Exercises: Economic cycles

Explain what a business cycle is and name its four phases, describing in one sentence what happens to economic activity in each one.

Assign each headline to the phase of the cycle it best describes and justify your choice: "Record Social Security registration and companies cannot keep up with demand", "$300$ businesses closing per month and unemployment keeps rising", "The economy has been growing for two years and business investment is rebounding strongly".

The figure shows the evolution of a country's GDP over time: the dashed line represents the long-term growth trend and the curve represents the actual path of activity. A point on the curve is marked with a question mark.

1. a) Which phase of the cycle does the marked point correspond to? Justify your answer.
2. b) Describe what happens to employment and investment in this phase and in the one that follows it.

Explain the difference between a recession and an economic depression. State what simple rule economists use to speak of a technical recession, and give an example of each that you know of (one recession and one depression).

Explain what leading indicators of the business cycle are and what they are for. Comment on three examples (new car registrations, building permits, consumer confidence) and reason why they move before general activity.

Describe how these three variables normally behave during an expansion and during a recession: unemployment, inflation and firms' profits. Justify each answer in one sentence.

Explain the difference between an economy's long-run growth trend (its potential GDP) and the swings of the business cycle around it. What is the output gap and what does it mean for it to be negative?

Cycles repeat themselves, but no cycle is the same as the previous one. Explain why economic history is said to "not repeat itself, but rhyme": what do different crises have in common and how do they differ (triggering cause, duration, sectors affected)?

The annual percentage change in Arta's GDP over seven consecutive years was: $+3\ \%$, $+2.5\ \%$, $+1\ \%$, $-1\ \%$, $-2\ \%$, $+0.5\ \%$ and $+2\ \%$.

1. a) Identify in which year the recession begins and in which year it bottoms out.
2. b) Place the expansion, recession, and recovery phases in the series and explain what happens to the level of GDP during the years with negative rates.

During a recession, a country's unemployment increases by $200,000$ people.

1. a) Explain what automatically happens to government tax revenues and to its expenditure on unemployment benefits.
2. b) Reason why these "automatic stabilisers" cushion the recession: what happens to household disposable income and to demand?

Classify each news item as a supply or demand shock and explain its effect on economic activity: a global drought that makes food more expensive, a collapse in consumer confidence following a financial crisis, and a new technology that makes battery production cheaper.

Meridia's GDP level over seven consecutive years was: $100$, $104$, $106$, $104$, $101$, $103$ and $107$ (index, year 1 $= 100$).

1. a) Calculate the rate of change of GDP for each year relative to the previous one.
2. b) Identify in which year the peak of the cycle is reached and in which the trough.
3. c) How many years did the recession last? Explain the difference between the rate of change being negative and its becoming positive again.

In Meridia, during the last expansion, inflation hovered around $3\ \%$; when the economy entered recession, it fell to $0.5\ \%$.

1. a) Explain why inflation usually rises during expansions and falls during recessions (relate it to demand).
2. b) Explain what stagflation is and why a supply shock (such as a sudden rise in the cost of energy) can produce inflation and recession at the same time.

In the middle of a recession, Briga's government builds a hospital for $500$ million euros. The construction companies hire workers, who spend their wages in local shops, and these, in turn, place new orders with their suppliers.

1. a) Explain how an initial public outlay ends up generating more activity than it costs (the multiplier effect).
2. b) Reason why that effect is more powerful in a recession, with idle resources, than in an economy at full employment.

Compare these two crises: the 2008 one, which began with the bursting of a property bubble and a financial crisis, and the 2020 one, caused by a pandemic that forced entire sectors to close.

1. a) Classify each crisis as a demand shock, a supply shock or a mixed one, and justify your answer.
2. b) Explain why the pandemic crisis was harder to treat with the usual demand-stimulus policies.
3. c) Comment on what specific measures were put in place in 2020 (direct aid, temporary lay-off (furlough) schemes) and with what aim.

In Arta's last recession, waiters lost their jobs and were taken back on when activity recovered; by contrast, many bank cashiers have been losing theirs year after year, in crises and outside them, because of digital banking.

1. a) Define cyclical unemployment and structural unemployment and classify the two cases.
2. b) Explain why the appropriate policies for each type are different (demand stimulus versus training and reskilling).

