Notes · EconomicsUK · A-Levels

Economic performance

This chapter analyses the determinants and consequences of the four dimensions of macroeconomic performance. It covers economic growth, the output gap and the economic cycle; the types and causes of unemployment; the causes and consequences of inflation and deflation; and the conflicts and trade-offs between the objectives, including the Phillips curve.

4 sections~17 min reading time4 competenciesLevel Standard 3 · Advanced 1

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Exam profile

AO1 · Define actual and potential growth, the output gap, the types of unemployment and demand-pull and cost-push inflationAO2 · Apply the AD/AS model and Phillips curve to episodes of growth, unemployment and inflationAO3 · Analyse the causes and consequences of growth, unemployment and inflationAO4 · Evaluate the costs and benefits of growth and the conflicts and trade-offs between objectives

Operators:defineexplainanalysecalculateevaluateassessdraw a diagram to show

basic level

AS-Level requires the causes and effects of growth, unemployment and inflation and simple trade-offs.

higher level

The full A-Level adds the output gap, the full typology of unemployment, the Phillips curve and evaluation of the conflicts between objectives.

Depth

Text

Contents · 4 sections

Economic performance

Economic growth, the output gap and the economic cycle#

StandardAQA 7136 4.2.3DfE GCE Economics - economic growth and the cycle

The economic cycle around the trend

Fig. 1Actual real GDP fluctuates around its rising long-run trend: peaks above the trend are booms (positive output gaps), troughs below are recessions (negative output gaps). Illustrative.

Economic growth is an increase in real GDP over time. Two forms must be distinguished. Actual growth is the annual percentage increase in real output actually produced - a movement of the economy towards or along its production possibility frontier, shown as a rightward shift of AD or SRAS bringing idle resources into use. Potential growth is an increase in the economy's productive capacity - an outward shift of the PPF or a rightward shift of LRAS - caused by more or better factors of production (a larger, more skilled workforce; a bigger capital stock; better technology). In the long run, sustained rises in living standards depend on potential growth.

The output gap is the difference between actual and potential (trend) real GDP, usually expressed as a percentage of potential output. A positive output gap arises when actual output exceeds the sustainable potential level - the economy is 'overheating', with demand pressing against capacity, and inflation tends to rise. A negative output gap arises when actual output is below potential - there is spare capacity and unemployed resources, and inflationary pressure is weak. The output gap is hard to measure precisely (potential output is not directly observed), which is itself an evaluation point, but it is central to judging whether the economy needs stimulus or restraint.

The economic (business or trade) cycle is the tendency of actual GDP to fluctuate around its long-run trend in a recurring pattern of phases: a boom (fast growth, a positive output gap, rising inflation and low unemployment), a downturn or slowdown (growth slowing), a recession (conventionally two consecutive quarters of falling real GDP, with a negative output gap, rising unemployment and falling inflation), and a recovery (growth resuming). The cycle is driven by fluctuations in aggregate demand - especially the more volatile components, investment and consumer confidence - amplified by the multiplier and accelerator.

Economic growth brings large benefits but also costs, and a balanced evaluation is expected. The benefits include higher average incomes and material living standards, more employment, higher tax revenues (enabling better public services without higher tax rates), and reduced absolute poverty. The costs and risks include environmental damage and the depletion of finite resources (raising the question of sustainable growth), the possibility that the benefits are distributed unequally so that not everyone gains, inflationary pressure if growth outstrips capacity, and, for some, a worse quality of life (longer hours, stress). Whether growth is desirable therefore 'depends on' its type (is it sustainable and inclusive?), its pace relative to capacity, and how its gains are shared - a judgement that draws on both positive analysis and value judgements.

\text{Output gap} = \text{actual real GDP} - \text{potential real GDP}

The output gap

A positive gap (actual above potential) signals overheating and inflationary pressure; a negative gap (actual below potential) signals spare capacity and weak inflation.

An inflationary (positive) output gap

Fig. 2When AD is strong, short-run equilibrium output (Y = 6) exceeds the full-employment level shown by the vertical LRAS (Y = 5): a positive output gap, with demand-pull inflationary pressure.

Worked example

Calculating the output gap

An economy's potential (trend) real GDP is 2,000 bn pounds, but actual real GDP is 1,940 bn. Calculate the output gap as a percentage of potential output and state what it implies.

