Actual growth The percentage annual increase in national output actually produced.
Potential growthThe percentage annual increase in the capacity of the economy to produce.
Potential output The sustainable level of output that could be produced in the economy: i.e. one that involves a ‘normal’ level of capacity utilisation and does not result in rising inflation.
Definitions
BOX 14.3 OUTPUT GAPS
A measure of excess or deficient demand
If actual output is below potential output (the gap is negative), there will be a higher than normal level of unemployment as firms are operating below their normal level of capacity utilisation. There will, however, be a downward pressure on inflation, resulting from a lower than normal level of demand for labour and other resources. If actual output is above potential output (the gap is positive), there will be excess demand and a rise in inflation.
If the economy grows, how fast and for how long can it grow before it runs into inflationary problems? On the other hand, what minimum rate must be achieved to avoid rising unemployment?
To answer these questions, economists have developed the concept of ‘output gaps’.1As we have seen, the output gap is the difference between actual output and potential output.
Output gaps in selected countries: 1980–2010
Note: Years 2009 and 2010 based on forecasts.
Source: Based on data in Economic Outlook (Organisation for Economic Co-operation and Development [OECD], various years).
people move from job to job. Potential output is thus somewhat below full-capacity output, which is the absolute maximum that could be produced with firms working flat out.
The difference between actual and potential output is known as the output gap. Thus if actual output exceeds potential output, the output gap is positive: the economy is operating above normal capacity utilisation. If actual out- put is below potential output, the output gap is negative:
the economy is operating below normal capacity utilisation.
Box 14.3 looks at the output gap since 1980 for four major industrial economies.
Two of the major factors contributing to potential eco- nomic growth are:
• An increase in resources – natural resources, labour or capital.
• An increase in the efficiency with which these resources are used, through advances in technology, improved labour skills or improved organisation.
If the actual growth rate is less than the potential growth rate, there will be an increase in spare capacity and prob- ably an increase in unemployment: the output gap will become more negative (or less positive). To close a negative output gap, the actual growth rate would temporarily have to exceed the potential growth rate. In the long run, how- ever, the actual growth rate will be limited to the potential growth rate.
EXPLORING ECONOMICS
equipment using this technology and in training labour in the necessary skills.
Business surveys
An alternative way to measure the output gap is to ask businesses directly. However, survey-based evidence can provide only a broad guide to rates of capacity utilisation and whether there is deficient or excess demand. Survey evidence tends to focus on specific sectors, which might, or might not, be indicative of the capacity position of the economy as a whole.
Evidence for the UK
The trend growth rate in the UK was about 2.4 per cent per year over the full economic cycle to 2008 (i.e. from 1991, the equivalent point in the previous cycle).
Until the recession of 2008/9, growth rates had been relatively stable since 1992 compared with previous cycles. The slowdown in 2001/2 was relatively mild. In fact, Gordon Brown was claiming in the early 2000s that
‘boom and bust’ were things of the past. During this period, therefore, output gaps, both positive and negative, were smaller than in the 1980s (or the 1970s for that matter).
Until the recession of 2008/9, it was argued that the greater stability in the UK economy created a climate that encouraged a long-term increase in investment and hence a long-term increase in potential growth. Whether that climate will be resumed in the future will have to be seen.
Under what circumstances would potential output (i.e. a zero output gap) move further away from the full-capacity output ceiling shown in Figure 14.3?
1See C. Giorno et al., ‘Potential output, output gaps and structural budget balances’, OECD Economic Studies, no. 24, 1995: 1.
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Generally, the gap will be negative in a recession and positive in a boom. In other words, output gaps follow the course of the business cycle.
The diagram shows output gaps for four countries from 1980 to 2009. As you can see, there was a large positive output gap in the UK in the late 1980s. This corresponded to a rapid rise in output and inflation and a fall in unemployment. You can also see that there was a large negative output gap in Japan in the early 2000s. This corresponded to a deep recession, high unemployment and inflation just below zero (i.e. a slight decline in prices).
Over the long term, the actual rate of economic growth will be approximately the same as the potential rate. In other words, over the years, the average output gap will tend towards zero.
But how do we measure the output gap? There are two possible methods.
