Economic Growth and

Business cycles
What is Demand? Who creates it?
• Consumption spending by households (C)
• Investment spending by business & households (I)
• Government purchase of goods & services (G)
• Net Exports (X-M)
The composition of GDP
GDPMP = C + I+G+X-M
MP denotes Market Price

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Economic growth
• Distinguish between actual and potential economic growth.
• Actual growth is the percentage annual increase in national output or
GDP (Gross Domestic Product)
• Potential growth is the speed at which the economy could grow. It is
the percentage annual increase in the economy’s capacity to produce:
the rate of growth in potential output.
• Potential output represents a ceiling on a country’s output and hence
will limit the living standards that can be achieved by its residents.

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Actual and Potential growth
• Actual growth is determined by Aggregate Demand.
• Aggregate Demand (AD) is the total spending on goods and services
made within the country.
• AD=C+I+G+X-M
• Potential growth is determined by:
(a) An increase in resources – natural resources, labor and capital
(b) An increase in the efficiency with which these resources are used
through advances in technology, improved labor skills and improved
organization.

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Actual and Potential growth
• If the potential growth rate exceeds the actual growth rate, there will
be an increase in spare capacity and an increase in unemployment.
• In the long run, the actual growth rate will be limited to the potential
growth rate.

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Policies to increase economic growth
• In the short run: increase AD
• In the long run: remove supply side constraints to increase potential
economic growth i.e. increase the quantity of the 4 factor of
production and efficiency (productivity levels).

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Economic growth and the business cycle

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The Business Cycle
• Alternating increases and decreases in economic activity
over time
• Phases of the business cycle
• Peak – business activity has reached a temporary maximum. Real
output is close to the economy’s capacity. Prices likely to rise.
• Recession – decline in total output, income and employment.
Contraction in economic activity.
• Trough – of the recession. Output and employment ‘bottom out’
at their lowest levels.
• Expansion – follows recession. Real GDP, income and
employment rise. Economy approaches full employment. If
spending expands more than production capacity, prices will
increase. Inflation will occur.
The Business Cycle

Peak

Peak
Level of real output

Peak

Trough

Trough

Time
Business Cycle Phases
Total
Output
Boom

Peak
Secular
Growth
Trend

Trough

Expansion Recession Expansion

Quarters
1 2 3 4 1 2 3 4 1 2 3
The Phases of the Business Cycle: Technicalities

• An expansion is an upturn that lasts at least two consecutive quarters

of a year
• A recession is a decline in real output that persists for more than two
consecutive quarters of a year
• A depression is a deep and prolonged recession. Recession versus a
depression.
• Depression of 1929 – GDP shrank by 27 percent, unemployment
increased by 25 percent. Seriously impaired business activity over a
decade.

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Why do business cycles occur?
• Causes of shocks
• Irregular innovation – new products, production methods,
such as those associated with railroad, automobile,
computer, internet… increase investment, consumption,
output and employment.
• Productivity changes – due to changes in resource
availability, general rate of technological advance.
• Monetary factors – changes in money supply.
• Political events – peace treaties, wars, terrorist attacks.
• Financial instability – financial bubbles i.e. asset prices
increase/decrease. Booms and bursts follow.
Recession of 2007 – 2009
• Precipitated by a combination of excessive money and a financial
frenzy that led to overvalued real estate and unsustainable mortgage
debt.
• Institutions bundled this debt into new securities (derivatives) that
were sold to financial investors.
• Some investors bought insurance against losses that might arise from
the securities.
• As real estate prices plummeted and mortgage defaults unexpectedly
rocketed, the securitization and insurance structure buckled and
nearly collapsed.
• Credit markets froze, pessimism prevailed, and spending by firms and
households declined.

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Fluctuations in economic activity
• Whatever the source of economic shocks, immediate cause of large
majority of cyclical changes in levels of real output and employment is
unexpected changes in level of total spending.
• If spending sinks and firms cannot lower their prices, firms find
themselves selling fewer units of output.
• Slower sales will cause firms to cut back on production. GDP falls. And
the employment will also fall. Economy will contract and enter a
recession.

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Structural Stagnation
 Structural stagnation is a cyclical downturn that we
do not expect to end any time soon with major
changes in the structure of the economy

 Unemployment is not due to temporary layoffs, but

to longer-term changes

 The distinction between a business cycle and

structural stagnation goes to the heart of the modern
macro policy debates
Unemployment and Jobs
 The unemployment rate is the percentage of people in the
economy who are willing and able to work but who cannot
find jobs
 Cyclical unemployment is that which results from fluctuations
in economic activity

 Structural unemployment is that caused by the institutional

structure of an economy or by economic restructuring making
some skills obsolete