Find the absolute gap
Output gap = actual - potential = 1,940 - 2,000 = -60 bn pounds. Actual output is below potential.
Express as a percentage
As a percentage of potential: -60 / 2,000 x 100 = -3%, a negative output gap.
Interpret
A negative output gap of 3% means the economy has spare capacity and unemployed resources, so inflationary pressure is weak and there is scope for demand-side stimulus without causing inflation.

Result: The output gap is -3% of potential GDP: the economy has spare capacity, so demand stimulus could raise output with little inflation.

Typical mistakes

Confusing actual growth (a movement towards the PPF) with potential growth (an outward shift of the PPF).
Assuming a positive output gap is always good - it signals overheating and rising inflation.

Active revision

Evaluate the view that a government should always aim to maximise the rate of economic growth.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Employment and the types of unemployment#

StandardAQA 7136 4.2.3DfE GCE Economics - employment and unemployment

The types of unemployment

Fig. 3Unemployment is classified by cause; the appropriate policy (demand-side or supply-side) depends on the type.

Unemployment has several types, distinguished by their cause, because the right policy response depends on the cause. Cyclical (demand-deficient or Keynesian) unemployment is caused by a lack of aggregate demand during a downturn or recession: as output falls, firms need fewer workers, so it rises and falls with the economic cycle. It is the type most amenable to demand-side policy - reflating AD can reduce it. Structural unemployment is caused by a long-term change in the structure of the economy - the decline of an industry (such as coal or steel), or a mismatch between the skills or location of the unemployed and the jobs available (occupational and geographical immobility). It persists even in a boom and requires supply-side remedies (retraining, mobility).

Frictional unemployment is the short-term unemployment of people moving between jobs - it exists even at 'full employment' because there is always some churn as people leave one job and search for another, and it is generally regarded as unavoidable and even healthy (it reflects a dynamic labour market). Seasonal unemployment arises from regular seasonal variations in demand for labour (tourism, agriculture, construction). Real-wage (classical) unemployment occurs when wages are held above the market-clearing level - by trade unions or a minimum wage - so that the quantity of labour supplied exceeds the quantity demanded, as shown in the labour-market chapter.

The concept of 'full employment' does not mean zero unemployment - it means the level at which everyone who wants a job at the going wage can find one, so that only frictional and structural (voluntary and mismatch) unemployment remain. The natural rate of unemployment is the rate that persists when the labour market is in equilibrium, consistent with stable inflation - the non-accelerating-inflation rate of unemployment (NAIRU). Cyclical unemployment is unemployment above the natural rate; supply-side improvements can lower the natural rate itself.

Unemployment imposes serious costs, which are examinable. To the unemployed: lost income, and often deterioration of skills, health and self-esteem, with the risk of long-term unemployment becoming entrenched (hysteresis). To the economy: lost output (actual GDP below potential - the economy operates inside its PPF), and a fiscal cost (higher benefit spending and lower tax revenue). To society: links to poverty, inequality, ill health and social problems. Because different types have different causes, the evaluation of any anti-unemployment policy must first diagnose the type: demand-side policy suits cyclical unemployment but cannot cure structural unemployment, which needs supply-side measures - matching the medicine to the disease is the key analytical move.

Worked example

Diagnosing the type of unemployment

Classify the likely type of unemployment in each case and suggest a policy: (i) steelworkers lose their jobs when a plant closes permanently; (ii) unemployment rises across all sectors during a recession; (iii) a graduate spends two months finding their first job.

Case (i)
The permanent loss of jobs in a declining industry with skills tied to steel is STRUCTURAL unemployment; the remedy is supply-side - retraining and help with geographical mobility.
Case (ii)
A rise across all sectors in a recession is CYCLICAL (demand-deficient) unemployment; the remedy is demand-side - expansionary fiscal or monetary policy to raise AD.
Case (iii)
A short gap while searching for a first job is FRICTIONAL unemployment; it is largely unavoidable, though better job-matching information can reduce it.

Result: The cases are structural, cyclical and frictional respectively - each needing a different policy response (supply-side, demand-side, and better information).

Typical mistakes

Treating all unemployment as demand-deficient - structural unemployment persists in a boom and needs supply-side policy.
Defining full employment as zero unemployment - frictional and structural unemployment remain.

