Economics (9640) | Economic growth and the economic cycle

Welcome to Economic Growth and the Economic Cycle!

Hello future economists! This chapter is incredibly important because it explores the two big questions facing every economy: How do we get richer over time? and Why does the economy sometimes boom and sometimes bust? Understanding economic growth and the economic cycle gives you the tools to analyze recessions and evaluate government policies aimed at stabilizing the economy. Don't worry if some concepts seem theoretical—we will use diagrams and real-world examples to make them crystal clear!

1. Understanding Economic Growth (The Two Types)

When economists talk about growth, they often mean two different things. It is crucial for your exams to understand the difference between short-run growth and long-run growth.

1.1 Short-Run Economic Growth

This is the most common definition of growth you see in the news.

• Definition: Short-run growth is the increase in the actual output of an economy (measured by Real GDP) over a period of time.
• What causes it? It happens when an economy uses up existing spare capacity. Think of it as putting idle resources (unemployed workers or unused factories) back to work.
• Illustration (PPC): On a Production Possibility Curve (PPC), short-run growth is represented by a movement from a point inside the boundary (like point X, representing spare capacity) towards the boundary.
• Illustration (AD/AS): Short-run growth is usually driven by an increase in Aggregate Demand (AD), shifting the AD curve to the right, leading to higher Real GDP.

Key Takeaway: Short-run growth is about maximizing what you can currently produce.

1.2 Long-Run Economic Growth (The Trend Rate)

This is what truly makes a country wealthier over generations.

• Definition: Long-run economic growth refers to an increase in the productive capacity or potential output of the economy. It is the increase in the economy's trend rate of growth over time.
• What causes it? It means the economy can produce more goods and services at full capacity. This requires improvement in the quantity or quality of the Factors of Production (Land, Labour, Capital, Enterprise).
• Illustration (PPC): Long-run growth is shown by an outward shift of the entire PPC boundary. The potential of the whole economy has increased.
• Illustration (AD/AS): Long-run growth is represented by a rightward shift of the Long-Run Aggregate Supply (LRAS) curve.

1.3 Determinants of Short-Run and Long-Run Growth

Demand-Side Determinants (Affecting Short-Run Growth)

These factors cause the AD curve to shift right, pushing the economy toward full capacity. They relate directly to the components of Aggregate Demand (AD = C + I + G + X - M).

• Consumption (C): Higher consumer confidence or lower interest rates lead to increased spending.
• Investment (I): Firms spending on capital equipment due to optimistic expectations or lower borrowing costs.
• Government Spending (G): Increased public spending on goods and services (e.g., building a new rail link).
• Net Exports (X-M): Stronger demand from foreign countries for domestic goods.

Supply-Side Determinants (Affecting Long-Run Trend Growth)

These factors cause the LRAS curve to shift right, increasing the economy's potential.

• Increase in Capital Stock: More factories, machinery, and infrastructure available (e.g., faster broadband across the country).
• Improved Technology: New inventions and innovations leading to more efficient production methods.
• Increase in Labour Productivity: The workforce becomes better educated, more skilled (human capital), or more motivated.
• Enterprise: Policies that encourage risk-taking, innovation, and the formation of new businesses.
• Factor Mobility: Making it easier for workers and capital to move where they are needed most.

Did you know? A crucial long-run determinant is Total Factor Productivity (TFP), which measures how efficiently inputs (labour and capital) are used together. Improvements in TFP are often the silent engine of sustained economic growth!

2. The Economic Cycle (Business Cycle)

The economic cycle (or business cycle) describes the regular fluctuations in the level of economic activity around the long-run trend rate of growth. Economies rarely grow at a steady pace; they move through periods of rapid growth and periods of stagnation or contraction.

2.1 The Concept and Phases of the Cycle

Imagine the economy is riding a rollercoaster. The cycle describes the ups and downs of that ride.

1. Recovery / Expansion: Growth begins to pick up after a slump. Real GDP rises, unemployment falls, but inflationary pressure remains low initially.
2. Boom / Peak: The highest point of economic activity. Real GDP growth is rapid, employment is high (or very low unemployment), and inflation is likely accelerating as resources become scarce.
3. Downturn / Slowdown: Growth slows down dramatically, potentially falling toward zero. Confidence falls, investment drops, and unemployment starts to rise.
4. Recession / Trough: The low point of the cycle. A recession is technically defined as two consecutive quarters of negative economic growth (falling Real GDP). Unemployment is high, and inflation may fall or even become negative (deflation).

