Understanding the Economic Cycle

Boom
A boom occurs when real national output is rising at a rate faster than
the trend rate of growth. Some of the characteristics of a boom include:

A fast growth of consumption helped by rising real incomes,

strong confidence and a surge in house prices and other forms of
personal wealth

A pick up in the demand for capital goods as businesses invest in

extra capacity to meet rising demand and to make higher profits

More jobs and falling unemployment and higher real wages for
people in work

High demand for imports which may cause the economy to run a
larger trade deficit because it cannot supply all of the goods and
services that consumers are buying

Government tax revenues will be rising as people earn and spend

more and companies are making larger profits this gives the
government money to increase spending in priority areas such as
education, the environment, health and transport

An increase in inflationary pressures if the economy overheats

and has a positive output gap.

The UK enjoyed sustained growth over the last fifteen from 1993
through to the end of 2008 but for better examples of booming
countries we have to look overseas. The obvious example
is China whose growth has been astonishing. And many other emerging
market countries have experienced a decade or more of phenomenally
rapid increases in the size of their economies. The BRIC countries have
interested economists interested in understanding their fast rates of
growth and development. In addition to China, the BRIC nations
include Brazil, Russia and India.
Slowdown

A slowdown occurs when the rate of growth decelerates but

national output is still rising

If the economy grows without falling into recession, this is called

a soft-landing.

Recession
Recession and rising unemployment

There is a risk is that productive capacity in the UK economy could be

permanently lost, as temporary job losses morph into long-term
unemployment due to job-seekers losing skills and dropping out of the
labour market
Source: IMF Blog, August 2011
A recession means a fall in the level of national output i.e. a period
when growth is negative, leading to a contraction in employment ,
incomes and profits .

The simple definition:

o

A fall in real GDP for two consecutive quarters i.e. six

months

The more detailed definition:

o

A recession is a significant decline in economic activity

spread across the economy, lasting more than a few
months, normally visible in real GDP, real income,
employment, industrial production, and wholesale-retail
sales.

There are many symptoms of a recession here is a selection of key

indicators:

A fall in purchases of components and raw materials from supplychain businesses

Rising unemployment and fewer job vacancies

A rise in the number of business failures including high profile

names such as Woolworths

A decline in consumer and business confidence

A contraction in consumer spending & a rise in the percentage of

income saved

A drop in the value of exports and imports of goods and services

Deep price discounts offered by businesses in a bid to sell excess

stocks

Heavy de-stocking as businesses look to cut unsold stocks when

demand is weak

Government tax revenues are falling and welfare spending is

rising

The budget (fiscal) deficit is rising quickly

The difference between a recession and a depression

A slump or a depression is a prolonged and deep recession

leading to a significant fall in output and average living standards

A depression is where real GDP falls by more than 10% from the
peak of the cycle to the trough.

What are the main causes of a recession?

Recessions are unusual. To some economists they are an

inevitable feature of a market economy because of the cyclical
nature of output, demand and employment.

Every recession is different! It is undeniable that the global credit

crunch has been hugely significant in causing the downturn even
though macroeconomic policy has tried hard to prevent it.

The 2009 recession was the result of a combination of domestic and

external economic factors and forces:

The collapse of the British property boom falling house prices hit
wealth and led to a large contraction in new house building

Reductions in real disposable incomes due to wages rising less

quickly than prices

A sharp fall in consumer confidence made worse by rising

unemployment leading to an increase in household saving
Keynes called this the paradox of thrift. (see the chapter on
Keynesian economics)

External events such as recession in the UKs major trading

partners including the USA (which accounts for 15% of UK trade)
and the Euro Area (which has 55% of UK trade)

UK exports declined because of recession in major trading

partners and this hit manufacturing industry and other
businesses that supply export firms

Cut-backs in production have led to a negative multiplier

effect causing a decline in demand for consumer services and
lower sales and profits for supply-chain businesses

The credit crunch caused the supply of credit to dry up affecting

many businesses and home-owners

Falling profits and weaker demand has caused a fall in business

sector capital investment known as the negative accelerator
effect.

Unemployment has started to rise early in the downturn a

reflection of our flexible labour market and sticky wages

An important evaluation point is that, in a recession, some businesses

are affected more than others.
The extent of the effects will depend on the type of business, the
market it operates in and the nature of the product sold
When real incomes are falling, we would expect to see a decline in
demand for products with a highincome elasticity of demand typically
these goods and services are regarded as luxury items by consumers,
things that they might choose to do without when the economy is
having a bad time.
Demand for products with negative income elasticity (i.e. inferior
goods) might rise during a recession!
Slow Recovery for the UK
The British economy which contracted 6.4pc in the downturn, has
rebounded 2.5pc, and is still 3.9pc below its peak. This recovery is
taking longer to take root than from any 20th Century recession bar the
Great Depression
Source: News reports, August 2011
Recovery

A recovery occurs when real national output picks up from

the trough reached at the low point of the recession.

The pace of recovery depends on how quickly AD starts to rise

after a downturn. And, the extent to which producers raise output
and rebuild their stock levels in anticipation of a rise in demand

The state of business confidence plays a key role here. Any

recovery might be subdued if businesses anticipate that a
recovery will be temporary or weak in scale.

A recovery might follow a deliberate attempt to stimulate demand. In

the UK a number of strategies have been used to boost confidence and
demand and prevent the recession turning into a damaging depression:

Cuts in interest rates the policy interest rate fell to 0.5% in the
Autumn of 2008 and they have stayed at this low level ever since
(0.5% at the time of writing in August 2012)

A rise in government borrowing the budget deficit rose above

150bn in 2009 and government borrowing is likely to remain
high for some time to come despite attempts to cut it

A policy of quantitative easing (QE) by the Bank of England to

pump more money into the banking system in a bid to increase
the supply of loans now worth more than 325 billion.

