Economic growth and the business (economic) cycle

Economic growth is the single most important objective for an economy and for policy makers. Without growth, none of the obvious benefits of growth can be gained, including the direct benefits of employment and increased standards of living. Without growth, the indirect benefits may also be lost, including maintaining healthy public sector finances out of which spending on a range of merit and public goods depends.

That is not to say that economic growth itself does involve costs. Growth can bring about inflation, cause harm to the environment, and lead to trade difficulties.

Whether the 'net' benefit of growth (benefits less costs) is positive or negative depends largely on the actual rate of growth at a point in time compared with the rate that is required to achieve the benefits while limiting the costs.

While there is no specific rate to maximise the net benefit, the idea of a 'trend rate' is often used. The trend rate is the rate at which an economy can grow without causing costs to rise at a rate where the problems cannot be effectively dealt with. While the trend rate is not a fixed rate of growth, it is possible for analysts to deduce the long-term average rate where costs and problem are minimised. The rate may be revised periodically to take into account new assessments of costs.

The estimated trend rate is rarely published because it is felt that it is a statistic that is too abstract and not easily understood, and there is little agreement about how best to calculate it. Hence, it is not recognised as an 'official' static, unlike GDP itself.

Difference between short and long run growth

Short run economic growth simply means that an economy has increased its real output between two points in time. However, the increase in real output is not necessarily an increase in the maximum output that could be achieved in the long run. Hence, an increase in long-term growth means an increase in the potential of the economy to produce.

This difference can be illustrated in to ways - firstly, through the use of a production possibility diagram, and secondly using an SRAS-LRAS diagram.

Using production possibilities

Short and long run growth

Using AD-AS analysis

Short and long run growth using an AD-AS diagram

In both cases, the movement from a to b represents short-run growth, and the movement from b to c represents long-run growth.

Determinants of short-run growth

Short run growth is largely determined by increases in AD, which may be the result of increases in:

  1. Consumer spending - as a result of increased confidence, lower interest or tax rates, and higher wages.
  2. Investment spending by firms - from similar factors, such as increased business confidence, lower interest rates, higher profits and lower business taxes.
  3. Net exports - from either an increase in exports, or a reduction in imports.
  4. A general increase in the supply of money.

All of these shift the AD curve to the right.

Demand side economic growth

Aggregate supply is also relevant in the short-run given that, graphically, the gradient of the AS curve has a bearing on how much real output increases following a shift to the right in the AD curve. This means that when AS is more elastic (as in the range Y to Y1), any shift to the right will increase real output compared with when the AS curve is inelastic (as with Y 1 to Y 2), with less upward pressure on prices.

Determinants of long term growth

In the long run, the reverse is true - while the main factor determining growth is aggregate supply (where the LRAS shifts to the right) aggregate demand is also relevant in that without sufficient demand, increases in aggregate supply capacity may lead to deflation. Hence, stable and sustainable long term growth relies on the factors that determine LRAS.

The business (or economic) cycle

The business cycle - or economic cycle - refers to the upturns and downturns of economic activity which commonly affect all economies.

While business cycles have been known about for centuries, it was not until the 1940s that they were fully analysed.[1] Since then, numerous theories have been put forward to explain the causes of cycles and how policy-makers can influence them.

Today, most economists [2] prefer to use the term 'short term fluctuations' in economic activity, rather than 'cycles' given that the idea of a cycle implies a balanced and symmetrical increase and decrease in economic activity, which is rarely the case with real-world cycles.

What happens in a business cycle?

The starting point for economists is to try to understand when an economy is in a stable equilibrium state and then explain the forces that can move it away from its stable equilibrium.

However, equilibrium does not mean 'ideal' - hence economists have traditionally referred to 'full-employment' equilibrium as optimum. While equilibrium means stable and balanced, an economy is constantly in a state of flux, pulled this way and that way by forces that can move it away from full-employment equilibrium towards a less desirable level of activity. Hence, economic fluctuations are the 'norm' rather than being abnormal.