In Briga's latest recession, GDP contracted by 2 %, but the unemployment rate rose sharply from 10 % to 15 %.

1. a) A government advisor argues that "it is impossible for unemployment to increase by 5 percentage points if output has only fallen by 2 %, so the employment statistics must be falsified." Refute his statement by analysing labour market duality (temporary versus permanent contracts) and apparent labour productivity.
2. b) If Briga's GDP grows by 2 % next year, recovering to its initial level, can it be predicted with certainty that the unemployment rate will automatically fall back to 10 %? Justify your answer using the concept of economic hysteresis or discouraged-worker effect.
3. c) Design a package of two short-term economic policy measures to curb job destruction in this scenario, under a key constraint: the country is running a high public deficit. Justify how you would ensure their effectiveness without triggering runaway debt.

During a televised debate on the national economy, a pundit states: "If households and firms were more prudent and decided to save more and invest less at the first signs of a crisis, the economy would be much more solid and we would avoid recessions."

1. a) Analytically refute the pundit's statement using the Aggregate Demand model and the paradox of thrift (or paradox of frugality). Explain what happens to national income and the total volume of saving in the economy when all agents attempt to increase their savings at the same time.
2. b) Suppose that the central bank responds by lowering the policy interest rate to 0 %, but households continue to postpone consumption and firms freeze hiring due to fear of the future. What is this situation called and why does conventional monetary policy lose traction?
3. c) Design a combined strategy (fiscal policy and management of expectations) to break this spiral of pessimism without compromising long-term budgetary stability. Justify the transmission channels through which your measures would restore confidence.

Examine the budgetary record of the country of Briga during the last economic cycle:

• Expansion phase (years 1 to 4): Average GDP growth of 3.8 % per year; average budget balance with a deficit of 2.5 % of GDP; public debt increased from 70 % to 82 % of GDP.

• Recession phase (year 5): GDP drop of 3.2 %; the Government cut public spending by 12 % and froze hiring to «clean up public finances in the face of falling revenues».

1. a) Technically justify why the actions of Briga's Government in both phases qualify as a procyclical fiscal policy and predict the impact that the spending cuts in year 5 had on the severity and duration of the recession.
2. b) A Government representative argues: «If families tighten their belts during a crisis because their income drops, the State has a moral and economic duty to do exactly the same». Refute this analogy by explaining how automatic stabilizers work and the macroeconomic difference between an individual agent and the public sector.
3. c) Design a fiscal rule for Briga that compels its leaders to act countercyclically in the next cycle, and identify two real-world dilemmas (political, institutional, or time-lag related) that would hinder its strict implementation.

Briga's statistics department estimates that the potential GDP of the economy stands at 1,250,000 million euros. Observe the macroeconomic forecasts for the next two fiscal years:

• Current fiscal year: Real GDP of 1,200,000 million euros; year-on-year inflation of 1.1 %.

• Next fiscal year: after an ambitious spending and stimulus programme, real GDP is projected at 1,300,000 million euros.

1. a) Calculate the output gap for both fiscal years as a percentage of potential GDP. Interpret the economic meaning of transitioning from one sign to the other in terms of industrial capacity utilization and labor market tightness.
2. b) Using the Aggregate Demand and Aggregate Supply model, predict what will happen to the price level and production costs if the economy reaches the projected 1,300,000 million euros. Why is it stated in macroeconomics that a positive gap is not sustainable in the medium term?
3. c) Given the projection for the next fiscal year, the central bank is debating between tightening monetary policy or keeping interest rates low. Evaluate the risks of both options and justify which decision you would prioritize to ensure macroeconomic stability.

In the wake of international financial turbulence, an economic analyst states: «Ireland is no longer at risk of suffering deep crises like the one in 2008 because the construction sector barely accounts for 5 % of current GDP (compared to 12 % back then) and households are buying fewer homes».

1. a) Partially refute the analyst's claim: explain through which transmission channels (credit crunch, wealth effect, consumer and investment expectations) a crisis originating in the financial system can severely hit employment and output in a modern economy, even without an oversized housing bubble.
2. b) Between 2008 and 2013, the cumulative drop in Irish GDP was 9 %, but unemployment soared from 8 % to over 26 %, an increase far more destructive than the European average. Justify which structural vulnerabilities of the Irish production model and labor market at that time explain this cyclical amplification.
3. c) Design a dashboard with three key early-warning macroeconomic indicators that supervisors should monitor to prevent future overindebtedness crises, explaining what anomalous behavior in each one would trigger the alarm.

