Economic cycle

A) Understanding of the trade (business) cycle

Trade cycle reduced severity

The trade/business cycle demonstrates the recurring trends in economic growth that economies often experience. A boom usually results in a slowdown, which is then followed by a recession, after this the economy goes into the recovery stage and then eventually back into a boom. Despite all of these fluctuations in actual growth, it still follows the trend growth of the economy.


B) Characteristics of a boom

High rates of economic growth

During times of economic boom there are large amounts of consumer spending and investment. As these are the two biggest components of AD, it causes a large increase in AD (AD1 to AD2) as shown by the diagram further down. Therefore, overall there are high rates of economic growth (Y1 to YFE).


Low rates of unemployment

As a result of the large increase in AD and high rates of economic growth, the economy equilibrium moves closer to/reaches the point of full employment (YFE). The economy can even operate past the full employment rate if taking a classical economics view. Therefore, the recessionary gap within the economy (difference between actual growth and the productive capacity of the economy) is minimal/non-existent. As shown from the diagram below, in this scenario the economy is operating at full employment. Therefore, the unemployment rate within the economy will only be around 4% (full employment is not classed as 0%). The less spare capacity within the economy, the lower the unemployment rate will be.


Demand-pull inflationary pressures

Keynesian LRAS AD SHIFTS Lots of spare capacityh.png

As shown from the diagram above, there are high rates of economic growth/real GDP in times of economic boom. However, this means that the economy moves much closer/to the full capacity (Y1 to YFE). This causes a large increase in the amount of pressure on existing factors of production in order to keep up with the large increase in the total demand for goods/services within the economy (AD1 to AD2). This causes a large increase in the general price level (P1 to P2).


High consumer and business confidence

During an economic boom consumer and business confidence is often high. Consumer confidence is high due to rising incomes, rising house prices, perceived job stability and a positive outlook on the economy as a whole. Business confidence is also high due to high levels of consumer spending and the knowledge that the economy is in a strong position, meaning that they don’t have to worry about saving most of their profits to cope with low levels of aggregate demand etc. Instead of trying to survive, firms switch their objectives to more optimistic ones, such as expansion. Overall, this leads to more consumer spending and investment, increasing economic growth further.


Improving government budget balance

When there is an economic boom within the economy, there is a large reduction in the recessionary gap and therefore less people are unemployed. This means that countries with a welfare system such as the UK will not need to spend as much money on welfare benefits. Furthermore, as more people are now in jobs, the number of people paying income tax will increase. Other sources of tax revenue such as VAT and corporation tax will also increase as consumer spending and business profits increase. Overall, this will cause a reduction in government spending and an increase in tax revenue, thus improving the government budget balance. This concept ties in with the topic of automatic stabilisers.  


C) Characteristics of a recession

Negative rates of economic growth

A recession occurs when there are two successive quarters of negative economic growth. This is caused by decreases in AD and therefore decreases in real GDP. The main two components that cause this fall in AD are often consumer spending and investment. As these are also the two largest components of AD, the negative impact that this has on the economy is often severe. The large fall in real GDP that often results in a recession can be seen on the diagram further down (YFE to Y2).


High rates of unemployment

As a result of the large decrease in AD (AD1 to AD2), real GDP falls to Y2, causing a recessionary gap of Y2 to YFE.

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