Active revision

Distinguish between cyclical and structural unemployment, and explain why the policies needed to reduce them differ.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Inflation, deflation and their causes and consequences#

StandardAQA 7136 4.2.3DfE GCE Economics - inflation and deflation

Inflation has two broad causes, which map neatly onto the AD/AS model. Demand-pull inflation is caused by excess aggregate demand: when AD rises faster than the economy's ability to supply, especially near full capacity, prices are 'pulled up' - shown as a rightward shift of AD along an upward or vertical AS, raising the price level (and, where there is spare capacity, output too). Cost-push inflation is caused by rising costs of production - higher wages, raw material or energy prices, import prices (via a weaker exchange rate) or taxes - which 'push up' prices as firms pass on higher costs; it is shown as a leftward shift of SRAS, raising the price level while REDUCING output.

A third strand links inflation to the money supply. The monetarist view, associated with the quantity theory of money, holds that inflation is ultimately caused by the money supply growing faster than real output - 'too much money chasing too few goods'. On this view, sustained inflation is a monetary phenomenon, which is why controlling the growth of money and credit, principally through interest rates, is central to modern anti-inflation policy. Demand-pull inflation and excessive monetary growth are closely related, since easy credit fuels demand.

The consequences of inflation depend on whether it is anticipated and on its rate, and a good answer avoids treating all inflation as equally bad. Costs of high or volatile inflation include: the erosion of the real value of savings and fixed incomes; a redistribution from lenders to borrowers (as the real value of debt falls); 'menu costs' (changing prices) and 'shoe-leather costs' (economising on money holdings); loss of international competitiveness if domestic inflation exceeds trading partners'; and, most damagingly, the uncertainty that unstable inflation creates, which discourages investment and long-term contracts. Very low, stable inflation (around the 2% target), by contrast, is generally seen as benign or even helpful, greasing the wheels of the labour market.

Deflation - a sustained FALL in the general price level - is often more dangerous than mild inflation, a point worth stressing. Malign deflation caused by falling demand can be self-reinforcing: expecting prices to fall further, consumers delay purchases, which cuts demand and pushes prices down again (a deflationary spiral); the real burden of debt rises (debt deflation), squeezing borrowers; and because nominal interest rates cannot fall much below zero, real interest rates may stay high, making monetary policy less effective. (Benign deflation from rising productivity and falling costs is less harmful.) The asymmetry - that deflation can be harder to escape than inflation - is a key reason central banks target a small positive inflation rate rather than zero.

MV = PQ

The quantity theory of money (Fisher equation)

The money supply (M) times its velocity of circulation (V) equals the price level (P) times real output (Q). If V and Q are stable, a rise in M feeds through to a higher price level P - the monetarist account of inflation.

Worked example

Identifying the cause of inflation from evidence

In an economy, inflation has risen from 2% to 6%, unemployment has fallen to a record low and real output is growing strongly. Is this more likely to be demand-pull or cost-push inflation?

Read the output and unemployment signals
Output is growing strongly and unemployment is very low - the economy is near or above full capacity, with buoyant demand.
Match to the cause
Cost-push inflation is normally accompanied by FALLING output and rising unemployment (stagflation); here output is rising, so the evidence points to DEMAND-PULL inflation.
Confirm with the model
Strong AD pushing against capacity shifts AD right along a steepening AS, raising both the price level and (a little) output while cutting unemployment - exactly the pattern described.

Result: Rising output and record-low unemployment alongside higher inflation point to demand-pull inflation, not cost-push.

Typical mistakes

Treating all inflation as harmful - low, stable, anticipated inflation is generally benign; it is high or volatile inflation that is damaging.
Assuming falling prices (deflation) are simply good for consumers - a deflationary spiral can be seriously damaging.

Active revision

Using AD/AS diagrams, distinguish demand-pull from cost-push inflation, and evaluate which is more damaging to an economy.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Conflicts between objectives and the Phillips curve#

AdvancedAQA 7136 4.2.3DfE GCE Economics - conflicts between objectives

The short-run Phillips curve

Fig. 4The short-run Phillips curve shows an inverse trade-off between unemployment and inflation; the long-run Phillips curve is vertical at the natural rate (NAIRU), so there is no permanent trade-off.

