4.2.3.1 - Economic Growth and the Economic Cycle

Short Run Economic Growth

An increase in real GDP in an economy over a period of time

Long Run Economic Growth

An increase in an economy's potential level of real output

Economic Recession

When an economy experiences two consecutive quarters of negative economic growth

Economic Recovery

When short-run economic growth takes place after a recession

Demand-side

Relates to the impact of changes in aggregate demand on the economy

(changes that affect components of AD)

Relationship between SREG & demand-side changes

Typically, SREG is assumed to be caused by demand-side changes (changes that affect C,I,G, or X-M)

Supply-side

Relates to changes in the potential output of the economy which is affected by the available factors of production (QQE of CELL)

Trend Growth Rate

Reflects the annual average percentage increase in the PRODUCTIVE CAPACITY of the economy.

The rate at which output can grow, on a sustained basis, without putting upward or downward pressure on inflation.

What must happen for 'sustainable economic growth' to continue?

LRAS must shift right. The PP must remain above actual real GDP in economy

Benefits of Economic Growth:

LIPTIE

L - Living standards; higher real incomes, higher living standards

I - Investment; increased funds for investment

P - Poverty; rising wealth reduces poverty

T - Tax; more tax revenue

I - Investment; higher profits fuels investment

E - Employment; creates new employment

- Virtuous circle of greater business confidence, increased investment, greater international competitiveness, higher profits, even more growth

Chain of Analysis Benefits of EG:

SREG -->

• ↑DD4L --> ↑Employment --> ↓u/e ↓NOG --> ↓Welfare payments --> Fiscal Budget Improves --> National debt ↓ --> Lower tax in future

• ↑Average National Income --> ↑ Consumption

• ↑Average National Income --> ↑ Income Tax --> Improves fiscal budget deficit

• ↑Average National Income --> ↑ Medicine, Shelter, Nutrition, ↑GNI per capita, ↑Send kids to school, Education ---> ↑HDI

• ↑Output --> Firms sales ↑ --> ↑Corporation tax

• ↑Output --> Firms sales↑ --> ↑Investment --> Multipler+Accelerator --> Further EG

• ↑Output --> ↓Spare capcity -->

Costs of Economic Growth:

SCI-FIE

S - Social problems arising

C - Cost; Opportunity cost of increased capital investment

I - Inflation; risk of demand-pull inflation

F - Finite resources; Overexploitation of scarce resources

I - Inequality; growth may be linked with rising inequality

E - Environmental damage; pollution from use of raw materials, production, transport

- Virtuous cycle of declining business confidence, low profits, low investment, lack of international competitiveness, even lower profits, zero growth and so on.

- Inflation can reduce international price competitiveness --> less X, more M and rising incomes --> Worsen current account position

Benefits of EG on INDIVIDUALS:

- More likely to be employed

- Higher incomes / less poverty

- Higher standard of living

- Less social issues (as less u/e --> less crime)

- Better gov services like NHS as gov has more money to spend on it

- Rising house prices due to rising incomes/confidence --> increased wealth

Costs of EG on INDIVIDUALS:

- Higher demand-pull inflation --> erodes real-wage value

- Maybe more inequality --> social unrest

- Rising house prices due to rising incomes/confidence --> worse for ppl without houses

Benefits of EG on the ECONOMY:

- Higher tax revenue (Income, VAT, Corp)

- Less u/e --> lower u/e benefits & regrettables spent on --> improved fiscal position --> reduced national debt

Costs of EG on the ECONOMY:

- Demand-pull inflation -->

- Reduction in international competitiveness --> worsening BoP position

- Increased inequality --> hamper Consumption

Benefits of EG on the ENVIRONMENT:

- Increased profits / better fiscal position --> improvements in green technology to protect our environment (GM crops, electronic cars)

- Increased education --> taking more care of environment

Costs of EG on the ENVIRONMENT:

- Using up finite resources (unsustainable in long-run)

- Increased pollution

Sustainable Economic Growth

Economic growth that can continue over time and does not endanger future generations' ability to expand productive capacity.

How can we sustain economic growth

Avoiding:

- Depleting non-renewable resources

- Damaging the environment

- Causing social unrest --> political and social upheaval

Why does EG deviate from the Trend Growth Rate?

- Seasonal Fluctuations - variation of economic activity resulting from seasonal changes in economy (e.g. weather)

- Cyclical Fluctuations - economic cycle, upswings & downswings in aggregate economic activity taking place over 4-12 years

- Demand-side Shocks

- Supply-side Shocks

Economic Cycle Diagram

Phases of Economic Cycle

- Recovery

- Boom

- Slowdown/Peak

- Recession

- Trough

Recovery (definition, effect on: real gdp, inflation, u/e, investment)

= When SREG takes place after a recession

• Things start to get better, consumers begin to increase spending, businesses feel more confident & start to invest again

Real GDP: Rising (< trend growth)

Inflation: Pressures increasing

Unemployment: Falling

Investment: Rising

Boom (definition, effect on: real gdp, inflation, u/e, investment)

= When the rate of economic growth exceeds the rate of growth of potential GDP

• High levels of consumer spending, business confidence, profits & investment. Price & costs rise faster, u/e low.

