The economic cycle and output gaps

Overview

Economic cycle, characteristics of a boom and characteristics of a slump.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is the economic cycle?

   Model answer

   The economic cycle is the recurring pattern of fluctuations in real output around the economy's underlying long-term growth trend. Output does not grow at a steady rate but alternates between periods of expansion, when growth exceeds the trend, and periods of contraction or subdued growth, when it falls below. The cycle is conventionally described as having four phases, and it is irregular in both length and depth, which is why it is described as a cycle rather than a predictable oscillation.

2. 2

   What are the four phases of the economic cycle, and what happens to output in each?

   Model answer

   In the recovery or expansion phase, real output is rising and the rate of growth is increasing as the economy comes back from a downturn. In the boom or peak phase, output is at or above the trend level and growth is fast but beginning to slow as capacity constraints bite. In the downturn or contraction phase, growth slows and then becomes negative, so output falls. In the slump or trough phase, output is at its lowest point relative to trend before recovery begins.

3. 3

   What are the characteristics of a boom?

   Model answer

   Real output is above its trend level and the economy is operating at or beyond normal capacity. Unemployment is low and firms report difficulty recruiting, so wages rise faster than productivity. Consumer and business confidence are high, so consumption and investment are strong and borrowing increases. Inflationary pressure builds as demand outstrips supply, and imports rise with incomes, so the current account tends to deteriorate. Tax revenues are buoyant and benefit spending is low, so the government's fiscal position improves.

4. 4

   What are the characteristics of a slump?

   Model answer

   Real output is well below trend and may be falling. Unemployment is high and rising, particularly cyclical unemployment, and vacancies are scarce. Confidence is low, so households postpone purchases and increase precautionary saving while firms cancel investment projects. Inflationary pressure is weak and the price level may even fall. Firms fail and productive capacity is destroyed. Tax revenues fall while benefit spending rises, so the government's deficit widens even without any change in policy.

5. 5

   Why does the economic cycle tend to be self-reinforcing during an upswing?

   Model answer

   Rising demand leads firms to increase output and take on staff, which raises household incomes, and the additional income is spent, raising demand further. Rising sales and profits improve business confidence, so firms invest, and that investment is itself expenditure that adds to demand. Asset prices rise as optimism grows, which makes households feel wealthier and increases their willingness to borrow and spend, while banks lend more freely against rising collateral values. Each element strengthens the others, so the expansion gathers pace rather than settling at a new level.

6. 6

   What role do confidence and expectations play in turning an expansion into a downturn?

   Model answer

   Expansions are sustained partly by the expectation that they will continue, which supports investment, borrowing and asset prices. When something causes that expectation to be revised, perhaps rising interest rates, an external shock or the realisation that asset prices have run ahead of earnings, firms postpone investment and households increase precautionary saving. The reduction in spending confirms the pessimism by reducing sales and incomes, so the change in expectations produces the outcome it anticipated. This is why turning points are abrupt while the underlying conditions change gradually.

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