Key points national income. Economic growth Economies change in size over tme. For example, the Chinese economy doubled the value of its production roughly every seven years between 1990 and 2010, The UK economy has seen is production grow at an average of 25 percent per annum forthe past 60 years Growth in the quantty of goods and services produced is measured by the percentage change in GDP. Ths Is the actual growth of the economy. However, the actual level of GDP may be diferent fom the productive poterial ofan economy. The productive potertal is determined by the factors of production avaiable to an economy, such as labour and capital The productive potertal ofan economy is shown by the long-run aggregate supply curve, or the production possibility frontier (PPF}. The actual level of output may be within the PPF if Some factors of production are unemployed or are being used inefficient. Potential growth isthe change in the productive potential ofthe economy overtime. Its shown an a clagram by the shift tothe rghtn the LRAS curve or the PPF. The phrase economic growth can mean ether actual growth or potential growth. Which of these two it refers to depends on the context invwhich the phrase is being used The trade cycle itis not possible fo measure the productive potential ofan economy drecty because there ‘sno way of producing a single monetary figure forthe value of variables sucn as machnery, workers and technology. Instead, economists use changes in GDP. the valve of cutput, as a proxy measure. The problem with using real GDP is that, nthe short term, (GDP fluctuates around the long-term trend growth path of output. These fluctuations are known asthe trade cycle or 160 Causes of economic growth and the trade cycle (253 (Theme 2 41, Economic growth isthe change in potential output of the economy shown by a shift to the right ‘of the production possiblity frontier. Economic growth is usually measured by the change in real . The trade cycle is the fluctuations of economic activity oround the trend rate of growth. . A postive output gop exists when the economy isin boom and GDP is above its long-term trend volve, ‘Anegotive output gop exists when the economy i in recession and GDP is below its long-term trend valve. |. Economic growth is caused by inereases in the quantity or quality of land, labour and capitol and by technological progress which lead to a rise in long run aggregate supply. ‘Aggregate demand can be important in determining economic growth, Exported growth can be stimulant to rises in the long run potential output of the economy. business cycle or economic cycle. All trade cycles are slightly different, However, they tend to have four main phases. These are illustrated in Figure 1. ‘# Peak or boom. When the economy is at a peak or is in a boom, national income is high. Its likely that the economy will be working at beyond full employment. Overheating is therefore present (although the economy could be at less than full employment, according to Keynesians, i there are bottlenecks in certain industries in the economy). Consumption and investment expenditure will be high Tax revenues will be high, Wages will be rising and profits increasing, The country will he sucking in imports demanded by consumers with high incomes and businesses with full ‘order books. There wil also be inflationary pressures in the economy, ‘* Downturn. When the economy moves into 2 downturn, ‘output and income fal, leading to a fallin consumption and investment. Tax revenues begin to fall and government expenditure on benefits begins to rise, Wage demands moderate as unemployment rises. Imports decline and inflationary pressures ease. Figure 4 ‘The traditional business cycle ‘The economy moves regulary from boom through recession to slump before recovering eqoin, ° Tine'* Recession or depression or trough or slump. At the bettom of the cycle, the economy is sald to be in a recession or depression or trough or slump. Economic activity is at alow in comparison with surrounding years. High unemployment exists, 50 consumption, investment and imports will below. There will be few inflationary pressures in the economy and prices may be falling (je there will be defiation). ‘e Recovery or expansion. As the ecoriomy moves into a recovery or expansion phase, national income and output begin to increase. Unemployment falls. Consumption, investment and imports begin to rise. Workers fee! more confident about demanding wage increases and inflationary pressures begin to mount. ‘There is no standard way used by textbooks, newspapers: {and govemments to describe or define the phases of the cycle. For example, sometimes the economic cycle is simply reduced tp two phases - boom and recession, or alternatively expansion and