Question

With reference to the business cycles briefly explain:

1. i) A Large positive output gap. Your answer should explain how the economy fluctuates from

   its potential.

2. ii) “Recession is defined as negative economic growth for two consecutive quarters”. Discuss.

Answer 1

i) An output gap- it is the difference between actual output of an economy with its potential output expressed as a percentage of GDP. Potential output is defined as the maximum amount of goods and services that can be produced in an economy when it is at full capacity. It is also referred as the production capacity of the economy. ­Output gap may either positive or negative.

A large positive output gap indicates outperforming expectations of an economy as the actual output is higher than its potential output.  A positive output gap takes place when actual output is more than potential output. This can happen when the demand in the economy is very high and factories and workers operate above their most efficient capacity to meet this spur in demand. A large gap might be considered beneficial for an economy as it increases demand and production of goods and services. However in case of excessively high demand businesses must work beyond their maximum efficiency to meet the spur in the demand. A large positive gap can also lead to inflation as labor costs and prices increase as a result of the increase in demand.

ii) A recession is refers to a significant decline in economic activity and prices  in a region. It is typically recognized as two consecutive quarters of economic decline indicated  by decline in GDP alongwith othermacro economic indicators such as rise in unemployment.

In recent years, a more precise and indicative definiton has been evolving with certain criteria to understand recessionary trends in a economy. These are:

• A 1.5% decline in real GNP.
• Decline in manufacturing activites over six-month.
• A 1.5% decline in non-farm employment.
• reduction in jobs across 75% of industries for over six months.
• A rise in unemployment level of at least 6%.

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