A temporary cut in the rate of VAT from 17.5% to 15% (now

reversed VAT rose to 20% in 2011)

The launch of a car scrappage scheme for older cars worth up to

2000 per car and a consumer subsidy for households replacing
their old boilers.

Why has the economic recovery in the UK economy been so weak?

The year 2009 saw the UK economy suffer a deep recession with a fall
in real GDP of 4.4% and a steep rise in the unemployment rate. There
was an encouraging recovery in national output in 2009 with real GDP
growing close to the estimated trend rate of growth.
Since then however the pace of expansion in the UK economy has
slowed down with growth of only 0.7% in 2011 and even weaker growth
forecast for 2012. Indeed in the 2nd quarter of 2012, data showed that
the British economy had fallen into a second recession known as a
double-dip.
The level of real GDP remains well below the peak reached at the end of
the last economic cycle. Many commentators are forecasting that
recovery will continue to be slow in the next couple of years and this
poses big risks for households, businesses and the government.
Why is GDP growth so difficult to forecast?
When economists make forecasts about the future path for an economy
they have to accept the inevitability of forecast errors. Conditions in
the economy are always changing and no macroeconomic model can
hope to cope with the fluctuations and volatility of indicators such as
inflation, exchange rates and global commodity prices. GDP growth is
hard to forecast the chart above is the one produced by the Bank of
England when they publish their quarterly Inflation Report. The
projection area is their forecast, notice how the uncertainty grows as
we move further from the present. In 2014, the range of probabilities
for real GDP growth in the UK stretches from -1% (recession) to over 5%
(very strong growth). The graph above is a probability fan chart, the
darker the area, the higher is the probability attached to the outcome.

Aggregate Demand
Aggregate means total and in this case we use the term to measure
how much is being spent by all consumers, businesses, the government
and people and firms overseas.

Aggregate demand (AD) = total spending on goods and services

AD = C + I + G + (X-M)

C: Consumers' expenditure on goods and services : Also known as

consumption, this includes demand for durables e.g. audio-visual
equipment and motor vehicles & non-durable goods such as food
and drinks which are consumed and must be re-purchased.

I: Capital Investment This is spending on capital goods such as

plant and equipment and buildings to produce more consumer
goods in the future. Investment also includes spending on
working capital such as stocks of finished and semi-finished
goods.

Capital investment spending in the UK accounts for between 1620% of GDP in any given year. Of this investment, 75% comes
from private sector businesses such as Tesco, British Airways and

British Petroleum and the remainder is spent by the government

for example building new schools or in improving railway or road
networks. So a mobile phone company such as O2 spending 100
million on extending its network capacity and the government
allocating 15 million of funds to build a new hospital are both
capital investment. Investment has important effects on
the supply-side as well as being an important component of AD. A
small part of investment spending is the change in the value of
stocks i.e. unsold products. Producers may find either than
demand is running higher than output (i.e. stocks will fall) or that
demand is weaker than expected and less than current output (in
which case the value of unsold stocks will rise.)

G: Government Spending This is spending on state-provided

goods and services including public goods and merit goods .
Decisions on how much the government will spend each year are
affected by developments in the economy and the political
priorities of the government.

Government spending on goods and services is around 18-20% of

GDP but this tends to understate the true size of the government
sector in the economy. Firstly some spending is on investment
and a sizeable slice goes on welfare state payments. Transfer
payments in the form of benefits (e.g. state pensions and the jobseekers allowance) are not included in current government
spending because they are a transfer from one group (i.e. people
in work paying income taxes) to another (i.e. pensioners drawing
their state pension having retired from the labour force, or
families on low incomes).

X: Exports of goods and services - Exports sold overseas are an

inflow of demand (an injection) into our circular flow of income
and spending adding to aggregate demand.

M: Imports of goods and services. Imports are a withdrawal of

demand (a leakage) from the circular flow of income and
spending.

Net exports measure the value of exports minus the value of

imports. When net exports are positive, there is a trade surplus
(adding to AD); when net exports are negative, there is a trade
deficit (reducing AD). The UK has been running a large trade
deficit for several years now.

Aggregate Demand in the UK Economy

All of the data above is expressed in billion at constant prices

Source: Office for National Statistics, Economic Trends 2011
The main components of aggregate demand are shown in the table
above
Remember that
AD = C + I + G + X M
The change in the value of stocks is a small component of the equation,
it relates to changes in how much investment businesses are making in
stocks (unsold products) to be consumed at a later stage.

Recession: 2009 was a year of recession what happened to each

of the components of aggregate demand in 2009 compared to
2008?

Recovery: The British economy started to recover in 2010; using

the table can you explain why this happened?

Shocks to aggregate demand

Many unexpected events can happen which causes changes in the

level of demand, output and employment

Headwinds can alter direction with great speed leading to

uncertainty about where the economy is heading

These events are called shocks. Some of the causes of AD

shocks are as follows:

A big rise or fall in the exchange rate affecting export demand

and having follow-on effects on output, employment, incomes
and profits of businesses linked to export industries.

A recession in one or more of our main trading partners which

affects demand for our exports of goods and services.

A slump in the housing market or a big change in share prices.

An event such as the credit crunch (global financial crisis)

involving a fall in the amount of credit available for borrowing by
households and businesses.

An unexpected cut or an unexpected rise in interest rates or

change in government taxation and spending for example the
shock of deep cuts in state spending expected in 2011 and
beyond.

These shocks will bring about a shift in the aggregate demand curve
and we turn to this next.
The Aggregate Demand Curve
The AD curve shows the relationship between the general price level
and real GDP.