Real GDP: Rising (> trend growth)

Inflation: Significant pressure

Unemployment: Nearing full employment

Investment: Falling

Slowdown/Peak (definition, effect on: real gdp, inflation, u/e, investment)

= When the rate of economic growth begins to reduce and approach zero

• Falling consumer spending & confidence, lower profits for businesses, cut back on investment, Spare capacity increases

Real GDP: Falling (but >0)

Inflation: Pressures falling

Unemployment: Near full employment

Investment: Very little

Recession (definition, effect on: real gdp, inflation, u/e, investment)

= When the rate of economic growth becomes negative and real GDP actually falls

• Very weak consumer spending & investment, many business failures

Real GDP: Negative

Inflation: Pressures low (or deflation)

Unemployment: Increasing & significant

Investment: Beginning to pick up

Trough (definition, effect on: real gdp, inflation, u/e, investment)

= When production is at its lowest, many business failures

Real GDP: Very low

Inflation: Pressures low (or deflation)

Unemployment: Large

Investment: Very low

Output Gap

When the level of actual real output in the economy is greater or lower than the productive potential.

Causes of Changes in the Various Phases of the Economic Cycle (causes of cyclical fluctuations)

Multiplier / Accelerator effect:

• As investment increases, the multiplier effect causes a greater than proportionate increase in real GDP

• The increase in real GDP causes firms to invest further (to fulfil the expanding output requirement), which accelerates the rate of investment.

• This process continues until boom and slow-down phases

Political Business Cycles:

• In democratic countries, general elections occur every 4-5 years

• As the election approaches, the incumbent party may attempt to get votes by expanding the economy.

• After the election, the party has to deflate AD to prevent over-heating

Consumer & Business Confidence:

• Keynes argued that economic cycles are caused by ‘animal spirits’.

• If households & firms believe there will be EG → ↑confidence → ↑C & I → ↑EG

• Eventually, pessimism rises and confidence falls, ↓C & I —> Recession

• Self-fulfilling prophecy

Additionally, what looks like a cycle could be due to random demand & supply-side shocks:

Demand-side Shocks:

• e.g. Slump in share prices

• Large boom in housing market

• Unexpected cut or rise in interest rate

• Unexpected rise or fall in exchange rate

Supply-side Shocks:

• Changes in commodity prices

• Natural disasters (poor weather affecting agriculture)

• Technological breakthroughs

Cyclical Instability =

The expansion and contraction of an economy’s output - fluctuations of real GDP

Causes of Cyclical Instability:

• Excessive growth in credit and levels of debt

• Asset Price bubbles

• Destabilising speculation and animal spirits or herding

Credit =

The funds available for households and firms to borrow

How ‘excessive growth in credit’ can lead to cyclical instability

Excessive growth in credit = The availability of credit (funds available for households and firms to borrow) has increased considerably

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Impact on Consumption:

• As a result, individuals & households are likely to borrow more money from financial institutions

• Thus, more funds available for C → ↑C → ↑AD

‎

Impact on Investment:

• Firms are likely to borrow more money from financial institutions

• Thus, more funds available for I→ ↑I→ ↑AD

• +ALSO, increased C → ↑I to meet increased demand

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Therefore, rise in AD will lead to short-run ‘cyclical’ economic growth.

As this increase is not part of the usual economic cycle fluctuations, the additional AD caused could be said to be causing ‘cyclical instability’

Speculation =

Engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of an asset, rather than attempting to profit from the underlying value of the asset.

Destabilising Speculation =

Market behavior where investors buy assets because prices are rising (expecting further increases) or sell because prices are falling (expecting further declines).

• Self-fulfilling prophecy

• Exaggerates price movements

Asset Price Bubble =

When the prices of securities rise so sharply that they exceed valuations justified by fundamentals.

Animal Spirits =

Emotional and psychological factors, such as confidence, fear and optimism, that influence economic decision aking and drive human behaviou

Herd Mentality =

The tendency for people to act in the same way as the majority around them.

How Asset Price Bubbles can lead to cyclical instability

• Normally priced asset

• Genuine increase in demand → price of asset increasing

• Animal spirits cause individuals to become bullish about the stock / the economy

• Herd mentality kicks in as individuals don’t want to be left out (FOMO) → ↑demand for assets

• Destabilising speculation → price rising further

• Asset price rises to an all-time high

• Some individuals begin to worry about longevity of price rises and become bearish

• Bearish individuals sell assets → price begins to fall

• Herd mentality as individuals don’t want to be left holding a declining value asset → assets sold

• Bubble bursts as the asset price falls dramatically

Ways to reduce Cyclical Volatility

• Monetary Policy

• Fiscal Policy

• Supply-side Policies

• Allow Automatic Fiscal Stabilisers to work - As EG↑, U/E benefits paid decreases + Higher tax revenue. (Automatically adjusts to counter cycle fluctuations)