contraction. Sometimes ‘recession’ and downturn’ are used interchangeably. Some economists define recession in terms of a range of indicators including unemployment and investment rather than using GDP alone. In the UK, the government defines recession as where real GDP falls in at least two successive quarters (le. where there is negative growth of real GDP quarter on quarter for tuo successive quarters). For example, the UK economy fell into, recession following the banking crisis of 2008. |crowth of real GOP|_irvestment_| Unemployment Exports - imports 3) (Ecitionat | (nitions) | (£bition at 201 prices) 2011 prices) 1987 55 [1954 28 78 24 1989 25 mee | at | 79 05 2306 20 25 12 2123, 25 03 1982| ow 2088 28 36 198326 2i04 28 12 Two types of trade cycle Figure 1 shows a rade eyele where GOP actual fls inthe recession pase However there are milder trade yes where GDP does not fll stead, the economy fuctuates around its long-run real GDP growth path but real GDP continues to ise sven ina dovmatn even the tae relivey sl. This type rade cyte ie shown in igure 2 For exam, iow of real GDP may fluctuate between one percent and fve per cent ised wget pa verapig tree por cone Figures 1 and 2 are not stety mathematical accurate. The ‘ere evel of eal GDP ine shoul be gently curving upwards showing the efects of compound growth i real GOP. However, Figure 2 Amild trade cycle Pecks ond troughs occur when economic growths high or low respectively =i itis conventional at A level to draw the level of real GDP line as a straight line to make it easier to draw the diagram. Causes of the trade cycle “here are many diferent reason why the short un rate of growth of real GDP may fluctuate around its lng-term trend: But they can be classed into two main types: demand-side shocks and eapphride thao Demand side shocks are shocks which affect aggregate dinar, Eramples of derrand-ide shocks cuca the Row i A oui market buble ey burst This oocrs wien house prices rise to too high a level and suddenly thee is a collapse fh demand for housing and a'sharp fallin house prices. Tres ects consumer cotidence lari to lose consi Spending and few new houses being but which affects cutpatand employment @ The stock market may crash. Perhaps stock market prices: aie tod high A stock market crash reduces the weak of individuals, They are then likely to cut back on their spending and save more to rebuld their wealth This reduces aggregate deinand causing the cession The conta bank may sharply ralseitoest rates perhaps so er ig flo, Tes eth Cx Spel on durables and iyestmest spencing, sending the economy ito recession ip Thetaprerenere ra hoy ae anor cut acer spending, perhaps to combat sing inflation or balance iS budget This leads fo lower aggregate demand and The world economy may go int recession, biting UK exports starply and so senang the UK int a receado too, There may bea sharp ise Inthe value of the pound against air crrefce Ts focos te Goripetinvencss ofthe Ueconomy sending ports dovn and imports up. The subeorlent fl waggroyate demand cende the wconory eee er 164Theme 2- Unie? Supply-side shocks are shocks which affect aggregate supply. Examples of supply-side shacks include the following. «© Alarge rise in worid commodity prices could both raise the price level in the UK and lead toa rise in import values Ff demand for the commodity is price inelastic. Te rise in import costs will reduce aggregate supply leading to tower output ‘An outbreak of trade union militancy could see large wage Increases which wil raise the price level substantially and reduce aggregate supply leading to recession. ‘The examples given above are all negative shocks which could move the economy info recession. However, a shock can also be positive, causing the economy boom. For example, a sharp fal incl and other commodity pices could cause the UK ‘economy to boom because the UKs a net importer of oll and ‘other commodities. The output gap ‘The diference between the actual level of real GOP and its ‘estimated long term value at a point in time is know as the ‘output gap. In Figure 3, the straight line is the trend rate of growth in real GDP over a long period of time. Its assumed ‘that this shows the level of real GDP associated with the productive potertial of the economy. The actual level of real ‘GDP varies around the trend growth line. This fluctuation is the. trade cycle, When the economy isin recession and there is high unemployment and deflation, the actual level of real GDP will be below the tend line. A negative output gap is then said to exist This means there is spare capacity in the economy, with factories, offices and workers iyng idle when they could bee producing goods and services. In an infationary boom, the actual level of real GDP is lkely to be above