Most economists argue that it is the role of policy-makers to prevent the extreme variations in economic activity that can result in significant economic problems.

Features of business cycles

Two features of business cycles are worth considering:

  1. Trends tend to persist over time. Once an economy moves into an upturn, with positive real growth, the trend is likely to continue.
  2. The variables involved in changes in real GDP, such as consumer spending, investment, productivity, employment and output, tend to move together - albeit with time lags.

Stages in the business cycle

Expansion

If we assume a stable equilibrium as a starting point - with a growth rate at around the economy's trend - say at 2.5% (which will vary from economy to economy), an expansion is the first phase in the cycle where real GDP increases. This could be triggered by an external (exogenous) shock. It is also suggested that changes within an economy's fundamental structure are cyclical, so that even in the absence of a shock, there is a tendency towards an increase in activity. In other words, external shocks - such as a fall in oil prices - may not be needed for an economy to expand.

The stages in a business cycle

The peak or 'boom' phase

Expansion may see growth rates rising above trend, and if the growth rates are significantly above trend and sustained the economy will experience a 'boom' phase. While this phase may continue for several years, growth is likely to slow, and at some point the cycle will reach its peak.

The downturn

At some point, either as a result of a shock, or because of an inbuilt tendency, rates of growth may start to slow down, and begin to decline. The economy may simply be readjusting, and moving back to a stable equilibrium, or a shock could trigger a fall in economic activity.

Recession and slump

When rates of growth turn negative, the economy will contract. This may be a temporary phenomenon, and result in a short-lived recession, or it may turn into a full-blown slump with several years of negative growth. It could be triggered by a significant global shock, such as the financial crisis of 2008-2010, or the COVID-19 pandemic, which started in early 2020.

The recovery

At some point economic activity will pick up, and the economy may recover some lost ground. This could occur as a 'natural' response to the recession, or more typically it may follow expansionary monetary and fiscal policy.

Expansion

The cycle is complete when an economy has 'fully' recovered and returns to its previous levels of real GDP, and once more enters an expansion phase.

Problems arising

At extreme points in the cycle economic problems will emerge which are likely to require corrective action.


    Problems associated with the boom phase

  1. Increases in economic activity may eventually lead to demand-pull inflation. Costs may also rise as a result of shortages, leading to cost-push inflation. Inflation can affect particular markets which cause specific difficulties, such as accelerating house prices and falling affordability.
  2. As the economy over-heats exports become relatively more expensive, and imports less expensive. Export competitiveness suffers, and trade problems arise - perhaps leading to a balance of payments deficit.
  3. The labour market becomes 'tight', with labour shortages in combination with rising wages. Wages may be driven up above productivity levels.
problems and policies associated with a business cycle

    Short term policy options to constrain growth

  1. Policy makers [governments and central banks] are likely to put the brakes on the economy with a range of contractionary policies, including:
  2. Tighter monetary policy, with monetary controls and higher interest rates.
  3. Tighter fiscal policy, with higher taxes and controls on public sector spending.
  4. Specific policies to reduce heat in the economy, such as public sector pay controls, price-caps, and encouraging inward migration.

    Problems associated with the slump phase

  1. Falling economic activity may lead to price deflation, postponed consumption, and falling consumer and business confidence.
  2. Falling activity means falling revenue to firms, lower profits, and rising unemployment.
  3. Business investment is postponed, leading to further job losses.
  4. Some wages may fall as firms look to cut costs - given that unemployment is high, workers cannot easily find higher paid jobs.
  5. Poverty levels may rise as a consequence of rising unemployment.

    Short term policy options to encourage growth

  1. Policy makers are likely to intervene to stimulate the economy with a range of expansionary policies, including:
  2. Looser monetary policy, with relaxations in monetary controls and lower interest rates.
  3. Looser fiscal policy, with lower taxes and increases in public sector spending, often financed by borrowing.
  4. Specific policies to increase economic activity in the economy, such as an increase in the national minimum wage, spending on infrastructure and green technology, and increased welfare benefits to the unemployed. As a result of the COVID-19 pandemic, governments around the world adopted aggressive policies to pump demand into the economy, and protect vulnerable workers, including furlough schemes and 'bounce-back' loans to businesses.

