The Economic Cycle (AQA A Level Economics)

• An economic (or business) cycle refers to the changes in real GDP that occur in an economy over time
  • This is the actual growth
     
• The real GDP will fluctuate above and below the long-term trend rate of growth
  • The long-term trend rate of growth refers to the average or long-term rate at which an economy expands over time
  • It represents the underlying, sustainable rate of growth that an economy can achieve over the long run, after accounting for fluctuations caused by the economic cycle
     
• There are four recognisable points in the cycle
  • Peak/boom; slowdown/downturn; recession, recovery

Diagram: The Economic Cycle

An economic cycle diagram illustrates the fluctuations of real GDP (actual growth) around long-term trend growth

Diagram analysis

• A positive output gap is identified as growth of real GDP that is above the trend
• A negative output gap is identified as growth of GDP that is below the trend
• There is often a natural flow through the different stages, from boom to slowdown to recession to recovery
• This flow of real GDP can be moderated by government intervention
  • E.g. Increasing taxes in a boom period or increasing spending in a recession will help the economy stay closer to the long term trend
    
    

A Table Explaining the Characteristics of a Boom & Recession

Characteristics of a Recession	Characteristics of a Boom
Two consecutive quarters (6 months) or more of negative economic growth Increasing/high unemployment Increasing negative output gap and spare production capacity Low confidence for firms and households Usually, low inflation	Increasing/high rates of economic growth Decreasing unemployment and increasing job vacancies Reduction of the negative output gap or creation of a positive gap. Spare capacity is reduced or eliminated High confidence and more risky decisions taken Increasing rate of inflation - usually demand pull An improvement in the government budget as tax revenues rise and expenditures fall

• It is difficult to measure output gaps accurately
• This is because it is hard to know exactly what the maximum productive potential of an economy is
• Rapidly rising prices can indicate a positive gap is developing
• Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing

Negative Output Gap on an AD/AS Diagram

• A negative output gap occurs when the economy is operating below its full potential

Diagram: Negative Output Gap

An Keynesian (top) and Classical (bottom) diagram illustrating an economy that has a negative output gap (Y₁- Y_FE) and is currently producing less than its potential output

Diagram analysis

• The potential output of this economy is at Y_FE
• The economy is in a short-run equilibrium at AP₁Y₁
  • A negative output gap exists at Y₁ - Y_FE
    • This effectively gives the economy spare capacity in the short-term
  • One cause of this may be that the AD has recently decreased due to a fall in consumption
  • The Classical view is that the output will return to Y_FE  in the long-run, but at a lower average price level
  • The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time

Positive Output Gap on an AD/AS Diagram

• A positive output gap occurs when the economy is operating beyond its full potential

Diagram: Positive Output Gap

An AD/AS diagram illustrating an economy that has a positive output gap (Y_FE - Y₁) and is currently producing more than its potential output

Diagram analysis

• The potential output of this economy is at Y_FE
• The economy is in a short-run equilibrium at AP₁Y₁
  • A positive output gap exists at Y_FE - Y₁
    • This effectively gives the economy more productive capacity in the short-term
  • One cause of this may be that workers are willing to work overtime once full capacity is reached
    • It is not sustainable and the Classical view is that the output will return to Y_FE, but at a higher price level

• Numerous factors can cause an economy to move between the different phases in its economic cycle
• In one period, it may be enjoying a considerable boom, only for a global catastrophe to occur (e.g. war) which may lead to a slowdown, or even recession
• Both global and domestic demand-side and supply-side shocks have the ability to influence the cycle

Causes of Change in Phases of Economic Cycle 

Causes	Explanation
Excessive growth in credit and levels of debt	High levels of borrowing and spending occur during an economic boom The period leading up to the 2008 financial crisis saw a surge in mortgage lending and high levels of household debt Which in turn led to economic downturn (recession) when the level of debt became unsustainable
Asset price bubbles	Rapid increases in asset prices, such as real estate or stocks, occur during the expansion phase when consumer confidence is high This is often driven by access to low interest loans The housing market boom in the UK in the early 2000s resulted in inflated property values The housing bubble burst in 2008, signalling an onset of a recession
Animal spirit / herding	Keynes coined the term animal spirits to describe how investment prices rise/fall based on human emotion rather than intrinsic value Herd behaviour occurs when individuals mimic the actions of others, assuming that a collective decision is more accurate or rational than an individual one, in financial markets Eg. The dot-com bubble in the UK was characterised by herd behaviour and animal spirits Bullish behaviour drove stock prices well beyond any rational valuation, leading to asset price bubbles When the bubble burst, the economy can swing from a boom to a recession
Role of speculative bubbles	Speculative bubbles can create an environment where people anticipate further price increases, and excessive buying may occur. The burst of such bubbles can lead to a sudden halt in spending Eg. After the burst of the UK housing bubble in 2008, consumer spending contracted as consumer and business confidence decreased, marking the transition to the recession phase
Economic shocks	Demand and supply side shocks in the economy can lead to sudden and significant changes in economic conditions The Covid Crisis and the fallout from Brexit impacted the supply side, leading to stagflation in the UK with high inflation and economic recession