Business Cycle, Short Run Growth,The Multiplier & Accelerator Effects

Draw & Label this diagram with what you recall from AS Economics

Objectives

• Understand the concept of the ‘output gap’• Be able to explain how the relationship

between the ‘output gap’ and short term and long term economic growth

• Be able to explain the economic theory behind multiplier and accelerator effects

• To be confident in calculating multiplier effect

The Output Gap

• The difference between actual GDP and it’s trend value

• In other words the actual level of output minus the potential level

• Negative = trough• Positive = peak

Growth and the Output GapTop pane: Real GDP Bottom Pane: Output Gap measured as a % of potential GDP source: OECD

UK Real GDP and Output Gap

Source: Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

07 08 09 10 11 12 13 14

-5

-4

-3

-2

-1

0

1

2

3

4

Pe

rce

nta

ge

of

po

ten

tial G

DP

-5

-4

-3

-2

-1

0

1

2

3

4

tho

usa

nd

bill

ion

s

1.39

1.41

1.43

1.45

1.47

1.49

at

con

sta

nt

pric

es

(th

ou

san

d b

illio

ns)

1.39

1.41

1.43

1.45

1.47

1.49

Annual percentage change in GDP measured at constant prices

The Cycle: Growth in UK National Output

Source: UK Statistics Commission

80 85 90 95 00 05 10 15 20

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Pe

rce

nt

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0New normal growth rate likely to be slow .............

A permanent loss of outputUK GDP, £ billion, quarterly data measured at constant 2003 prices

Has the recession caused lasting damage?

Source: Reuters EcoWin

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

bill

ion

s

290

300

310

320

330

340

350

360

370

GB

P (

bill

ion

s)

290

300

310

320

330

340

350

360

370

UK GDP still well below the peak before the last recession..............

Trend growth is falling – why?Source: OECD World Economic Outlook

UK - Potential GDP and Trend Growth

Source: OECD World Economic Outlook

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

tho

usa

nd

bill

ion

s

1.15

1.25

1.35

1.45

1.55

Re

al G

DP

£ (

tho

usa

nd

bill

ion

s)

1.15

1.25

1.35

1.45

1.55

Potential GDP

0.00

1.00

2.00

3.00

4.00

Pe

r ce

nt

pe

r ye

ar

0.00

1.00

2.00

3.00

4.00

Estimated UK Trend Growth Rate

Recession may have inflicted damage on trend growth

AD/AS & Short Run Growth

AD & AS through a business cycle

• Multiplier Effect : “the ratio of a change in equilibrium real income to the autonomous change that brought it about ; it is calculated as 1/mpw (marginal propensity to withdraw)”

• In other words when workers see their income increase, it is the proportion of the increase that is spent and therefore benefits the economy

• Marginal Propensity withdraw : “the sum of marginal propensities to save, tax, import – the proportion of additional income that is withdrawn from the circular flow”

Worked example of multiplier

• Households save 5%• Households spend 10% of imports• Households are taxed 25%• MPW = s+m+t = ?• Multiplier effect = 1/mpw = ?

The larger the multiplier, the bigger the AD shift

Work out this example

• Households save 10%• Households import 15%• Households tax 30%• What is the marginal propensity to withdraw?• What is the multiplier effect?

The accelerator effect

• “a theory by which the level of investment depends upon the change in real output”

• As economic growth increases in recovery, firms invest more. As the cyclical growth slows, firms reduce investment

• Works in tandem with multiplier.• Firms invest, increases income of workers who

spend some in the economy, leads to growth, leads to further investment