Measuring trend growth
The simplest way of calculating the output gap is by assuming that it averages zero over the long term. This means that potential output is given by the dashed line in Figure 14.3, which shows output trend: the sum of the areas where actual output is above potential output equal the sum of the areas where it is below. To measure the output gap at any particular point in time, we simply see how much actual output diverges from trend output.
A key assumption of this method is that the potential level of output grows steadily. This is, in fact, a major weakness of this method. Technological innovations tend to come in waves, generating surges in an economy’s potential output. Rates of innovation, in turn, depend upon how flexible the economy is in adapting to such new technologies and how much investment takes place in Output gap The difference between actual and potential output. When actual output exceeds potential output, the gap is positive. When actual output is less than potential output, the gap is negative.
Definition
There are thus two major policy issues concerned with economic growth: the short-run issue of ensuring that actual growth is such as to keep actual output as close as possible to potential output; and the long-run issue of what determines the rate of potential economic growth.
Economic growth and the business cycle
Although growth in potential output varies to some extent over the years – depending on the rate of advance of tech- nology, the level of investment and the discovery of new raw materials – it nevertheless tends to be much more steady than the growth in actual output.
Actual growth tends to fluctuate. In some years, coun- tries will experience high rates of economic growth: the country experiences a boom. In other years, economic growth is low or even negative: the country experiences a slowdown or recession.1This cycle of booms and recessions is known as the business cycleor trade cycle.
There are four ‘phases’ of the business cycle. They are illustrated in Figure 14.3.
1. The upturn. In this phase, a contracting or stagnant economy begins to recover, and growth in actual output resumes.
2. The expansion. During this phase, there is rapid eco- nomic growth: the economy is booming. A fuller use is made of resources, and the gap between actual and potential output narrows.
3. The peaking out. During this phase, growth slows down or even ceases.
4. The slowdown, recession or slump. During this phase, there is little or no growth or even a decline in output.
Increasing slack develops in the economy.
A word of caution: do not confuse a high levelof output with a high rate of growthin output. The level of output is highest in phase 3. The rate of growth in output is highest in phase 2 (i.e. where the curve is steepest).
Figure 14.3 shows a decline in actual output in recession.
Redraw the diagram, only this time show a mere slowing down of growth in phase 4.
Long-term output trend
A line can be drawn showing the trend of national output over time (i.e. ignoring the cyclical fluctuations around the trend). This is shown as the dashed line in Figure 14.3. If, over time, firms on average operate with a ‘normal’ degree of capacity utilisation, the trend output line will be the same as the potential output line. Also, if the average level of capacity that is unutilised stays constant from one cycle to another, the trend line will have the same slope as the full-capacity output line. In other words, the trend (or
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potential) rate of growth will be the same as the rate of growth of capacity.
If, however, the level of unutilised capacity changes from one cycle to another, then the trend line will have a different slope from the full-capacity output line. For exam- ple, if unemployment and unused industrial capacity rise from one peak to another, or from one trough to another, the trend line will move further away from the full-capacity output line (i.e. it will be less steep).
If the average percentage (as opposed to the average level) of capacity that was unutilised remained constant, would the trend line have the same slope as the potential output line?
The business cycle in practice
The business cycle illustrated in Figure 14.3 is a ‘stylised’
cycle. It is nice and smooth and regular. Drawing it this way allows us to make a clear distinction between each of the four phases. In practice, however, business cycles are highly irregular. They are irregular in two ways:
• The length of the phases. Some booms are short-lived, lasting only a few months or so. Others are much longer, lasting perhaps several years. Likewise some recessions are short while others are long.
• The magnitude of the phases. Sometimes in phase 2 there is a very high rate of economic growth, perhaps 4 per cent per annum or more. On other occasions in phase 2 growth is much gentler. Sometimes in phase 4 there is a recession, with an actual decline in output. On other
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Figure 14.3 The business cycle
Business cycle ortrade cycle The periodic fluctuations of national output round its long-term trend.
Definition
1In official statistics, a recession is defined as when an economy experiences falling national output (negative growth) for two or more quarters.
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occasions, phase 4 is merely a ‘pause’, with growth simply being low.
Nevertheless, despite the irregularity of the fluctuations, cycles are still clearly discernible, especially if we plot growthon the vertical axis rather than the levelof output.