Aggregate Demand and the Price Level

There are several explanations for an inverse relationship between AD
and the price level in an economy. These are summarised below:

Falling real incomes: As the price level rises, so the real value of
peoples incomes fall and consumers are less able to buy the
items they want or need. If over the course of a year all prices
rose by 10 per cent whilst your money income remained the same,
your real income would have fallen by 10%

The balance of trade: A persistent rise in the price of level of

Country X could make foreign-produced goods and services
cheaper in price terms, causing a fall in exports and a rise in
imports. This will lead to a reduction in net trade and a
contraction in AD

Interest rate effect: if the price level rises, this causes inflation
and an increase in the demand for money and a consequential rise
in interest rates with a deflationary effect on the economy. This

assumes that the central bank (in our case the Bank of England) is
setting interest rates in order to meet a specified inflation target
Shifts in the AD Curve

A change in the factors affecting any one or more components of

aggregate demand i.e. households (C), firms (I), the government
(G) or overseas consumers and business (X) changes planned
spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from

AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase
in AD might have been caused for example by a fall in interest rates or
an increase in consumers wealth because of rising house prices.

Factors causing a shift in AD

Changes in
Expectations
Current spending is
affected by
anticipated income
and inflation

The expectations of consumers and businesses have

a powerful effect on spending

Changes in

If interest rates fall this lowers the cost of

When confidence falls, we see an increase in saving

and businesses postpone investment projects
because of worries over weak demand and lower
expected profits.

Monetary Policy
i.e. a change
ininterest rates

borrowing and the incentive to save, encouraging

consumption. Lower interest rates encourage firms
to borrow and invest
There are time lags between changes in interest
rates and the changes in aggregate demand.

Changes in Fiscal
Policy
Fiscal Policy refers
to changes in
government
spending, welfare
benefits and
taxation, and the
amount that the
government
borrows

The Government may increase its expenditure e.g.

financed by a higherbudget deficit - this directly
increases AD

Economic events in
the international
economy
International
factors such as the
exchange rate and
foreign income
(e.g. the economic
cycle in other
countries)

A fall in the value of the pound () (a depreciation)

makes imports dearer and exports cheaper - the net
result should be that UK AD rises

Changes in
household wealth
Wealth is the value
of assets owned
e.g. houses and
shares

A fall in the value of share prices or a slump in the

housing market can lead to a decline in household
financial wealth and a fall in consumer demand

Changes in the
supply of credit

The availability of credit is vital for the smooth

functioning of most modern economies

Income tax affects disposable income e.g. lower

rates of income tax raise disposable income and
should boost consumption.
An increase in transfer payments increases AD
particularly if welfare recipients spend a high % of
the benefits they receive.

The impact depends on the price elasticity of

demand for imports and exports and also the
elasticity of supply of UK exporters in response to
exchange rate depreciation.
An increase in overseas incomes raises demand for
exports. In contrast arecession in a major export
market will lead to a fall in exports and an inward
shift of aggregate demand.

Declining asset prices also have a negative effect on

consumer confidence / a fall in expectations

We have seen in recent years how the bursting of

the credit bubble in countries such as the UK and
the USA has created many problems for businesses

and individuals
Many banks and other lenders are now more
reluctant to lend
Interest rates on different loans have become more
expensive
Instead of taking out new loans, in recent times
businesses have been paying back debt. In the 5
years before the financial crisis UK companies
borrowed 107m from banks every day. Since then
they've been repaying 5.8m a day.

Keynesian Economics
An understanding of Keynesian ideas can be helpful in evaluating macro
policies and the search for macroeconomic stability in terms of prices,
jobs, incomes and profits
Keynesian economics focuses
on psychology, uncertainty and expectations in driving macroeconomic
decisions and behaviour. In Keynesian economics, the state of animal
spirits is vital.
Keynesian economists and free markets
Keynesian economists believe that free markets are volatile and not
self correcting.

Free market volatility:

o

The free-market system is naturally prone to periods of

recession & depression

The volatility of aggregate demand (AD = C+I+G+X-M) can

be explained by changes in consumer and business
sentiment also known as animal spirits.

In a world of stagnation or depression direct intervention in

the economy may be essential

Free markets are not always self-correcting:

o

When a recession or a depression occurs, the free market

system is not necessarily self-correcting indeed en-masse,
individuals can become trapped in a deflationary depression
which is in no ones interest but which, left on our own, no
one can counter-act.

Persistent deflation can be as costly as high inflation it can

be damaging especially in economies where there is a huge
level of private & public sector debt

You cannot always rely on new inventions / innovations and

other natural stabilisers to drag an economy out of a
recession

Savings and aggregate demand

The paradox of thrift helps to explain why a rise in precautionary

saving (people looking for security) can lead to a fall in demand
and incomes and a reduction in output, income and wealth

Negative multiplier and accelerator effects can drag production

and employment to a low level where it can stay unless there is
some external stimulus to lift demand and output again

On an international level, when the global desire to save exceeds

the global willingness to invest the result is a contraction in world
demand and production leading to a fall in incomes and
employment

The risks of a deflationary depression

Recession (and worse a depression) represents a pure waste of

scarce resources. Unemployed workers want to work, and
businesses want to use their productive capacity to supply goods
and services. If they had work, the things they produced would be
available for all to buy, and the incomes they received would
enable them to purchase the products of others. Incomes from
higher wages and stronger profits would feed through the circular
flow in the standard macro model.

But in a recession a country can experience a persistent state

where output is well below a countrys capacity to produce

The key is to take measures to lift AD and bring about an

expansion along the short-run aggregate supply curve.

