Business cycles and short-run fluctuations
Aggregate demand
● AD = C + G + I + NX
○ Main component is consumption for many countries
○ Some countries have a greater proportion of GDP made up of trade
■ Differing importance of the internal vs international market
● Consumption and investment move together over time
○ Consumption is more stable due to the consumption of necessities
(consumption smoothing - permanent income hypothesis)
○ Investment is more volatile so drives the business cycle
■ Depends on expectations
■ Low expectations of future demand mean capacity is not used,
reducing incentives to invest and spending
Business cycle
● A nation’s economy fluctuates between periods of expansion and contraction
○ The peak is at the highest growth rate
○ Recession = a slowdown
○ The trough shows the start of the recovery
● Fluctuations are minimised to reduce uncertainty
● Keynesian economics - the economy can reach short-run equilibria above or
below full employment
○ Demand-side policy can smooth fluctuations
● Mainstream economics - fluctuations are due to exogenous causes
○ Minimal government regulation to focus on long-run growth
○ Real business cycle theory - fluctuations can be accounted for by real
shocks
● Higher output can increase inflation during booms
The output gap
● Output gap is the difference between actual and potential output
○ Expressed as a % for comparisons
○ Difficult to estimate as potential output is hard to calculate
● Potential output is the amount of goods and services an economy can
produce when it is at full capacity / its most efficient
○ Could produce more if all resources (labour) were used
● 3 main methods of measuring the output gap
○ Statistical trend - difference between actual output and the trend
○ Estimate a production function - use it to generate estimates of
potential output
Aggregate demand
● AD = C + G + I + NX
○ Main component is consumption for many countries
○ Some countries have a greater proportion of GDP made up of trade
■ Differing importance of the internal vs international market
● Consumption and investment move together over time
○ Consumption is more stable due to the consumption of necessities
(consumption smoothing - permanent income hypothesis)
○ Investment is more volatile so drives the business cycle
■ Depends on expectations
■ Low expectations of future demand mean capacity is not used,
reducing incentives to invest and spending
Business cycle
● A nation’s economy fluctuates between periods of expansion and contraction
○ The peak is at the highest growth rate
○ Recession = a slowdown
○ The trough shows the start of the recovery
● Fluctuations are minimised to reduce uncertainty
● Keynesian economics - the economy can reach short-run equilibria above or
below full employment
○ Demand-side policy can smooth fluctuations
● Mainstream economics - fluctuations are due to exogenous causes
○ Minimal government regulation to focus on long-run growth
○ Real business cycle theory - fluctuations can be accounted for by real
shocks
● Higher output can increase inflation during booms
The output gap
● Output gap is the difference between actual and potential output
○ Expressed as a % for comparisons
○ Difficult to estimate as potential output is hard to calculate
● Potential output is the amount of goods and services an economy can
produce when it is at full capacity / its most efficient
○ Could produce more if all resources (labour) were used
● 3 main methods of measuring the output gap
○ Statistical trend - difference between actual output and the trend
○ Estimate a production function - use it to generate estimates of
potential output
