2.5.3 Trade Cycle

Edexcel A-Level Economics (9EC0) | Theme 2.5.3

Specification Coverage: Edexcel unit 2.5.3 - The Trade Cycle. Students should be able to understand and explain what the trade cycle is, identify the stages of the cycle, link the cycle to positive and negative output gaps, analyse the causes of cyclical fluctuations, and evaluate the role of demand-side policy in stabilising the cycle.

What Is the Trade Cycle?

Definition: The trade cycle is the fluctuation in real GDP over time, with periods of boom and recession.

Key Idea: Actual GDP rises and falls around the underlying long-term trend rate of growth, which represents the path of potential GDP or LRAS.

The Stages of the Trade Cycle

PPF diagram showing long-run growth
Figure 1: The Trade Cycle showing the stages of boom and recession around a long-term trend growth line.

Characteristics of Each Phase

Boom or Peak Recession or Trough
High or rising economic growth, where actual GDP is above trend. Low or negative economic growth, where actual GDP is below trend.
Demand-pull inflation and rising prices. Low inflation or deflationary pressure.
Low unemployment and labour shortages. High and rising unemployment, especially cyclical unemployment.
High consumer and business confidence, often described as strong animal spirits. Low confidence with delayed investment and spending.
The government budget improves because tax revenues rise and welfare spending falls. The government budget deteriorates because tax revenues fall and welfare spending rises.
A current account deficit may appear because strong domestic demand increases imports. The current account may improve because weak domestic demand reduces imports.

Output Gaps and the Trade Cycle

  • During a boom, the economy operates with a positive output gap, where actual output is above potential output.
  • During a recession, the economy operates with a negative output gap, where actual output is below potential output.
  • The trend line represents the path of potential output, while fluctuations around it reflect changes in aggregate demand.

Causes of the Cycle

Changes in Aggregate Demand: The main driver of the cycle. Fluctuations in investment, which is the most volatile component of AD, and in consumer confidence are particularly important.

External Shocks: Supply-side shocks such as an oil price rise or demand-side shocks such as a global financial crisis can trigger or worsen the cycle.

Inventory Cycles: Firms may build up and then run down stocks of unsold goods.

Credit Cycles: Periods of easy borrowing can fuel booms, while credit crunches can deepen recessions.

The Role of Government

Governments and central banks try to smooth the cycle and reduce the severity of booms and recessions through demand-side stabilisation policy.

During a boom: They may use contractionary policies such as higher interest rates, higher taxes, or lower government spending to cool aggregate demand and control inflation.

During a recession: They may use expansionary policies such as lower interest rates, lower taxes, or higher government spending to boost aggregate demand, close the negative output gap, and reduce unemployment.

Exam Preparation

  • Draw and label the trade cycle diagram, including the trend growth line and the main phases of the cycle.
  • Explain the key characteristics of both a boom and a recession.
  • Link the phases of the cycle to positive and negative output gaps.
  • Analyse the causes of the cycle, especially the importance of investment and confidence.
  • Evaluate the role of government demand-side policies in stabilising the cycle.