The economy of Meridia faces a complex scenario: the inflation rate stands at 6.5 % due to an energy supply shock, while GDP has recorded two consecutive quarters of decline (-1.5 %).

1. a) If the Government passes a large package of public spending and tax cuts to fight the recession while the central bank cuts interest rates to make credit cheaper, predict the effects of this expansionary coordination on growth, inflation, and the trade balance.
2. b) Explain the specific dilemma facing the central bank in this stagflation context: why do traditional cyclical stabilization tools generate an inevitable conflict between the growth objective and price stability in the face of a supply shock?
3. c) Design an alternative policy mix that cushions the impact of the recession on the most vulnerable households without fueling an inflationary spiral or exhausting the State's public debt margin. Justify the chosen instruments.

During a severe recession caused by a drastic fall in private demand, two countries implement opposite strategies:

• Country A: approves a 10,000 million euro public spending cut to reduce its deficit. The following year, its GDP falls by an additional 14,000 million and its public debt-to-GDP ratio increases from 75 % to 81 %.

• Country B: executes a 10,000 million euro public investment programme. Its GDP grows by 13,000 million and its public debt-to-GDP ratio goes from 45 % to 48 %.

1. a) Calculate the public spending multiplier implied by each country's outcome and interpret why the multiplier tends to be larger in recessionary phases with idle resources than during economic booms.
2. b) Explain the paradox observed in Country A: how is it possible for a Government that implements spending cuts to clean up its public finances to end up with a worse debt-to-GDP ratio than before? Break down the impact on the numerator (debt) and the denominator (GDP) through tax revenues.
3. c) Suppose Country B had an initial debt of 115 % of GDP instead of 45 %. Evaluate how this figure would affect the viability of its stimulus plan and what role the risk premium or central bank backing should play to avoid a sovereign debt crisis.

Following a crisis, Meridia's economy experiences a «K-shaped» recovery. The top 25 % highest-earning workers (teleworkable, tech sectors) saw their disposable income grow by 5 % and raised their savings rate from 12 % to 24 %. In contrast, the bottom 25 % lowest-earning workers (in-person services, temporary contracts) suffered a 15 % loss in income and their savings rate plunged into negative territory (-4 %).

1. a) Using the concept of marginal propensity to consume (MPC), predict how this divergence in income distribution will affect the strength of total aggregate demand and the reactivation of GDP. Justify why one euro in the hands of the low-income quartile generates greater economic stimulus than in the high-income quartile.
2. b) A parliamentary group proposes: «To save lost jobs, the State must indefinitely subsidize the wages and costs of struggling firms in the hardest-hit sectors». Critically evaluate this proposal by distinguishing between temporary cushioning measures and the risk of propping up «zombie firms» that hinder productive reallocation.
3. c) Design a public intervention proposal structured along two axes: a conditional short-term income protection measure and an active labor market and training policy aimed at reducing these workers' vulnerability in future economic cycles. Justify how you would finance both measures without harming overall competitiveness.

Unit challenge. Does growing more guarantee living better? Act as an economic advisor and prepare a two-page executive report on Ireland's recent socioeconomic evolution ($2013$-$2023$).

1. Data collection: Go to the CSO (cso.ie) and extract the annual series for real GDP, the unemployment rate, and the Gini coefficient.

2. Cycle and factors: Prepare a table and a graph contrasting year-on-year GDP variation with unemployment. Identify the phases of the business cycle (such as the $-11.2\%$ recession in $2020$ and the subsequent recovery) and indicate which productive factors drove each phase.

3. Welfare and equity: Cross-reference GDP per capita with the Gini index. Discuss the limitations of GDP for measuring social welfare and propose the use of alternative indicators (such as the HDI or the AROPE rate).

4. Proposal: Put forward two economic policy measures to mitigate cyclical fluctuations and improve income distribution.

Evaluation criteria:

• Rigor in collecting and graphically displaying official CSO data.

• Accurate identification of cyclical phases and the determining factors of growth.

• Critical judgment when contrasting quantitative growth with distribution and welfare.

• Technical coherence and feasibility of the proposed measures.