The Economic Cycle

The economic cycle describes the cycle/fluctuation of economic growth around the trend rate of economic growth which for the UK is 2.25-2.50%.

When actual GDP is below the productive potential of the economy there exists a potentially deflationary negative output gap:

↓AD → ↑stock levels for firms → ↓requirement for production → ↓firms’ output → ↓derived demand for F.O.Ps (including labour) → labour supply surplus → ↓wage rates → ↓household income → ↓household expenditures → ↓AD

This deflationary spiral may continue, leading to a slump, characterised by rapidly rising unemployment, falling output and falling prices.

When the economy is underperforming, the government may seek to intervene to boost AD.

When actual GDP is above the productive potential, there exists a potentially inflationary positive output gap:

↑rate of growth → AD>AS → employed F.O.P.s → ↑firms’ output ↑derived demand for labour → ↑wage rates → ↑production costs → ↑prices (firms seek to maintain profit margins)

The economy is ‘overheating’ during a boom, characterised by high levels of output, low unemployment, rising wage levels and rising prices, and the government may seek to intervene to reduce aggregate demand.