Memory Aid: Think of the phases as 'RBDR' (Recovery, Boom, Downturn, Recession).

2.2 Key Economic Indicators Used to Identify Phases

Economists use various data points to figure out where the economy is in the cycle.

• Real GDP: Measures the overall output; the most direct indicator of where we are.
• Rate of Inflation: Tends to rise during a boom (too much demand chasing too few goods) and fall during a recession.
• Unemployment: Falls rapidly during a recovery/boom and rises sharply during a downturn/recession.
• Investment (I): Highly volatile. Firms invest heavily when confidence is high (boom) and slash investment during a recession.

Common Mistake: Students sometimes confuse The Trend Rate (the underlying long-run potential) with the Actual Cycle (the squiggly line). The cycle moves *around* the trend rate.

3. Output Gaps: Actual vs. Potential

The output gap is a critical concept that links the current phase of the economic cycle to inflationary and unemployment pressures. It is the difference between an economy's Actual GDP (what we are producing right now) and its Productive Potential (what we could produce if all resources were used efficiently).

3.1 Negative Output Gap (Recessionary Gap)

• What it is: Actual GDP is BELOW Potential GDP.
• Analogy: Your car engine has a maximum speed of 100 km/h, but you are only driving at 60 km/h.
• Consequences:
  • Unemployment: High, particularly cyclical unemployment (demand-deficient unemployment).
  • Inflation: Low or negative, as there is little pressure on wages or costs.
  • AD/AS Diagram: The short-run equilibrium (AD = SRAS) is significantly to the left of the LRAS curve.

3.2 Positive Output Gap (Inflationary Gap)

• What it is: Actual GDP is ABOVE Potential GDP.
• Analogy: Your car engine is running so fast it's hitting the redline. You can only sustain this speed for a short time before the engine overheats.
• Consequences:
  • Unemployment: Very low. The economy is "overheating," running beyond its sustainable capacity.
  • Inflation: High, driven by excessive demand leading to rising wages and input prices.
  • AD/AS Diagram: The short-run equilibrium is to the right of the LRAS curve.

Quick Note on Potential: An economy can only run above its normal capacity (Positive Output Gap) by making workers work overtime or pushing machinery past optimal limits. This is not sustainable.

4. Demand-Side and Supply-Side Shocks

Economic cycles are often triggered or worsened by unexpected events, known as "shocks." These shocks cause shifts in either Aggregate Demand (AD) or Aggregate Supply (AS).

4.1 Demand-Side Shocks

These are sudden, unexpected changes to the components of AD.

• Positive Shock: An unexpected surge in consumer confidence leads to massive spending, shifting AD right. Example: A sudden housing boom leads people to feel wealthier and spend more.
• Negative Shock: A global banking crisis causes banks to stop lending and businesses to halt investment, shifting AD left. Example: The 2008 Financial Crisis.
• Effect on Domestic Activity: A negative demand shock typically leads to a recession (falling Real GDP) and increased cyclical unemployment, usually accompanied by falling inflation.

4.2 Supply-Side Shocks

These are sudden, unexpected changes in the costs of production or the availability of resources, affecting SRAS or LRAS.

• Negative Shock (SRAS): A sudden, dramatic rise in the global price of oil or raw materials. This increases costs for almost all businesses, shifting SRAS to the left. Example: The Oil Price Shocks of the 1970s.
• Consequence of a Negative SRAS Shock: This is particularly damaging because it leads to stagflation (falling output/GDP alongside rising inflation).
• Positive Shock (LRAS): A rapid technological breakthrough (like a sudden huge increase in the productivity of microchips) shifts LRAS to the right.
• Consequence of a Positive LRAS Shock: This leads to higher potential output and lower inflation—the best-case scenario for policymakers!

Key Takeaway: Shocks make the economic cycle volatile. Demand shocks primarily affect output and unemployment (and subsequently inflation), while negative supply shocks can cause the worst outcome: rising prices *and* falling output (stagflation).