cima c04 2013 class chapter 12 the trade cycle

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Chapter 12

The macroeconomic context 1 the trade

cycle

CHAPTER 12 THE TRADE CYCLE

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CHAPTER CONTENTS

LEARNING OUTCOMES ------------------------------------------------- 130

FACTORS AFFECTING NATIONAL INCOME --------------------------- 131

THE CIRCULAR FLOW OF INCOME ------------------------------------ 133

STAGES IN THE TRADE CYCLE ----------------------------------------- 139

IMPACT OF THE TRADE CYCLE ON THE BUSINESS ENVIRONMENT ---------------------------------------------------- 140



LEARNING OUTCOMES

(a) Explain the determination of macroeconomic phenomena, including

equilibrium national income, growth in national income, price inflation,

unemployment, and trade deficits and surpluses.

(b) Explain the stages of the trade cycle, its causes and consequences for the

policy choices of government.

(c) Explain the consequences of the trade cycle for organisations.



FACTORS AFFECTING NATIONAL INCOME

The UK economy -

The UK government monitors the level of economic activity by reference to the

following indicators.

Gross domestic product (GDP): output produced by resources within the UK.

Gross national product (GNP): output produced by resources within the UK, plus net property income from abroad.

National income: output produced by resources within the UK, plus net property income from abroad, minus depreciation of the



Aggregate demand and aggregate supply

Aggregate demand: the total value of demand for goods and services produced in

the economy during a year.

Aggregate supply: the maximum potential output of the economy during a year.

In relation to the above diagram students are expected to be able to identify

inflationary and deflationary gaps.

Inflationary gaps arise when planned aggregate demand exceeds the full

employment of national income.

Deflationary gaps arise when the planned level of aggregate demand is below the

level needed to assure full employment.

Yf

AS Prices

AD

Real national income

Y

P

At full employment

prices rise as no scope to increase real output



THE CIRCULAR FLOW OF INCOME

Closed economy

Characteristics of a closed economy include:

o No government

o No overseas sector

o All income is spent on consumption

o All production is sold to households

DISCUSSION 1

How would one calculate the level of gross domestic product within the above

closed economy?

Firms Households

Factor income paid by firms

Expenditure on goods and services

Productive resources

Goods and services



Open economy

With an open economy, the above diagram must take into consideration

withdrawals and injections, which comprise the following elements:

Withdrawals Injections

Savings (S) Investment (I)

Taxation (T) Government spending (G)

Imports (M) Exports (X)

DISCUSSION 2

Adopting an expenditure approach how would one measure GDP within an open

economy?

Illustration -

Households Firms

Financial Sector

Government Sector

Foreign Sector

Withdrawals Injections



Marginal propensities to consume and withdraw

Figure 1 shows the consumption function for an economy, illustrating the way in

which planned consumption varies as income rises.

EXERCISE 1

If a consumption function has the formulae C = 750 + 0.4Y, where Y is the change

in national income, and injections are 500, then equilibrium national income will be

at?

$........................

Consumption

Income

Y = C

Autonomous consumption

Figure 1

Consumption

C = a + bY



Marginal propensity to consume (MPC) measures the percentage of any

additional income that is spent on consumption.

MPC is calculated as follows:

EXERCISE 2

come has increased from $300 to $360, and household consumption has increased from $260 to $290.

Marginal propensity to withdraw (MPW) comprises

a) Marginal propensity to sale (MPS); plus

b) Marginal propensity to tax (MPT); plus

c) Marginal propensity to import (MPM).

Therefore

MPW = MPS + MPT + MPM

MPC + MPW = 1



The multiplier effect

each $1 injected into an economy. The question being whether national income

rises less than in proportion, equal to or by a greater extent than the initial

injection.

EXERCISE 3

Consider the following exercise with regard to a closed economy that experiences a

$100m injection, but with a MPC of 0.9.

Increase in expenditure

$m

Increase in savings $m

Income rises $100 -

90% consumed $90m $10m

If the exercise was continued, then

Total increase in income

The multiplier is calculated as follows:

In an open economy, withdrawals will include taxation and imports, as well as

savings! Therefore the calculation may be written as follows:



Determinants of injections

As noted previously, injections comprise: investment (I), government spending (G)

and exports (X).

Consider three explanations that map bring about an increase in each

Investment

Government spending

Exports



STAGES IN THE TRADE CYCLE

Trade cycles refer to periods of accelerated growth in national income followed by

a slow-down in growth resulting in a drop in national income, referred to as a

recession.

Phases of the trade cycle

A B : Recession phase;

B - C : Recovery phase;

C - D : Boom phase

Output

Time

Actual output

A

Trend in output

B

C

D



IMPACT OF THE TRADE CYCLE ON THE BUSINESS

ENVIRONMENT

The recovery and boom phase:

Due to high levels of demand in the economy, the direct impact on business:

a) Need to expand capacity;

b) Resource shortages, in terms of both staffing and materials;

c) New entrants into the market seeking a share of the high profits;

d) Acquisition activity as firms look to consolidate their position in the market;

e) Inflation;

f) Exchange rate depreciation.

Secondary effects of the trade cycle include:

1. Government may increase interest rates to deal with inflation;

2. Government may look to increase taxation;

3. Government may cut back on expenditure.



The recession and depression phases:

During these phases, demand is falling, along with low levels of business and

consumer confidence in the economy. The direct impacts of which include:

a) Firms will need to cut back focusing primarily on core activities, this may

involve cutting back on staffing numbers.

b) Firms with excess levels of stock will look to off-load at lower prices. With

less cash to spend, a fall in demand will also place downward pressure on

prices.

c) Investor pressure shareholders and other key investors will look to

maintain profits, forcing firms to make wholesale cut-backs across the

business.

Secondary effects of the above, insofar as government policies may include:

1. Banks will look to reduce interest rates so as to encourage borrowing and

discourage savings!

2. Government may commence large public sector projects so as to inject cash

into the economy.

3. Government may consider targeted tax reductions so as to stimulate

business activity in certain sections of the economy.

cima c04 2013 class chapter 12 the trade cycle

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