Keynes on under-employment equilibrium

One of Keyness revolutionary propositions was that following a big
economic shock - usually a collapse in investment - there were no
automatic recovery forces in a market economy. The economy would go
on shrinking until it reached some sort of stability at a low level.
Keynes called this position "under-employment equilibrium"
Professor Robert Skidelsky, Biographer of Keynes
The Liquidity Trap:

In normal circumstances it is possible to boost demand by cutting

interest rates. But there is a level below which interest rates
cannot go (they have been at 0.5% in the UK since the spring of
2009 and at low levels in other countries) and at that point
monetary policy may become powerless.

Moreover, even if interest rates can be lowered this may have no

effect if people cannot or will not borrow. This is known as
the liquidity trap.

At this point, aggregate demand can only be boosted by the

Government borrowing more, either to spend directly or to give to
others via tax cuts or the like.

In other words, we need a targeted Keynesian fiscal stimulus.

Keynesians believe that fiscal multiplier effect is higher for

spending than it is for tax cuts.

The aim is simple when private sector demand for goods and
services is low, the government needs to find a compensating
source of demand to rebalance the economy and the solution
comes from the government in the form of higher borrowing or
less saving.

Animal spirits

John Maynard Keynes coined the notion of animal spirits which

refers to the driving force that gets people going in the economy.

Animal spirits helps to explain why countries fall into a recession

but also what eventually brings about a recovery. It refers to a
broad mix of confidence, trust, mood and expectations and animal
spirits can fluctuate very quickly as populations of people change
their thinking

This focus on animal spirits helps to explain why psychology can

be so important in macroeconomics

When animal spirits are poor, individuals save more, businesses

save more too and, because demand and profits are lower than
expected, they cut back on production and perhaps postpone or
cancel capital investment projects.

Higher saving and reduced investment both have the effect of

reducing demand and incomes in the circular flow causing an
economic contraction

As our chart below shows, capital spending in the economy is

volatile a reflection of the upswings and downswings of business
sentiment a key part of animal spirits in any modern economy.

Multiplier & Accelerator Effects

In this chapter we look at two ideas, the multiplier process and
the accelerator effect, both of which help to explain how we move from
one stage of an economic cycle to another
What is the multiplier process?

An initial change in aggregate demand can have a much

greater final impact on equilibrium national income

This is known as the multiplier effect

It comes about because injections of new demand for goods and

services into the circular flow of income stimulate further rounds
of spending in other words one persons spending is anothers
income

This can lead to a bigger eventual effect on output and

employment

What is a simple definition of the multiplier?

It is the number of times a rise in national income exceeds the rise in
injections of demand that caused it
Examples of the multiplier effect at work

Consider a 300 million increase in capital investment for

example created when an overseas company decides to build a
new production plant in the UK

This may set off a chain reaction of increases in expenditures.

Firms who produce the capital goods and construction businesses
who win contracts to build the new factory will see an increase in
their incomes and profits

If they and their employees in turn, collectively spend about 3/5

of that additional income, then 180m will be added to the
incomes of others.

At this point, total income has grown by (300m + (0.6 x 300m).

The sum will continue to increase as the producers of the additional
goods and services realize an increase in their incomes, of which they in
turn spend 60% on even more goods and services.
The increase in total income will then be (300m + (0.6 x 300m) + (0.6
x 180m).

Each time, the extra spending and income is a fraction of the previous
addition to the circular flow.
The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the

1930s when John Maynard Keynessuggested it as a tool to help
governments to maintain high levels of employment

This demand-management approach, designed to help

overcome a shortage of capital investment, measured the amount
of government spending needed to reach a level of national
income that would prevent unemployment.

Factors that affect the value of the multiplier effect

The higher is the propensity to consume domestically produced

goods and services, the greater is the multiplier effect. The
government can influence the size of the multiplier through
changes in direct taxes. For example, a cut in the rate of income
tax will increase the amount of extra income that can be spent on
further goods and services

Another factor affecting the size of the multiplier effect is

the propensity to purchase imports. If, out of extra income,
people spend their money on imports, this demand is not passed
on in the form of fresh spending on domestically produced output.
It leaks away from the circular flow of income and spending,
reducing the size of the multiplier.

The multiplier process also requires that there is sufficient spare

capacity for extra output to be produced.
If short-run aggregate supply is inelastic, the full multiplier effect is
unlikely to occur, because increases in AD will lead to higher prices
rather than a full increase in real national output. In contrast, when
SRAS is perfectly elastic a rise in aggregate demand causes a large
increase in national output.
In short the multiplier effect will be larger when
1. The propensity to spend extra income on domestic goods and
services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend
gains in income)

5. Businesses in the economy have the capacity to expand

production to meet increases in demand
Time lags and the multiplier effect

It is important to remember that the multiplier effect will take

time to come into full effect

A good example is the fiscal stimulus introduced into the US

economy by the Obama government. They have set aside many
billions of dollars of extra spending on infrastructure spending
but these sorts of capital projects can take years to be completed.
Delays in sourcing raw materials, components and finding
sufficient skilled labour can limit the initial impact of the spending
projects.

Calculating the value of the multiplier

The formal calculation for the value of the multiplier is
Multiplier = 1 / (sum of the propensity to save + tax + import)
Therefore if there is an initial injection of demand of say 400m and

The marginal propensity to save = 0.2

The marginal rate of tax on income = 0.2

The marginal propensity to import goods and services is 0.3

Then the value of national income multiplier = (1/0.7) = 1.43

An initial change of demand of 400m might lead to a final rise in GDP
of 1.43 x 400m = 572m
If

The marginal propensity to save = 0.1

The marginal rate of tax on income = 0.2

The marginal propensity to import goods and services is 0.2

The value of the multiplier = 1/0.5 = 2 the same initial change in

aggregate demand will lead to a bigger final change in the equilibrium
level of national income.

