In this video we’ll learn about the trade cycle diagram, its four stages
and what output gaps represent.
Let’s start with the diagram.
If you have a pen and paper handy, copy this diagram along with the explanation.
On the Y axis is real GDP and on the X axis is time. We draw a straight line
for the trend rate of growth which is generally positive for all economies.
The trend line represents the potential of an economy which expands over time.
The fluctuations along the way in real GDP are represented by the purple line
which is actual output and this can be above, equal to or below the trend line.
When actual output exceed potential output by the greatest amount, we have a boom.
On the other end, when real GDP is farthest from potential GDP you have an economic slump.
In between we have economic downturns and upturns. We’ll take each of these in turn
and look at what is happening with economic indicators as we move from one stage to the next.
Let’s look at each stage in turn, starting with an economic upturn.
First we’ll look at an economic upturn.
In an economic upturn, the economy is just recovering from a slump.
Sometimes you’ll hear this referred to as a recovery. Economic growth is increasing,
more is being produced than before so unemployment is falling. Pressure on prices is rising as
consumers start spending more than before and this will then boost business and consumer confidence.
As more and more people are back to work and buying goods and services,
income taxes collected will rise on both individuals and corporations. With less
people to support with government benefits, benefit spending should start to fall as well.
Next up, is a boom. After a period of improving
economic activity, an economy might hit a boom, which is also often called a peak.
Economic growth will be reaching a high as resources are used beyond efficient use.
Workers will be putting in extra time and capital equipment will be pushed to its maximum use.
With high levels of output comes very low unemployment. With so much earnings generated,
consumers and businesses will be spending a lot and thus put upward pressure on prices
resulting in inflation. In general business and consumer confidence will be high.
Due to high earnings, the government will be collecting significant tax
revenues while also spending much less than before on welfare benefits.
After a peak, there is only one way to go…down.
During an economic downturn such as the early days of the 2008 crisis, economic growth slows
down. This could be due to different shocks to the economy that in some cases are difficult
to anticipate. As things start slowing down and output decreases, unemployment starts to rise.
With falling spending, pressure on prices falls and the inflation rate will decrease.
Consumer and business confidence will fall as output falls and unemployment rises.
The government will increase their spending on benefits while receiving less in tax revenues.
At the very bottom of the downturn and preceding the upturn, the economy is in a slump.
In a slump, economic growth is very low and potentially negative. You may be visualizing
the Great Depression for this stage but the extent of the slump is determined by the level by which
economic growth has fallen.
Unemployment is reaching its high and the pressure on prices falls
and so the rate of inflation is reduced and also possibly negative.
Consumption spending is relatively low in comparison to the earlier stages of the cycle and
business and consumer confidence will be very low in such a period. Government spending on benefits
will increase significantly and tax revenues will be much lower than in the previous stages.
Having developed an understanding of the stages of the trade cycle,
we now come to the idea of positive and negative output gaps. Following this video we’ll go into
further detail about each but for now let’s look at them in the context of the trade cycle.
Output gaps exist where actual output is above or below potential output.
Here we can see two output gaps in areas X and Y.
The area X above the trend line but below actual output represents a positive output gap.
The area Y below the trend line but below actual output represents a negative output gap.
By now you should have a strong understanding of
the four stages of the trade cycle and have an introductory understanding of output gaps.
If you have any questions or comments, please leave them below and let’s try to
solve your problem together. That’s us done for now and I will see you in the next one!