagram analysis

• The potential output of this economy is at Y_FE

• The economy is in a short-run equilibrium at AP₁Y₁

  • A positive output gap exists at Y_FE – Y₁

    • This effectively gives the economy more productive capacity in the short-term

  • One cause of this may be that workers are willing to work overtime once full capacity is reached

    • It is not sustainable and the Classical view is that the output will return to Y_FE, but at a higher price level

Factors that Change the Phase of the Economic Cycle

• Numerous factors can cause an economy to move between the different phases in its economic cycle

• In one period, it may be enjoying a considerable boom, only for a global catastrophe to occur (e.g. war) which may lead to a slowdown, or even recession

• Both global and domestic demand-side and supply-side shocks have the ability to influence the cycle

Causes of Change in Phases of Economic Cycle