The objective of economic policy is to ensure that the economy operates on or near the PPF – it would use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in output and incomes in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy’s production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: output and employment expand beyond capacity levels.
An economic recession occurs when output
falls below the economy’s capacity output.
A boom is a period of high growth that
raises output above normal capacity output.
Recent history provides examples. Following the U.S financial crisis in 2008-09 many industrial countries were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, spending and exports. Lower expenditures reduced producers’ revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent. Although economic growth recovered, that growth had not been strong enough to restore the economy to capacity output at the end of 2011. The unemployment rate fell to 7.4 but did not return to its pre-recession value.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be needed to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF as at W in Figure 1.6 by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again we will examine how the economy reacts to such a state in our macroeconomic analysis.
Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.
Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above the economy’s capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z to a point such as X on the PPF.
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