1. AS Macro Revision
Aspects of the Economic Cycle
Spring 2014

2. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

3. Identifying Stages of the Economic Cycle
Cycle is when GDP growth fluctuates around the trend (or underlying) growth
Recession
Slowdown
Recovery
Boom

4. Explaining the Stages of the Economic Cycle
Boom
A period when the rate of growth of real GDP is fast
and higher than its long-term trend
Slowdown
A weakening of the rate of growth, real GDP is still
rising but increasing at a slower rate
Recession
A period of at least six months when an economy
suffers a fall in output. Or a broadly-based contraction
in output, employment, investment and confidence
Recovery
A phase of the cycle, after a recession or depression,
during which real GDP starts to increase and
unemployment begins to fall
Depression
A prolonged downturn in the economy and where a
nation’s GDP falls by at least 10 per cent

5. The Output Gap
General
Price Level
LAS
AS
GPL1
AD
Y1
Yp Real GDP
The output gap is the
difference between the
actual level of GDP and its
(estimated) potential level
and is usually expressed as
a percentage of the level of
potential output.
In the example on the left,
the equilibrium level of
national income (GDP) is
less than long run potential
output – therefore the
output gap is negative

6. Negative and Positive Output Gaps
Negative Output Gap
Positive Output Gap
When actual GDP is less
than potential GDP
Actual GDP is greater
than potential GDP
Some factor resources
are under-utilized
Some resources working
beyond usual capacity
(shift work & overtime)
Main problem is likely to
be higher unemployment
Main problem is rising
inflationary pressures

7. Evidence for the Output Gap in the UK Economy
Positive output gap
after several years of
strong growth
Recession
Recession
causes
negative
output gap

8. Identifying Some Possible Causes of a Recession
External events
• A recession in a trading partner e.g. The European Union or the USA
• A sharp rise in global commodity prices e.g. Rising oil and gas prices
Tightening of macro policy
• Higher interest rates leading to more expensive loans
• A rise in taxation or a cut in government spending
Fall in asset prices or supply of credit
• Steep decline in the level of share or house prices
• A collapse in the supply of credit (e.g. Global financial crisis)
Drop in business and consumer confidence
• Lower business confidence cuts investment and may lead to job losses
• Declining consumer confidence leads to less spending and more saving

9. External Shocks to Aggregate Demand
Many unexpected events cause changes in the level of demand,
output and employment. These events are called “shocks”. Some
of the causes of AD shocks are as follows
A large rise or fall in the exchange rate
A recession or boom in one or more main
trading partner countries
A slump in the housing market or a change
in the level of share prices
An event such as the global financial crisis
which caused a fall in the supply of credit

10. UK Economic Growth in Recent Years
Forecast
A long period of strong,
sustained growth with rising
real GDP and incomes
Two years of recession
followed by a slow
recovery

11. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

12. Short Term Economic Effects of a Recession
Effects of recession depend in part on its causes and how long it lasts
Business profits and investment
• Falling demand can cause more businesses to fail and profits fall
• Planned investment declines – hitting industries that make the capital goods
Unemployment
• The drop in aggregate demand causes a fall in the demand for labour
• This causes a contraction in employment and a rise in cyclical unemployment
Government finances
• Recession causes a decline in tax revenues and more welfare spending
• The result is usually an increase in the budget deficit
Inflation
• Many business offer price discounts to off-load excess stocks
• A deep recession risks causing a period of price deflation (negative inflation)

13. Longer Term Economic & Social Effects of a Recession
Effects of recession depend in part on its causes and how long it lasts
Long Term Economic
Consequences
Long Term Social
Consequences
Rising structural longterm unemployment
Falling real wages hits
living standards
Low investment can
reduce the capital stock
Widening inequality of
income and wealth
Persistent budget deficit
and rising national debt
Social costs from rising
relative poverty

14. Legacy of Recession: Hysteresis v Creative Destruction
Here are two competing views about the effects of a recession
Hysteresis
When an economy
is disabled by
recession – big risk
of permanent loss
of national output
Creative
Destruction
Recessions can cast
a dark shadow but
capitalist
economies usually
bounce back
Loss of productive
capacity due to low
investment /
business closures
Recessions prompt
emergence of new
business models
and an increase in
start-ups
High rates of longterm structural
unemployment –
shrinking labour
force
New technologies
can act as a catalyst
for renewed
growth and
investment

15. The Difference between Recession and Depression
• A depression is a prolonged slump where real GDP falls by more
than 10% from the peak of the cycle to the trough
• In Greece, real GDP has fallen in seven successive years and real
GDP is more than 25% lower than at the peak of the cycle

16. Why has the UK Economic Recovery been weak?
Domestic demand-side factors:
Weak consumer demand, low business capital
investment, cuts in real level of government spending
Domestic supply-side factors:
Low supply of bank credit to businesses, falling labour
productivity (output per worker) + high energy prices,
External demand-side factors:
Weak growth in key overseas markets, hitting UK export
sales e.g. Euro Area, too few exports to Asian region
External supply-side factors:
Rising world food and energy prices, keeping UK inflation
high and squeezing real disposable incomes

17. Problems in Forecasting Real GDP Growth
No macroeconomic model can hope to cope with the volatility of
indicators such as inflation, exchange rates and global commodity
prices. This makes forecasting GDP growth difficult
Uncertain
business
confidence levels
Rate of business
job creation hard
to forecast
Uncertain
reactions to
macro policy
changes
Forecast growth for UK (source: BoE)
Fluctuations in
exchange rate
External events
e.g. volatile oil
and gas prices

18. Real Incomes and Economic Activity
Real income measures the purchasing power of a given amount of
nominal (money) income – i.e. nominal income adjusted for inflation
Year
2008
2009
2010
2011
2012
2013
Earnings
Consumer
(Wages, Bonuses Price Index
and Overtime)
% annual
% annual change
change
4.7
3.0
1.9
2.3
2.1
3.7
0.4
4.5
1.6
3.0
2.2
2.4
Real
incomes
Rising
Falling
Falling
Falling
Falling
Falling
Year of recession
In each of the last five years, the annual growth of earnings for people
in work has been less than inflation – causing real incomes to fall

19. How The Housing Market Affects AD
• The construction sector employs about 10% of the UK
workforce (over 2 million people) and contributes almost
£90 billion to the UK economy each year
• The recession of 2008-2010 caused a steep fall in new
house building and led to hundreds of thousands of job
losses – this was a factor causing unemployment to rise
• House-building remains labour intensive so changes in
demand and output have quite large multiplier effects
• Changes in house prices affect the level of household wealth
and this can affect consumer spending and saving decisions
• Falling house prices often cause a fall in consumption
• Since 2012, house prices have started to rise again but so too
have housing rents – housing affordability is a big issue

20. Costs & Benefits of High House Prices
Benefits of rising prices
Costs of rising prices
• Increases wealth of
home owners
• Boosts consumer
confidence
• Stimulates an
expansion of new
house-building
• Increases tax revenues
from stamp duty
• Improves the financial
stability of the banks
• Worsens affordability
for first time buyers
• Increases level of
mortgage debt
• Increases wealth
inequality
• Causes an increase in
demand for and cost of
renting property
• Worsens geographical
mobility of labour
Evaluation Points
Effects of rising
house prices
depends in part on:
1. The scale of the
rise in prices
2. The volatility of
the housing
market
3. The extent to
which homebuyers overextend
themselves
with high
mortgages

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