the trend line. A positive output gap then eaists. Output gaps can aso be ilustrated using an aggregate demand and aggregate supply curve diagram. In Figure 4, the long-run equilbrium output ofthe economy is OY, This is shown Figure 3 ‘The output gop ‘The trend rate of growth of GDP approximates the grow in productive potential ofthe economy. When actual GDP falls below this or rises above it, there is sci to be on output gop. When actual GOP grow fells below thi, theres e neqetive output ap. When ‘ociual GOP grovith rises above it, there is a positive output gop. o Time 162 Figure 4 Apositive output gap ‘The postive output gap isY:¥, shown by the difference between the ecto! level of output of Y, and the long-run potertial ouput of, the economy atY, eal output by the vertical long-run aggregate supply curve. However in the short run, equilibrium fs higher at CY, because this is where short-run aggregate supply and aggregate demand are equal. ‘There wil therefore be a postive output gap in the economy of Y: Yo Tis positive output gap willbe filed either through long-run economic growth moving the LRAS curve to OYp, or through a recession shifting aggregate demand downwards and the SRAS shiting upwards, or some combination of both Figure 5 shows a negative output gap. Long-run aggregate supply isto the right of the short-run equilibrium output level (oF OY, The negative output gap is therefore YY, To close the Figure 5 Anegative output gop ‘The negative output gap iss, shown by the difference between ‘the ortual level of output of OY; and the long-run potential output ofthe economy ot OY. = z igap, aggregate demand is likely to rise faster than the long-run growth in the economy shown by the shifts to the right of the ‘AD and LRAS curves. It might seem that the size of any output gap is easy to estimate. In practice, t can be dificult to gauge. Ths is mainly because economists do not know exactly the position of the long run aggregate supply curve. Far example, following the lengthy recession and very low recovery rate in the UK between 2008 and 2013, economists revised downwards their estimates for the long run rate of growth of the economy. By 2014, the negative output gap on the average 2008 estimate of the trend rate of growth was above 15 per cent of GDP. By reducing the ‘rend rate of growth, this had been reviced down to a few per cent in 2014 estimates, The other problem in estimating the ‘output gap is that intial estimates of GDP, showing where short run aggregate supply and demand are equal, are almost always inaccurate. GDP figures are constantly revised. There can be quite major changes to figures one or two years after the period being measured, Some economists believe that output gaps are so difficult to measure that they are not a valid concept to use for the purpose af economic policy. ‘Questi 12 Figure 6 Cyclical indicator estimates of the output gap a 5 ‘ oat A of al A REE A CES SRS OR wT _ the UK's histoneol output gap by Tarn Pybus, Office Explain sing on oggregete demond and supply diogram, whether. scparoncicampinaa son Hysteresis Figure 3 might suggest hal there i tle cost associated with fuetveons nthe level of acy, Output lst na recession \eretahed Uurigiatoory, aly the ecmecsno beter or worse of nthe long term, However, there are possible ether casa, Those made unemployed dung a recession, however mid fue alas inthe income even Ifthe malorty of weshers ore unatlected Those on fed incomes sun a bod inal He Ther spending power ts eroded because of higher prices Figure 7 Hysteresis The vend rete of growth of an economy con shift downwards iF there ise deep recesion becouse of permanent lasses of human cond physical capital, Realoutput Tine ° a s ‘» Some economists argue that in a deep recession, economies do not bounce back to their previous trend leve! of growth, This is an example of hysteresis. Instead, the economy remains ata lower level of output, albeit sil growing at Its previous trend rate. In Figure 7, the economy starts off on a ‘rend growth path of AA. However, a deep recession with its ‘rough at OR means that the economy only booms at a level consistent with a lower growth path of BB. The economy then suffers ancther deep recession with a trough at 0S, The trend line of growth shifts dovn to CC. After this, the business cycle Is much shallower and actual output fluctuates around the trend line of CC. One reason why an economy may fall to recover fuly from a deep recession is that there Is a permanent loss of human capital, In a recession, millions can lose thelr jobs. Some take early retirement, with a consequent loss of output for the economy. Others suffer long periods ‘of unemployment and become deskilled. They are therefore less productive than before. Another