cima c04 2013 class chapter 12 the trade cycle
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www.studyinteract ive.org 128
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
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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.
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
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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
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
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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 -
Households Firms
Financial Sector
Government Sector
Foreign Sector
Withdrawals Injections
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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
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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.
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
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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.
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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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