The Accelerator Effect

The accelerator effect is when an increase in national income results in
a proportionately larger rise in investment
Consider an industry where demand is rising at a strong pace.
Firms will respond to growing demand by expanding production and
making fuller use of their existing productive capacity. They may also
choose to meet higher demand by running down their stocks of finished
products.
At some point and if they feel that the higher level of demand will
be sustained they may choose to increase spending on capital goods
such as plant and machinery, factories and new technology in order to
increase their capacity. If this investment goes beyond what is needed
simply to replace worn out, fully depreciated machinery, then the
capital stock of the business will become larger.
In this sense, the demand for capital goods is being driven by the
demand for the products that the firm is supplying to the market. This
gives rise to the accelerator effect - the principle states that a given
change in demand for consumer goods will cause a greater percentage
change in demand for capital goods.

A good example might be the surge in capital investment in wind

turbines due to the super-high level of oil and gas prices and a rising
market demand for renewable energy. In this case, strong demand
created a positive accelerator effect. But this can also go into reverse
e.g. during an economic slowdown or recession. World oil prices have
collapsed and many wind farm projects have been scaled back or
postponed.
Similarly the sharp fall in UK motor car production is also leading to
a reverse accelerator effect with planned investment spending subject
to severe cut-backs and many jobs lost.
The Capital Output Ratio

The accelerator model works on the basis of a fixed capital to

output ratio

For example if demand in a given year rises by 4 million and

each extra 1 of output requires an average of 3 of capital
inputs to produce this output, then the net level of investment
required will be 12 million.

One criticism of this simple accelerator model is that the capital stock
of a business can rarely be adjusted immediately to its desired level
because of adjustment costs and time lags. The adjustment costs
include the cost of lost business due to installation of new equipment or
the financial cost of re-training workers. Firms will usually make
progress towards achieving an optimum capital stock rather than
moving smoothly from one optimal size of plant and machinery to
another.
A further criticism of the basic accelerator model is that it ignores the
spare capacity that a business might have at their disposal and also
their ability to outsource production to other businesses to meet a
short term rise in demand.
The accelerator principle is used to help explain business cycles. The
accelerator theory suggests that the level of net investment will be
determined by the rate of change of national income. If national income
is growing at an increasing rate then net investment will also grow, but
when the rate of growth slows net investment will fall. There will then
be an interaction between the multiplier and the accelerator that may
cause larger fluctuations in the trade cycle.
The accelerator effect will tend to be high when

The rate change of consumer income and spending is strongly

positive

The amount of spare productive capacity for businesses is low

The available supply of investment funds is high

Aggregate Supply
Aggregate supply (AS) measures the volume of goods and
services produced within the economy at a given price level.
AS represents the ability of an economy to deliver goods and services
to meet demand
The nature of this relationship will differ between the long run and the
short run
1. Short run aggregate supply (SRAS) shows total planned
output when prices in the economy can change but the prices and
productivity of all factor inputs e.g. wage rates and the state of
technology are held constant.
2. Long run aggregate supply (LRAS): LRAS shows total planned
output when both prices and average wage rates can change it
is a measure of a countrys potential output and the concept is
linked to the production possibility frontier
In the long run, the LRAS curve is assumed to be vertical (i.e. it does
not change when the general price level changes)
In the short run, the SRAS curve is assumed to be upward sloping (i.e. it
is responsive to a change in aggregate demand reflected in a change in
the general price level)
The short run aggregate supply curve

A change in the price level brought about by a shift in AD results in

a movement along the short run AS curve. If AD rises, we see
an expansion of SRAS; if demand falls we see a contraction of SRAS.
Shifts in Short Run Aggregate Supply (SRAS)

The main cause of a shift in the supply curve is a change in business

costs for example:

Changes in unit labour costs: Unit labour costs are wage

costs adjusted for the level of productivity. A rise in unit labour
costs might be brought about by firms paying higher wages or a
fall in the level of productivity

Commodity prices: Changes to raw material costs and other

components e.g. the prices of oil, copper, rubber, iron ore,
aluminium and other inputs will affect a firms costs

Exchange rates: Costs might be affected by a change in the

exchange rate which causes fluctuations in the prices of imported
products. A fall (depreciation) in the exchange rate increases the
costs of importing raw materials and component supplies from
overseas

Government taxation and subsidies:

a. An increase in taxes to meet environmental objectives will
cause higher costs and an inward shift in the SRAS curve
b. Lower duty on petrol and diesel would lower costs and
cause an outward shift in SRAS

The price of imports:

a. Cheaper imports from a lower-cost country has the effect of

shifting out SRAS
b. A reduction in a tariff on imports or an increase in the size
of an import quota will also boost the supply available at
each price level
c. The exchange rate affects how much a business must pay
for imported raw materials and components
Long Run Aggregate Supply (LRAS)
In the long run, the ability of an economy to produce goods and
services to meet demand is based on thestate of production
technology and the availability and quality of factor inputs.
Growth and size of economy
Seemingly small differences in growth rates can have a large impact
over a period of many years. For example, if an economy grew by 2 per
cent every year, it would double in size within 35 years; if it grew at 2
per cent a year, it would double in size after 28 years - seven years
earlier
Source: UK Treasury
A long run production function for a country is often written as follows:
Y*t = f (Lt, Kt, Mt)

Y* is a measure of potential output

t is the time period

L represents the quantity and ability of labour input available

Kt represents the available capital stock

Mt represents the availability of natural resources

LRAS is determined by the stock of a countrys resources and by

the productivity of factor inputs (labour, land and capital). Changes in
the technology also affect potential real national output.
Causes of shifts in the long run aggregate supply curve
Any change in the economy that alters the natural rate of growth of
output shifts LRAS. Improvements in productivity and efficiency or an
increase in the stock of capital and labour resources cause the LRAS
curve to shift out. This is shown in the diagram below.