reason is that there can be a permanent loss of physical capital. In a recession, firms ‘cut back on their investment. If they fail to make this up in the next boom, there is less physical capital in the economy than would otherwise have been the case, Potential output must then fall The production possibility frontier Production possibilty frontiers (PPFs) can be used to discuss feccnamic ofboth. The PPF shows the maximum or potential cutout ofan economy, When the economy grows, the PPF wil ‘move outward as in Figure &. A moverert rom A to C would be classified as ecanomic growth, However, there may be unemployment in the economy. Wah a PPF passing through a movement from B (oynere there is unemployment) to C {fll employment) would be classified as economic recovery rather than economic growth. Hence, an increase in eal national income does not necessarily mean that there has been feccnomie ofoith In practice it's #fcutto know exacty the location of an economy's PPF and therefore economist tend to treat all increases in al GNP as economic growth 163Theme 2- Unie? Figure 8 can also be used to show the conflct between investment and consumption. One major source of economic growth is investment, ll other things being equal, the greater the level af investment the higher will be the rate of growth inthe future, However, increased production of investment goods can only be achieved by a reduction in the production ‘of consumption goods ifthe economy is at full employment. So there is a trade off to be made between consumption now and ‘consumption in the future. The lower the level of consumption today relative to the level of investment, the higher wil be the level of consumption in the future. The causes of long-run economic growth Fluctuations in the level of real GDP around the trend rate ‘of growth are caused by demand and supply side shocks. However, what explains why the productive potential ofthe economy increases overtime? All economists would agree that an increase in long-run aggregate supply will increase the potential level of output in an economy. Long-run aggregate supply can increase if there 's an increase in the quantity or qualty of the Inpus to the production process. Output can also be increased if existing inputs are used more efficient, This can be expressed in terms of a production function: ‘Output = f (land, labour, capital, technical progress, efficiency) Each of these factors will now be considered. Land Different countries possess different endowments of land. Land in economics is defined as all natural resources, not just land itself, Some countries, such as Saudi Arabia, have experienced large growth rates almost solely because they are so richly endowed, Without oil, Saudi Arabia today would almost certainly be a poor developing country. Other countries have received windfalls. The UK, for instance, only started to exploit its oll and {gas resources in the mid 1970s. However, most economists 164 argue that the exploitation of raw materials is unlikely to be a significant source of growth in developed economies, although it ‘can be vital in developing economies. Labour Economic grovith is likely to occur if there is either an increase in the quantity of workers in the economy or there is an increase in the quality of labour. Increases in the labour force can result from changes in the birth rate, increases in participation rates and increases in immigration. Changes in demography Today's birth rate has a knock-on effect on the size of the labour force in 20 years’ time, Countries that have a high birth rate, such as many African countries, have increasing numbers of workers. In Europe, the birth rate has been relatively low in recent decades, This has reduced the size of the current labour force from what it would otherwise have been. Changes in participation rates Participation rates are the proportion of the population of a certain age who are either in work or seeking wok. Increases in the proportion of young people staying on in education have reduced the size of the UK labour force ever the past few decades. At the opposite end of the age range, two contradictory forces have been at work. More ‘workers can afford to take early retrement than 30 years ago. ‘On the other hand, the pushing up of the state pension age is seeing a growing number of workers work beyond the traditional ages of retirement for men of 65 and women of 60. Lasty, more and more women have entered the labour force in the UK, ‘encouraged by higher wages, better childcare arrangements and more labour saving devices in the home. Immigration A relatively easy way of increasing the labour force is to employ migrant labour. In the UK, for example, there have been large inward flows of migrant labour from