Chapter 12

The macroeconomic
context 1 the trade
cycle

w w w . s t ud y i n t e r a c t i v e . o r g

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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

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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.

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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

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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.

Prices

AD

AS

At full
employment
prices rise as no
scope to increase
real output

Yf

Real national
income

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.

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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

Factor income paid by firms

Productive resources

Firms

Households

Goods and services

Expenditure on goods and services

DISCUSSION 1
How would one calculate the level of gross domestic product within the above
closed economy?

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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 -

Firms

Households

Financial Sector
Withdrawals

Injections

Government Sector

Foreign Sector

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Marginal propensities to consume and withdraw

Consumption

Figure 1
Y=C

Consumption
C = a + bY

Autonomous consumption

Income
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?

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

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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

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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:

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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

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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.

Actual output
Output

D
Trend in
output
A
C

Time

Phases of the trade cycle

B:

Recession phase;

B-C:

Recovery phase;

C - D:

Boom phase

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IMPACT OF THE
ENVIRONMENT

TRADE

CYCLE

ON

THE

BUSINESS

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.

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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.

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