Policies to increase LRAS

1. Expanding the labour supply - e.g. by improving work
incentives and relaxing controls on inward labour migration. In
the long term many countries must find ways of overcoming the
effects of anageing population and a rising ratio of dependents to
active workers
2. Increase the productivity of labour e.g. by investment in training
of the labour force and improvements in the quality of
management of human resources. Productivity can be measured
in several ways including output per person employed and output
per hour worked
3. Improve mobility of labour to reduce certain types of
unemployment for example structural unemployment caused by
occupational immobility of labour. If workers have more skills and
flexibility, they will find it easier to get work. Conversely when
unemployment remains high, the economy loses out on potential
output and there is a waste of scarce resources
4. Expanding the capital stock i.e. increase investment and
research and development

5. Increase business efficiency by promoting greater competition

within markets
6. Stimulate invention and innovation to promote lower costs and
improvements in the dynamic efficiency of markets. Innovation
creates new goods and services and encourages investment

For most advanced nations it is the growth of productivity that is

critical to raising the long term growth of real GDP. Our chart above
tracks an index of labour productivity in the UK and shows that, after a
period of strong growth from the mid 1990s inwards, productivity
improvements stalled. Can this be reversed now that the economy is
trying to sustain a recovery?
Aggregate Supply Shocks
Aggregate supply shocks might occur when there is
A sudden rise in oil prices or other essential inputs such as foodstuffs
used in food-processing industries. Foodstuffs are an example of
intermediate products items that are used up in manufacturing goods
for consumers to buy
Vulnerable economies
The inter-connectedness of the global economy makes it more
vulnerable to major shocks......these shocks include cyber attacks,
pandemics, geomagnetic storms, social unrest and financial crises.
Source: OECD Report on Future Global Shocks, June 2011

The invention and diffusion of a new production technology

A major change in the movement of migrant workers from one

economy to another

Shocks and long run aggregate supply

The effects of supply-side shocks are normally to cause a shift in

the SRAS curve. For example changes in the world prices of
foodstuffs, oil and gas and minerals.

There are occasions when changes in production technologies or

step-changes in the productivity of factors of production that
were not expected, feed through into a shift in the long run
aggregate supply curve.

Natural disasters and political conflicts including civil wars can

also have a significant effect on a countrys productive potential
and therefore affect the LRAS although it is often difficult to
measure accurately just how damaging these events have been.

An example of volatile commodity prices the US dollar price of Brent

Crude Oil
Economic Growth
Economic growth is a long-term expansion of a countrys productive
potential
Short term growth is measured by the annual % change in real national
output this is mainly driven by the level of aggregate demand
(C+I+G+X-M) but is also affected by shifts in SRAS
Long term growth is shown by the increase in trend or potential GDP
and this is illustrated by an outward shift in a countrys long run
aggregate supply curve (LRAS)

There are big variations in average growth rates for different countries
and evidence for this is shown in the chart above which tracks real GDP
changes for China, India, the UK, USA and average growth for nations
inside the Euro Zone.

China and India are examples of very fast-growing countries.

Their annual growth has far exceeded that for most advanced
economies; China has out-paced India although both have
experienced a slowdown in growth over the last couple of years

For nations such as the USA and the UK, normal growth is of
the order of 2 3% per year depending on where each economy
is in their business (trade) cycle. The Euro Zone growth rate is
similar but keep in mind that this is an average, there are
seventeen countries at present who share the same currency,
some have been growing quite quickly and others have struggled
to escape from a deep recession and the persistent risk of a
depression.

Economic Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward
shift in the PPF

In our diagram we see how a rise in a nations productive capacity

causes the PPF to shift out and this allows increased supply both
of consumer and capital goods.

Where the economy ends up depends on the decisions made

about the allocation of scarce resources between products to be
bought and consumed today and the production of capital goods
such as new technology, plant and equipment and buildings.

Growth is not the same as development!

The table below tracks the growth rates achieved in the world economy
for three recent years and also for developing countries excluding
China and India.
Real GDP growth (annual % change)

2010

2011

2012

World Economy

4.1

2.7

2.5

Developing countries excluding China

and India

5.6

4.4

3.6

Key drivers of growth

There have been numerous research studies in what determines

long term GDP growth

Every country is different, each factor will vary in importance for a

country at a given point in time

Remember too that in our increasingly inter-connected globalising

world, economic growth does not happen in isolation. Events in one
country and region can have a significant effect on growth prospects in
another

Advantages of Economic Growth

1. Higher living standards i.e. an increase in real income per head
of population
2. Employment effects - growth stimulates more jobs to help new
people as they enter the labour market
In the long term, an economy grows because technology gets better
and we get better at producing things. In the short term, growth is an
indication that the economy is producing as much as it could be and
resources are not being needlessly wasted. With a growing population
and rising wages, the economy has to grow to create sufficient new
jobs.
Professor Jon Von Reenan, LSE
Fiscal dividend sustained GDP growth boosts tax revenues and
provides the government with extra money to improve public services
such as education and healthcare. It makes it easier for a government
to reduce the size of a budget deficit