Eastern Europe in recent years. It should be noted that increasing the size of the labour force may increase output but wil not necessarily increase economic welfare. One reason is that increased income may have to be shared out amongst more people, causing lite or no change in income per person. If women come back to work, they have to give up leisure time to do so. This lessens the increase in ‘economic welfare which they experience Increasing the size ofthe labour force can increase output ‘but inereasing the quality of labour inputs is likely to be far more important in the long run. Labour is not homogeneous ((¢. Itis not all the same). Workers can be made more productive by education and training, Increases in human ‘capital are essential for a number of reasons. ‘© Workers need to be sufficiently educated to cope with the ‘demands of the existing stock of capital. For instance, it is important for lorry drivers to be able to read, personal assistants to use computer software and shop workers to ‘operate tls. These might seem very low grade skils but it requires a considerable educational input to get most of the ‘population up to these elementary levels, ‘© Workers need to be flexible. On average in the UK, workers are likely to have to change job three times during theirlifetime, Increasingly workers are being asked to change roles within existing jobs. Flexibility requires broad general education as well as in-depth knowledge of a particular task. ‘¢ Workers need to be able to contribute to change, It is easy +0 see that sclertists and technologists are essential If inventions and new products are to be brought to the market. What is less obvious, but as important, is that every worker can contribute ideas to the improvement of techniques of production, An ablity of all workers to take responsibilty and solve problems will be increasingly important in the future, Capital The sick of capital inthe economy needs increase over iene econo yiowth ii be sister: This teat that there mast ba austahed inestment inthe econory. Hosea there isnot necessary a correlation between high vestmert and high growth. Some investments not growled. For srarple, Reuter argued that frestnert new fusing dies not lead to future increases in eal GDP Investment ean also be ‘ested if ittakes place in inst in projects which fl to be commercial suctesshl Technological progress ‘Technological progress increases economic growth in two ways. «It cuts te average cost of production ofa product. For instance, a machine which performed the tasks ofa simple Scientific calculator was unavalabie 100 years ago. 50 years ago, tneeded a large room fll of expensive equipment to do this. Today calculators are portable and avallable fora few pounce ft creates new product forthe market. Without new products, consumers would be less likely to spend increases in their income. Without ext spencing, there wuld be less orn economic growth Efficiency The way in which the factors of production are used together is ial fo scemonic growth Increased elie nthe use ot resources in self wil bring about rises in output Tia fshat econcry; Compatort shoud load eitat efficiency, Firms which use more efficient production techniques: wel deve leas efiient fis cut ofthe market Frm wich deel view better product vl deve sd products out of ‘fe arte Se-econorrc grow can come about becavee of government polices wilch promate Gornpctiion and potect ear. For ame; plies sch as pave dereguition and control of monopoles should nerease competion, Lars wich protect paints and copyright il encourage innovation Markets promote efcehey but they ean alo fail So government may have to step in to redress market failure. In the past, some have argued that market failure isso widespread thatthe goverment should com mat; not al of ndty This socialist or communist view ts most rejected today. The probit wa Yel fh cornmurit counties We Russi agverenent fare becama so text hat outwoighed any Benefs fom i carecion of tafket fale, Howes or counties inday are more ikereriorst han others France Question 3 Figures from the Office for Notional iristis (ONS) show the ‘main drivers of growth over the period 2000-2013, Throughout the period, the impact of o better educated workforce shown by “Lobour composition’ in Figure 9, has made o positive contribution to ‘ecnomic gro. Fr the most por, so too has the numberof hours ‘worked, On the whole thishas not come from individual fill time employees working longer hours. hos come from an expanding ‘chow force particulary dueto immigration from the FU and from or-tme workers inceosing their hours perhopst ful ime Copital input to hos mode a positive contribution to growth, This smode up of new investment but oso past investment in opital goods buildings