the trend growth rate and measurements of economic welfare

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Alex Potter 6N2                                                                            3rd March 2009

Economics Essay

  1. What determines the trend growth rate in the United Kingdom? (20)

First and foremost the trend growth rate can be defined as an averaged total of economic growth, illustrated in a linear format on a graph over a 12 month period, or alternatively as the mean growth rate during an economic cycle. The trend rate of economic growth is determined by taking the percentage change in Real GDP (adjusted for inflation) over the course of a year. Compiled in this manner, it allows considerable fluctuations in output to be smoothed - providing more reliable figures.

An output gap exists when there is a differential between the trend rate of economic growth and the actual GDP. A positive output gap usually occurs when the economy is in a “boom” period, whereby the current output lies above the trend. This can be illustrated on figure 1 below, where the horizontal line converges between C and D.

Figure 1

Similarly, a negative output gap can be shown between the other horizontal line, this time going from A to B. Conditions such as these typically occur during recessions (whereby there is two consecutive quarters of negative economic growth).

There are many factors which can have a direct influence upon the trend growth rate in the UK:

Perhaps rather surprisingly, climatic factors play a major role in determining the trend rate of output growth. Variations in sunspots affect the power of the sun’s rays, which consequently has a significant influence on the quality of the crop harvest and therefore the price of the commodities sold, which in turn promotes greater economic confidence and leads to the achievement of larger profits earned, these profits can then be reinvested into the circular flow of income – leading to further growth.

Another factor is the role of speculative bubbles; rapid economic development and growth usually leads to hasty asset price increases. Once it begins to dawn on consumers that market prices for property and shares etc have risen far above their “Real” values, then mass selling of a wide range of financial and non financial assets begins to take place. A very recent example of this effect is the ongoing global credit crunch beginning in 2008. Although house prices have fallen dramatically, the evidence of destruction as a consequence of rapid asset selling has been seen more obviously in the financial markets, whereby shares are now experiencing a bear market (where values have plunged to less than 20% of their previous peak). The effect of this quick fire selling is that the speculative bubble bursts very quickly, this implosion inevitably destroys consumer and business confidence. This then unfortunately leads to an economic recession as consumers cut back dramatically on their spelling.  

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Political business cycle theory applies to democratic countries which have national elections every four or five years. As an election approaches, the party in power may decide to “buy votes” by initiating a pre election boom in aggregate demand and supply, this decision  has a direct influence upon the country’s trend  rate of economic growth -  indeed it is highly likely that the trend  rate will increase in the short term as a consequence. However, after the election (providing the ruling party wins again), then the government will cut back on spending in the economy, in order to prevent ...

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