Output gaps

Output gaps help identify weaknesses and problems in an economy, and help inform policy makers about the most appropriate policy mix for dealing with the gap.

They can also help analyse whether a particular policy [including fiscal, monetary and supply-side policy] has been successful, or not.

Positive output gaps

An output gap exists when there is a difference between the potential output that an economy is capable of producing, and the current level of output. Identifying output gaps allows policy makers to select the most appropriate policy mix for the current circumstance.

Statistically, output gaps are calculated as actual GDP less potential GDP as a percent of potential GDP. (Source: Quandl)

There are two types of output gap - positive and negative.

Characteristics of a positive output gap

A positive output gap means that the current level of economic activity is unsustainable in the long run given that the capacity of the economy is not capable of operating at this level, with causing significant economic harm. Of course, this depends on the size of the output gap. The greater the gap, the less sustainable it is.

It is convenient to model output gaps by using the aggregate demand-supply framework. With a positive output gap, aggregate demand exceeds an economy’s ability to produce, at Yf in the graph.

Output gaps

This can be troublesome for an economy as this excess demand can create specific problems, including:

Demand-pull inflation

Excess demand above capacity can lead firms to raise prices, given that they may find it difficult to increase supply.

When aggregate demand exceeds long run aggregate supply (or LRAS) - any increase in aggregate supply (AS), such as V to W, which attempts to meet this new demand is likely to be unsustainable – the price level is driven up to P1 - creating inflation.

Negative output gaps

A negative output gap exists when aggregate demand AD is insufficient to enable the economy to reach its full capacity, which is shown below at [Yf], and there is downward pressure on output, employment [Y2], and the price level [P2].

The consequence of this is rising unemployment and the possibility of deflation – two problems to be avoided.

Closing output gaps and the multiplier

In order to close an output gap, government may need to inject new spending into the economy - how much depends on the size of the multiplier. For example, of the output gap is estimated to be $400bn, and the multiplier is 2.0, then only $200bn of new government spending is required to close the current output gap.

The size of the multiplier affects how an injection changes national income

Trend rates

Output gaps can also be identified by comparing the actual growth rate of an economy with its trend rate of growth.

The trend rate of growth is the average rate over a period of time. When actual is below trend there is a negative output gap and when actual is above trend there is a positive output gap.

The US faces a $380bn output gap in 2021

Negative output gap

video on output gaps
Video on negative output gaps

Output gaps

Issues

There are significant difficulties in estimating potential output, which means that other indicators of pressure on an economy's capacity are also used, including:

  1. Levels of employment
  2. Average hours worked
  3. Capacity utilisation
  4. Surveys of the capacity pressures firm face
  5. Labour shortages
  6. Inflation relative to 'expectations of inflation'

Despite these difficulties, assessing the extent of any output gaps is an important activity for central banks and other policy makers.



Consumer spending

Consumer spending and aggregate demand

Consumer spending
Investment spending

What determines export spending?

Investment
Supply-side policy

How effective is supply-side policy?

Supply-side policy

[1] US economists, Arthur Burns and Wesley Mitchell first analysed business cycles in Measuring Business Cycles,, 1946 published by the National Bureau of Economic Research (NBER).

[2] Romer, Christina D, Business Cycles, viewed 21 May 2021, https://www.econlib.org/library/Enc/BusinessCycles.html

[3] Adam, K, Merkel, S, Working Paper Series Stock Price cycles and Business cycles, ECB September 2019, viewed June 4, 2021 https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2316~4effe6153e.en.pdf

[4] Ahmad, S, Real Business Cycles: A Survey of Theories And Evidence, 1996, https://www.lpem.org/repec/lpe/efijnl/199617.pdf

[5] Lipsey, R G, Chrystal, A, 2004, Economics, OUP.

[6] Begg, D, Vernasca, G, Fischer, S, Dornbusch, R, Economics, 2014, McGraw-Hill Education