The macroeconomic objectives frequently conflict, so that improving one worsens another - the central reason macroeconomic policy involves trade-offs. The most famous is the short-run trade-off between unemployment and inflation, captured by the Phillips curve. A. W. Phillips found an inverse relationship between unemployment and wage (and hence price) inflation: when unemployment is low, a tight labour market bids up wages and inflation rises; when unemployment is high, wage pressure is weak and inflation falls. The short-run Phillips curve therefore slopes downwards, suggesting policymakers can 'buy' lower unemployment at the cost of higher inflation, or lower inflation at the cost of higher unemployment.

The short-run Phillips curve is the mirror image of the AD/AS analysis: a rise in AD moves the economy down the Phillips curve (lower unemployment, higher inflation) and rightwards on the AD/AS diagram (higher output and prices). This gives policymakers an apparent menu of choices. But the relationship is not stable in the long run. The long-run Phillips curve, in the monetarist and new-classical view, is vertical at the natural rate of unemployment (NAIRU): any attempt to hold unemployment below the natural rate by expanding demand raises inflation, and once workers come to expect that inflation and build it into wage demands, unemployment returns to the natural rate but at a permanently higher inflation rate. There is thus no long-run trade-off - only supply-side improvements can lower the natural rate.

Other conflicts between objectives recur throughout macroeconomics. Growth and full employment versus inflation and the current account: faster growth and lower unemployment tend to raise inflation (as above) and to worsen the current account (higher incomes pull in imports). Growth versus the environment: faster growth can increase pollution and deplete resources, conflicting with environmental sustainability. Growth or efficiency versus equity: policies that boost growth (deregulation, lower taxes) may widen inequality, while redistributive policies may blunt incentives. Reducing a budget deficit (austerity) versus supporting growth and employment in the short run.

Not all conflicts are permanent, and some objectives are complementary - a crucial evaluation point. In a recession with spare capacity, expansionary policy can raise growth AND employment AND reduce the deficit (as tax revenues recover) with little inflation - the objectives align. Effective supply-side policy can, over time, deliver faster growth, lower unemployment AND lower inflation together by raising productive potential. So whether the objectives conflict 'depends on' the state of the economy (the size of the output gap) and the type of policy used: demand-side policy tends to create trade-offs, whereas supply-side policy can ease several objectives at once, which is why it is so prominent in the policy chapters that follow.

Worked example

Reading the Phillips-curve trade-off

An economy moves from 8% unemployment with 0.5% inflation to 3% unemployment with 4.7% inflation. Interpret this using the Phillips curve, and explain whether it can be sustained.

Identify the movement
Unemployment falls (8% to 3%) while inflation rises (0.5% to 4.7%) - a movement DOWN the short-run Phillips curve, the classic inverse trade-off.
Explain the mechanism
Rising aggregate demand cut unemployment but tightened the labour market, bidding up wages and prices - lower unemployment was 'bought' with higher inflation.
Assess sustainability
If 3% is below the natural rate, the position cannot last: once workers expect 4.7% inflation and demand higher wages, unemployment drifts back to the natural rate at a higher inflation rate - the economy shifts to a worse short-run Phillips curve. Only supply-side reform could lower the natural rate itself.

Result: The economy has moved down its short-run Phillips curve (lower U, higher inflation), but if unemployment is below the natural rate this is temporary - the long-run curve is vertical.

Typical mistakes

Assuming the inflation-unemployment trade-off is permanent - the long-run Phillips curve is vertical at the natural rate.
Presenting the objectives as always in conflict - in a recession, or with supply-side policy, several can improve together.

Active revision

Evaluate the extent to which a government faces a trade-off between reducing unemployment and controlling inflation.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

Economic performance

4 sections~17 min reading time4 competenciesLevel Standard 3 · Advanced 1

Economic performance

Key points

Calculating the output gap

Key points

Diagnosing the type of unemployment

Key points

Identifying the cause of inflation from evidence

Key points

Reading the Phillips-curve trade-off

Sources

Economic performance

Key points

Calculating the output gap

Key points

Diagnosing the type of unemployment

Key points

Identifying the cause of inflation from evidence

Key points

Reading the Phillips-curve trade-off

Sources