1. Investment - the accelerator effect - rising demand and output

encourages investment this sustains growth by increasing long
run aggregate supply
2. Consumer and business confidence - growth has a positive impact
on business profits & confidence. A stronger economy will help to
persuade consumers that the time is right to make major
purchases
3. Growth can also help protect the environment such as lowcarbon investment, innovation andresearch and development,
resulting in more efficient production processes to reduce
costs. Ethical consumerism and corporate social responsibility has
become important in recent years.
Virtuous circle of growth

Disadvantages of economic growth

There are economic and social costs of a fast-expanding economy.
Inflation risk: If demand races ahead of aggregate supply the scene is
set for rising prices. Many fast growing developing countries have seen
high rates of inflation in recent years, a good example is India
Working hours sometimes there are fears that a fast-growing economy
places increasing demands on the hours that people work and can
upset work-life balance

Structural change although a growing economy will be creating more

jobs, it also leads to structural changes in the pattern of jobs. Some
industries will be in decline whilst others will be expanding. Structural
unemployment can rise even though it appears that a country is
growing the labour force needs to be occupationally mobile.
Environmental concerns:

Fast growth can create negative externalities for example higher

levels of noise pollution and lower air quality arising from air
pollution and road congestion

Increased consumption of de-merit goods which damages social

welfare

It can leads to a huge increase in household and industrial waste

which again creates external costs for society

Growth that leads to environmental damage may lower the sustainable

rate of growth. Examples include the destruction of rain forests
through deforestation, the over-exploitation of fish stocks and loss of
natural habitat and bio-diversity created through the construction of
new roads, hotels, retail malls and industrial estates.
Deforestation releases more CO2 into the atmosphere each year than
all of the world's planes, trains and automobiles put together. Globally,
an area almost the size of England and Wales is cut down every year
releasing billions of tons of CO2 into the atmosphere.
Using-up scarce resources
The consequences of environmentally unsustainable production are
already visible. Increased exposure to drought, floods and
environmental stress is a major impediment to realizing peoples
aspirations
Source: UNDP Report, 2011
The worlds resources are limited, and recognizing this fact and trying
to preserve them for future generations is vital for sustainable growth.
Our rampant use of oil has run many reserves dry and each year it
becomes more difficult to find new oil fields.
Even water, which so many people take for granted will become a
scarce resource, like many other raw materials. According to the United
Nations, by 2025 1.8bn people will be affected by water scarcity. The
pollution caused by economic growth is another concern.
The Stern Report highlighted the dangers of our disregard for the
environment, especially large CO2emissions. It is predicted that many
species will become extinct as forests and jungles, homes for many
animals, are cut down to pave way for the growing world population.

At present 16,000 species are threatened today. In 1900 according to

the UNs Global Environmental Outlook, there were 7.91 hectares per
person, while it is estimated that there will only be 1.63 by 2050 if
present trends continue.
Economic Growth and Inequality
"Although economic growth in China has created vast wealth for some,
it has amplified the disparities between rich and poor. Although the
average wealth per Chinese citizen was $17,126 - almost double that of
other high growth economies such as India - median wealth was just
$6,327. In 2010, China's Gini-coefficient stood at 0.47. Inequality in
China has now surpassed that in the United States."
Source: Dr Damian Tobin School of Oriental and African Studies
Not all of the benefits of growth are evenly distributed. A rise in real
GDP can lift millions of people out ofabsolute poverty but it can often
be accompanied by widening income and wealth inequality in society
that is reflected in an increase in relative poverty
If inequality grows as a country becomes richer, this raises important
questions about a potential trade-off between equity and efficiency
The Gini coefficient is one way to measure the inequalities in the
distribution of income and wealth in different countries. The higher the
value for the Gini co-efficient (the maximum value is 1), then greater
the inequality.
Countries such as Japan, Denmark and Sweden typically have low
values for the Gini coefficients whereas African and South American
countries have an enormous gulf between the incomes of the richest
and the poorest elements of the population.
When economists look at data on income and income inequality they
nearly always focus on median rather than mean incomes per capita.
The reason is that the very uneven distribution of income means that
there are people who earn astounding salaries and wages and the
income of the super-rich tends to drive up mean incomes. For example,
In the United States, mean income is almost a third higher than median
income, and the gap is growing
Inequality in the UK in 2011: Households below average income
18% of children (2.3 million) in households with incomes below 60 per
cent of medium disposable income
15% of working-age adults (5.5 million) had incomes below 60 per cent
of medium disposable income

17% of pensioners (2.0 million) had incomes below 60 per cent of

medium disposable income
Why does fast growth often lead to a widening of inequalities in both
developed and developing countries?

Very high increases in the pay of people in the top-paying jobs

market-based economies offer the highest rewards to households
with the most valuable skills, education and access to capital

Increasing wealth including rising property prices fast-growing

economies will often seen a rapid increase in property prices

Growing gaps between urban and rural areas with rural poverty
on the increase

High fertility in the poorest households

Linked effects of inequality in health and education

Much depends on the extent to which a particular government has a

welfare benefits and/or a progressive tax system in place and also a
desire to redistribute rising incomes and wealth so that the benefits of
growth can be more equitably shared out.
Evaluation: What are the main constraints or limits on economic
growth?
The USA economy is no longer the biggest single driver of global
demand. 70% of world economic growth in the next few years will come
from the emerging world

The Importance of Infrastructure

Infrastructure systems transport, electricity, telecommunications,
water, etc. play a vital role in economic and social development.
Increasingly interdependent, they are a means towards ensuring the
delivery of goods and services that promote economic prosperity and
growth, and contribute to quality of life
Source: OECD Report, 2008
In this section we outline some of the possible constraints or limitations
on the sustained growth of a country.
Some of these factors apply mainly to developed countries and some
are focused on the growth potential of lower-income emerging
economies many of whom have enjoyed rapid growth in recent years.