and infrestructure, ‘Woryinaly, however since the recession, which started in 2008, the ficiency (led mult fxtor productivity by ONS) with which the ‘ectors of production are combined has tended to be negative. The ‘worst-performing sector of Ue economy in ters of efiieney hos been North Sea oil where oning il elds have made charderto extroct ol despite grotercopital investment, and the employment ‘of more ond better qualified workers. ‘The ONS estimates thot before 1997, Brin’ grovah was diven bby @ more rpily grwing eopitel stock. Since 1997, the most Jmportont driver for growth bos been the improvement in the education ofthe labour force Sear ota rm th eral Tins 263.2015, Ah ase, vaso gp (0) Using the dato, explain why GDP fll in 2003. {b) How con () more workers and (i) a hetter educated workforce contibuie to economic growth? (2) IFfrmsinvested more in North Seo oi production, discuss “whether this would ese the rte of exoremie growth for the UK. 165Theme 2- Unie? and Germany, for example, intervene more in markets than, say, the USA, In low and middle income countries, many of the features of a functioning market economy may be missing. Resources are then combined inefficiently, For example, laws may not exist which protect property rights, or laws may exist but the state may take assets away from private citizens and businesses ‘through corruption, bribery and a judiciary which doesn't Uphold the lave. If property rights are not protected, ctizens and firms have litle incentive to save and invest in the long term. Widescale bribery leads to resources being appropriated by a few individuals rather than being used in the most efficient ‘manner across the economy, Another problem is that there may bbe no properly functioning capital markets. Farmers in rural areas, for example, may have no access to banks. They are then cut off from access to relatively cheap loans to expand their businesses. At worst, there may be civil war and a complete breakdown of government. Civil wars lead to negative growth as assets, both physical and human, are destroyed Aggregate demand Many economists argue that aggregate demand can also affect the lana run growth rate of an economy, For example, over the past 70 years, many polticians and economist in the UK have advocated export-led growth. They have seen the success of Germany, Japan and China and linked that tothe strength of their exports. Arise in exports wil intally increase aggregate demand rather than aggregate supply. However, a permanent increase in exports all ether things being equal, wil force UK firms to invest in equipment and lead ta rise in the demand for labour to satisty the increased demand, The rise in investment willeac toa ese in the productive potential ofthe economy and hence impact on economic growth The other impact of export led growth is on compettiveness and eficiecy, To exsor, UK firms have o have a competitive advantage over domestic rms in foreign markets. For example, their prices have to be lower, or the goods have to better designed or of better quality. Becoming more export orientated therefore forces frm to become more efficent. Greater eficiency lead to an increase in long run aggregate supply and economic growth. Some economists also argue that increases in aggregate demand in genera, trough fs influence on investment, mpacts on aggregate supply. When an economy goes into a moderate to severe recession, ms react by cutting ther investment Lower output means they don't need as much capital as before. Lower sales aso reduce the amount of cash fms have to use for investment ifthe economy bounces back quickly, frm will tend to overinvest inthe next boom, making up forthe loss of investment in the recession, However in a prolonged recession, the loss of investment andthe fallin human capital can lead to long run aggregate supely being permanent loner Ths isthe problem of hysteresis described above What # the economy fli 0 recover even within, say, 20 years and runs permanenty below is productive potential? 166 This is an important current issue because of the experience cf Japan and 2 number of countries in the eurozone such as, Italy. in a number of eurozone countries, for example, there are unemployment rates of 10-25 per cent that have persisted over ‘a number of years. Supply-side economists would argue that this shows that supply-side reforms need to be implemented in the labour marke. Reducing warkers' rights in areas such as the ability of employers to sack workers will encourage ‘employers to take on mare workers and so solve the prablem, Other economists would argue that there will be no extra jobs, if aggregate demand remains depressed. Government policies cf fiscal austerty, for example, which reduce aggregate demand are