This is done in Figure 14.4, which shows the business cycles in selected industrial economies from 1970 to 2010. As you can see, all four suffered a recession or slowdown in the mid 1970s, the early 1980s, the early 1990s and the early and late 2000s, and a boom in the early 1970s, the late 1970s, the late 1980s and, except in the case of Japan, the late 1990s.
But despite this broad similarity in their experience, there were nevertheless significant differences in the mag- nitude and timing of their individual cycles. For example, the UK and the USA went into recession in the early 1990s two years before the other three countries. Also, the reces- sion of 2001–2 was more severe in Japan and the eurozone than in the UK and the USA.
Causes of fluctuations in actual growth
The major determinants of variations in the rate of actual growth in the short run are variations in the growth of aggregate demand. As we saw in section 14.2, aggregate
demand is total spending on the goods and services pro- duced in the economy:
AD=C+I+G+X−M
A rapid rise in aggregate demand will create shortages.
This will tend to stimulate firms to increase output, thus reducing slack in the economy. Likewise, a reduction in aggregate demand will leave firms with increased stocks of unsold goods. They will therefore tend to reduce output.
Aggregate demand and actual output, therefore, fluctu- ate together in the short run. A boom is associated with a rapid rise in aggregate demand: the faster the rise in aggregate demand, the higher the short-run growth rate. A recession, by contrast, is associated with a reduction in aggregate demand.
A rapid rise in aggregate demand, however, is not enough to ensure a continuing high level of growth over a numberof years. Without a corresponding expansion of potential output, rises in actual output must eventually come to an end as spare capacity is used up.
In the long run, therefore, there are two determinants of actual growth:
• The growth in aggregate demand. This determines whether potential output will be realised.
• The growth in potential output.
Figure 14.4 Growth rates in selected industrial countries, 1970–2010
Note: Years 2009 and 2010 figures based on forecasts; EU-12 =the 12 original members of the eurozone.
Source: Based on data in Economic Outlook(Organisation for Economic Co-operation and Development [OECD], various years).
BOX 14.4 IS STABILITY ALWAYS DESIRABLE?
Should firms sometimes be given a short, sharp shock?
CASE STUDIES AND APPLICATIONS
When bad is good
But recessions can have benefits. If the economy is stable, firms may simply prefer to carry on doing what they have done before. If competition is strong, or where there is a risk of a takeover, this may not be possible. But when competition is weak, many firms can remain inefficient and still make reasonable profits.
When times are tough, however, firms may have to take a much closer look at how their business is operated and find new more efficient methods of production or new and better products. If they cannot, they may not survive. A recession, therefore, may be a useful means of getting rid of inefficient firms and releasing resources – labour, office space, raw materials, equipment, etc. – for the creation of new firms.
If the market is where the fittest survive, bad times are when you need to be fit – or rapidly become so.
1. If, over a ten-year period, your income stayed constant at £20 000 per year, would you consider yourself to be better or worse off than if your income averaged
£20 000 over the period but fluctuated from £5000 to £35 000 per year?
2. Explain whether a more risky business environment encourages higher or lower growth in potential output.
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Governments around the world aim for stableeconomic growth; they try to prevent the ups and downs of the business cycle. Gordon Brown, in his ten years as Chancellor of the Exchequer, claimed to have ‘put and end to boom and bust’. But why is stability desirable?
The first reason is that a stable economic environment allows firms to plan with more certainty and thus encourages investment. Instability, by contrast, makes firms cautious and unwilling to make long-term commitments, such as building a new factory; investment becomes more risky. Investment is thus lower and so too, as a result, is long-term economic growth.
The second reason is that some people suffer in times of recession. True, for most people, recessions are relatively minor affairs, as long as they have a job and their pay is little affected. But some firms go out of business; some people lose their jobs. Personal lives are devastated, resulting in stress at the best and the break-up of relationships, depression, crime and suicide at worst. In other words, the effects of recessions are unequally spread.
The third reason concerns perception. Governments are often judged as successes or failures according to the state of the economy, and recessions are seen as a failure – whether or not the recession was caused by global factors largely beyond the scope of the government. Stable growth is thus a high policy priority for all governments.