Remember that economic growth is a long-term concept referring in the

main to a nations productive potential and international
competitiveness the factors discussed below are some of the demand
and supply-side issues that can hold back potential output growth for a
country.
What can limit the rate of economic growth?
Infrastructure infrastructure includes capital such as ports, transport
networks, energy, power and water supplies and telecommunications
networks. Poor infrastructure hampers growth because it causes higher
costs and delays for businesses, reduces the mobility of labour and hits
the ability of export businesses to get their products to international
markets. A good example is India whose future growth is often said to
be threatened by structural weaknesses in her infrastructure. Many
countries will need to increase their spending on infrastructure in the
years ahead to adapt to and deal with the consequences of climate
change.
Dependence on limited exports many nations still relying on
specialising and then exporting low value added primary commodities
and the prices of these goods can be highly volatile on world markets.
When prices fall, an economy will see a sharp reduction in export
incomes, a higher trade deficit and a growing risk that a nation will not
be able to finance investment in education, healthcare and core
infrastructure. Over-specialisation can make a country vulnerable to the
global economic cycle.
Vulnerability to external shocks in todays global economy, events in
one part of the world can quickly have an effect in many other
countries. Consider the fall-out from the global financial crisis of 20072010 which brought about recession and deep financial distress in many
regions.
Access to Finance
Ensuring access to finance is essential for businesses to survive,
invest and grow. Finance might come from banks, private investors or
capital markets. Barriers to accessing appropriate finance can prevent
new companies from starting up and existing businesses from investing
and growing
Source: UK Treasury Report
Low national savings and low absolute savings savings are needed to
provide finance for investment. In many smaller low-income countries,
high levels of poverty make it almost impossible to generate sufficient
savings to provide the funds needed to fund investment projects. This
increases reliance on international borrowing or tied aid.

Limited access to financial capital and poorly developed domestic

capital markets this is particularly the case for many small, lowincome countries
Corruption and poor governance this is a crucial factor for many
developing countries. High levels of deeply embedded corruption and
bureaucratic delays can harm growth in many ways for example
inhibiting inward investment and also making it more likely that
domestic businesses will invest overseas rather than at home.
Governments need a stable and effective legal framework to collect
taxes to pay for public services. Look at deficit and debt problems
facing countries such as Greece. In India, there are 15 times more
phone subscribers than taxpayers. If a legal system cannot protect
private property rights then there will be less research and
development & innovation.
Declining and/or ageing population in some countries the actual size
of the population is declining partly as a result of net outward
migration. If a nation loses many younger workers this can have a
damaging effect on growth. The changing age-structure of a population
also matters, leading for example to a fall in the ratio of workers to
dependants.
Rising inflation fast growing countries may experience an accelerating
rate of inflation which can have damaging economic consequences
these are covered in the chapter on inflation. Two effects in particular
can hit growth, namely falling real incomes and profits together with
higher costs and reduced competitiveness in international markets. In
our chart below we track real GDP growth and inflation rates in India
notice the steep rise in inflation in recent years. Many other developing
countries have seen high rates of inflation in large part because of
booming food and other commodity prices.
Sustainability
Anyone who believes exponential growth can go on forever in a finite
world is either a madman or an economist.
Kenneth Boulding, economist
Persistent trade deficits due to rising imports Some countries may
experience large and widening deficits on the current account of their
balance of payments. This means that the value of imported goods and
services is greater than the value of exports and net investment
incomes leading to an outflow of money from their economy. High trade
deficits might have to be covered by foreign borrowing or a reliance on
inflows of capital investment from overseas multinationals. And large
trade gaps can eventually lead to a currency crisis and possible loss of
investor confidence.

Over-extraction of the natural resource base natural resources

provide an important source of wealth for many lower-income countries
and when world prices are high, there is incentive to increase
extraction rates to boost export earnings. However this might lead to
an excessive rate of extraction that ultimately damages the growth
potential of an economy. Deforestation and rapid extraction of oceanic
fish stocks are two good examples of this.
Inadequate investment in human capital to sustain growth requires
longer-term improvements in productivity, research & development and
innovation. Whilst physical capital such as factories and technology
plays a role, so too does the quality of the human input into production.
Economic growth might be limited by skills shortages as businesses
seek to expand which forces up average wages and labour costs. High
level skills and qualifications are also needed to help businesses (and
ultimately countries) to move up the value chain and supply products
that can be sold for higher prices in the world economy.
Weaknesses in promoting and supporting entrepreneurship a thriving
enterprise culture is crucial to encouraging new business start-ups and
supporting them through the early growth stage.
Economic and social costs from high levels of inequality of income and
wealth this is an issue that has grown in significance over the years.
Although two decades or more of globalisation has strengthened
average growth rates in many lower and middle-income countries, it
has brought an increase in inequalities of income and wealth. When the
gap between rich and poorer communities gets bigger there are many
possible dangers not least the costs of social tension and conflict and
increasing spending on insurance, law and order systems and
government welfare bills.
Excessive borrowing this feature is common in fat-growth phases for
richer developed countries. In particular we have seen in recent years a
huge rise in personal sector borrowing and debt, much of it linked to
easy credit availability and rising property prices. When a housing
bubble bursts and house prices fall, many thousands find themselves in
deep trouble.
Protectionism Protectionism is the use of tariff and non-tariff
restrictions on imports to protect domestic producers from foreign
competition. These barriers to exporting restrict access to international
markets and damage growth for nations who have chosen an open
approach to trade and investment as a key pathway to expanding their
economies. China and South Korea have had export-led growth during
most of their rapid-growth years. In the wake of the global financial
crisis there have been widespread fears of a return to protectionist
trade policies.