contributing to low or zera growth rates in the economy, ‘This would suggest that a necessary condition of economic ‘growth is that there is adequate aggregate demand to stimulate investment and employment of unutlised resources. Four distinctions Economic growth is typically measured by the rate of change of ‘output or GDP, When measuring GDP, four important distinctions should be made, «Economic growth is typically measured by the rise in the ‘output oF goods and services over time. Economic grawth is changes in real GDP and not changes in nominal GDP ‘hich also includes increases in prices. Real GOP over time has to be measured using one year’s prices. So, for example, in 2015, real economic growth was measured by the UK statistical service, the Office for National Statistics, using 2011 prices. (¢ Real GDP is @ proxy measure of the volume of goods and services produced. It is equal to the quantity produced in ‘an economy, The value of goods and services produced is. volume times the average price. So a proxy measure of the volume of goods produced can be calculated by taking the nominal value of GDP and dividing it by the price level ‘© Total GDP js the total amount of GDP produced in an ‘economy. However, when comparing living standards, itis often more Important to compare GDP per capita or total GDP divided by the size of the population. Similarly, growth in GDP per capita, which takes into account both change in GDP and the change in population, is often more useful shen comparing living standards than simply using growth in total GOP, ‘# Falling economic growth dees not mean that the level of real GDP itself is faling. China grew at 10 per cent per annum between 1980 and 2010. If ts growth rate fell to two per cent per annum, its GDP would stil be rising by two per cent each year. A falling rate of growth simply means that GDP is not rising as fast as before, So tis very important to distinguish between the level of GDP and the rate of growth ‘of GDP. Only ifthe rate of growth of GDP became negative would GDP be fallingKey Term ‘Actual growth - economic growth as measured by recorded changes in real GDP over time. Boom or peak - period of time when the economy is growing strongly and is operating above its productive potential Demand-side shock -a sudden and large impact on ‘aggregete demand. Depression or slump - a period of the trade cycle when there. is a particularly deep and long fall n output Downturn - a period of the trade cycle when either economic ‘growth or GDP itseltisfaling, Economic growth - a rise in output in an economy which can be either actual growth or potential growth Economic recovery - the movement back from where the ‘economy is operating below its productive potential to a point where itis at its productive potential, Export-led growth -a rise in aggregate demand caused by a ‘ise in exports, Hysteresis - the process whereby a variable does not return to its former value when changed. In terms ofthe trade cycle, itis used to describe the phenomenon of an economy failing to return to its former long term tend rate of growth after a Output gap - the diference between the actual level of GOP and the productive potential ofthe economy. There isa postive output gap wher actual GDP ie above the productive potential ofthe economy and itis in boom. There isa negative output gep when actual GDP is below the productive potential ef the economy, Potential growth - economic growth as measured by the changes in the productive potential of the economy overtime Recession - a period ofthe trade ojce when output o crow in output fals. The technical defniton now used by the UK governments that a recession occurs when growth in output is negative fortwo successive quarters (Le two periods of three months). Spare capacity fora whole economy, this exists when long run aggregate supply is greater than aggregate demand and 50 there isa negative output 929 Supply-side shock - a sudden and large impact on aggregate supp}, Trade or business or economic cyte - regular fluctuations in the level of economic activity around the productive potent of the economy. In business cycles, the economy veers from recession, when fis operating wel below fe productive Potential to booms when itis ely to beat or even above its productie potential Thinking like an economist Economic growth in the UK economy In his 1999 Pre-Budget Report, the Chancellor of the Exchequer at the time, Gordon Brawn, who later on went on to become Prime Minister, said that ‘under this government, Britain will net return to the boom and bust of the past, He came to regret those words. ‘As can be seen from Figure 10, the UK economy performed well between 2000 and 2007. The world economy suffered no | Figure 10 _ Economic growth, quarry (change in GDP at ‘market pr 11 prices, year on yecr) 167Theme 2-thiea2 major shacks, which could have led toa demand-side shack for the UK economy, Positive economic growth encouraged UK firms to invest. Education standards improved whilst many UK firms, particularly large firms, became more efficient in the face of international competition However, the period also saw major market failure in the banking sector. Banks over lent ta customers, seeking to grow and gain market share. Households in the UK increased their Indebtedness as a proportion of their income, Banks also engaged in riskier and riskier activities in a search for profit, The catalyst for the financial crisis of 2007-08 came from the USA. Barks there had given large numbers of mortgages to low- income household (co called ‘sub-prime’ borrowers) on deals hich fixed low repayments for a few years. When they came to pay the full rate of interest on their loans, many coulda't afford the repayments. The bad loans that resulted exposed the risky lending practices of many banks across the ward. The result was a near collapse of the world banking system. Governments, were left to bail out the banks. In the UK, banks cut back their lending and there was a sharp fallin housing prices. The demand-side shock led the economy into recession. In previous recessions, the UK economy had bounced back stronaly within two or three years. This recession shown In Figures 10 and 11, however, was diferent in a number of different ways. First, households were highly indebted at the start of the recession. They were reluctant to increase their borrowing and kick start a recovery through increased consumer spending, ‘Their income was also hit by tax rises from 2010 and relatively high inftation due to increases in world commodity pri between 2010 and 2013, Finally, depressed demand meant thal employers were reluctant to give any pay Increases to workers. The government itself imposed a general pay freeze on public sector workers between 2010 and 20114 Second, firms cut back their investment. This is normal in a recession. However, lack of domestic demand and lack of growth in the UK's main export market meant that investment Stayed depressed for a longer period of time than usual. Third, a new government elected in 2010 prioritised cutting the large public sector budget deficit aver ather abjectives Including growth, ses in taxes and cuts in public spending between 2010 and 2012 in particular cut aggregate demand and stalled the recovery, Fourth, in previous recessions the warld economic climate ‘was much better. Growth in other countries meant that UK exports too saw growth. This contributed to higher aggregate demand. However, the financial crsis of 2007-08 was worldwide and affected particularly our main export partners Including the rest of the European Union. A failure of the world economy to bounce back quickly contributed to the UK's failure 1p recover 168 Quarterly real GDP in the UK peaked in the first quarter of 2008. It wasn't tl the third quarter of 2013 that GDP returned to that level, Historically this was an exceptionally long period of lime for a UK recovery. Source: wh rfrmatio fron wawansgov: Pre Budget Report 1909; woeFigure 42 Economic growth (annual % change in GDP) b hb ow bo oF ‘2007 02 aa G4 05 06 07 08°09 1011 12 1214 1516 Figure 14 Inflation rate (onnuel % chonge in prices) 4 20070205 04 05 06.07 08 OF 10 TIS 1415 16 Figure 16 Output gop (deviation of actual GDP from potential GDP 0s % of potential GDP)'? £2003 020s 05060708 03" 10"11"12"15"14'15'18 4. The uromnets he gous of EU cours wl as edt ho ero 38 nd earene nding Pol, Gary Fence ond elon! But cing oar ord be UR, 1212085 ord 2016 or foreant dota. Sour adopted re ant or —— Data Response Question Poland, Portugal and the eurozone Figure 13 Unemployment rate (%) oot 026s 04 05°06 a7 08 99 101112 15" 14 15 18 Figure 15 Investment (reol totol gross fixed capital formation, connual % change) 20 6 ‘zoniea oso 05060708 og 10" 11"12"15" 141516" 4. Giving examples from the data, explain what is meant by recession, 2. Explein, using examples from the dato, the link between investment and growth in the potential output of an economy. 3, Discuss whether Poland's economic performance was ‘better than that of either Portugal or the eurozone over the period shown in the data, Evalbation Story defining economic performance. Then rompare trends forthe twee economies for dh econemic vrible Look at the performance tthe beginning ofthe period de middle ofthe period ard the end of the period, Weigh up the exidence for your evluetion. Whot vorcbles fare not present in the dota but which are important for judging the ‘ecanemic performance of an economy? How does thei absence fect your overall judgement? 169