How a recession may be caused by a decrease in total demand, a decrease in the quantity of resources or a decrease in the quality of resources

Economic Growth and Recession – Cambridge IGCSE 0455

1. Macro‑economic aims (4.1.1)

• Economic growth – increase in real GDP and real GDP per‑capita.
• Full‑employment – unemployment at the natural rate (only frictional & structural). No cyclical unemployment.
• Low inflation – price stability; usually defined as CPI growth below 5 % per year.
• Balance‑of‑payments stability – current‑account deficit not persistently large; exchange‑rate volatility limited.
• Equitable distribution of income – reduction of poverty and inequality (redistributive fiscal policy).
• Environmental sustainability – growth that does not deplete natural resources or cause unacceptable pollution.

Governments must often choose between these aims (e.g., stimulus to reduce unemployment may raise inflation). Understanding the trade‑offs is a key part of the syllabus.

2. Economic growth

• Definition: an increase in the total value of goods and services produced by an economy over a period of time.
• Measurement

  • Real Gross Domestic Product (GDP) – market value of all final goods and services produced in a year, adjusted for price‑level changes.
  • Growth‑rate formula: Growth % = [(Real GDPt – Real GDPt‑1) / Real GDPt‑1] × 100
  • Real GDP per‑capita = Real GDP ÷ population (measures average living‑standard change).

• Supply‑side causes of growth

  • Increase in the quantity of resources – more labour, capital, land or entrepreneurship.
  • Improvement in the quality of resources – better skills, healthier workers, newer technology.
  • Better utilisation of resources – more efficient organisation, lower transaction costs.

• Consequences of growth

  • Higher real incomes and living standards.
  • Increased tax revenue for the government.
  • Potential environmental pressure (see section 6).

• Policy measures to promote growth (4.5.5)

  • Supply‑side (long‑run) measures

    • Investment in infrastructure (roads, ports, broadband).
    • Education and training – raise labour quality.
    • Research & Development subsidies – improve technology.
    • Incentives for foreign direct investment – increase capital stock.
    • Environmental “green” incentives that also raise productivity.

  • Demand‑side (short‑run) measures

    • Expansionary fiscal policy – increase G or cut taxes.
    • Expansionary monetary policy – lower interest rates, increase money supply.

3. Unemployment (5.2)

• Definition: the proportion of the labour force that is willing and able to work but cannot find a job.
• Measurement

  • Labour‑force survey: Unemployment Rate = (Number unemployed ÷ Labour force) × 100
  • Labour force = employed + unemployed (people not seeking work are excluded).

• Types of unemployment

  • Frictional – short‑term job search after leaving a job or entering the labour market.
  • Structural – mismatch between workers’ skills and the skills demanded.
  • Cyclical – caused by a fall in aggregate demand (recessionary unemployment).
  • Seasonal – linked to regular seasonal fluctuations (e.g., tourism).

• Consequences

  • Lower household incomes and consumer confidence.
  • Higher welfare‑state spending.
  • Loss of skills (human‑capital depreciation).

• Policy responses

  • Demand‑side: expansionary fiscal or monetary policy to raise AD.
  • Supply‑side: training programmes, apprenticeships, immigration incentives, subsidies for relocation.
  • Active‑labour‑market policies: job‑search assistance, subsidised employment schemes.

4. Inflation (5.3)

• Definition: a sustained rise in the general price level of goods and services in an economy.
• Measurement – Consumer Price Index (CPI)

  • Basket of typical consumer goods and services.
  • Formula: CPI = (Cost of basket in current year ÷ Cost of basket in base year) × 100
  • Inflation rate = ((CPI_t – CPI_t‑1) / CPI_t‑1) × 100

• Causes

  • Demand‑pull inflation – AD shifts right faster than SRAS (e.g., strong consumer spending).
  • Cost‑push inflation – SRAS shifts left because of higher production costs (wage rises, oil price shock).

• Consequences

  • Reduced purchasing power of money.
  • Uncertainty for businesses → lower investment.
  • If inflation is high, interest rates may rise, affecting borrowing.

• Policy responses

  • Monetary: raise interest rates, reduce money supply (contractionary monetary policy).
  • Fiscal: reduce government spending or increase taxes.
  • Supply‑side: improve productivity, remove bottlenecks, reduce indirect taxes on key inputs.

5. Balance of payments (BOP) (4.2)

• Definition: a record of all economic transactions between residents of a country and the rest of the world over a period.
• Main components

  • Current account – trade in goods and services, net income, net current transfers.
  • Capital account – capital transfers (e.g., debt forgiveness).
  • Financial account – direct investment, portfolio investment, other investment, reserve assets.

• Current‑account balance = Exports – Imports + Net income + Net transfers.
• Implications of a persistent deficit

  • Financing needed from foreign borrowing or reserve depletion.
  • Potential depreciation of the domestic currency.

• Policy tools for BOP stability

  • Exchange‑rate adjustments (devaluation to boost exports).
  • Import tariffs or quotas.
  • Export subsidies (subject to WTO rules).
  • Fiscal measures that affect domestic demand for imports.

6. International trade & globalisation (4.3)

• Specialisation and comparative advantage – countries export goods in which they have a lower opportunity cost and import others.
• Benefits of free trade

  • Higher real incomes (gain from trade).
  • Greater variety of goods for consumers.
  • Technology spill‑overs.

• Trade restrictions

  • Tariffs – raise the price of imports.
  • Quotas – limit the quantity of a good that can be imported.
  • Non‑tariff barriers – standards, licences, subsidies.

• Exchange‑rate concepts

  • Nominal vs. real exchange rate.
  • Appreciation makes exports more expensive and imports cheaper; depreciation has the opposite effect.

• Multinational corporations (MNCs) – firms that operate in more than one country; they can bring inward investment, technology and jobs but may also repatriate profits.

7. Market failure & mixed economy (4.4)

• Public goods – non‑rival and non‑excludable (e.g., street lighting). Usually provided by government.
• Merit goods – socially desirable (e.g., education, vaccinations); often subsidised.
• Demerit goods – socially undesirable (e.g., cigarettes); often taxed or restricted.
• Externalities

  • Negative externality – production creates a cost to third parties (pollution).
  • Positive externality – production creates a benefit to third parties (research spill‑over).

• Monopoly and imperfect competition – can lead to higher prices and lower output than in perfect competition.
• Government interventions

  • Taxes and subsidies (internalise externalities).
  • Price controls – ceilings (to protect consumers) or floors (to protect producers).
  • Regulation – antitrust law, environmental standards.

• Mixed economy – combination of market mechanisms and government intervention; the Cambridge syllabus expects students to recognise the role of both.

8. Recession (4.5.4)

• Definition: a period of falling real GDP, normally identified when output contracts for two consecutive quarters.
• Consequences

  • Higher unemployment (especially cyclical).
  • Lower household incomes and consumer confidence.
  • Reduced business profits → fall in investment.
  • Lower tax receipts → pressure on public‑sector spending.
  • Potential rise in poverty and inequality.

9. How a recession may be caused

9.1 Decrease in total (aggregate) demand

Aggregate demand (AD) = C + I + G + (X − M)

• Consumption (C) – falls when interest rates rise, consumer confidence drops, or income taxes increase.
• Investment (I) – falls with tighter credit, lower expected profits, or higher business taxes.
• Government spending (G) – may fall under fiscal consolidation or austerity.
• Net exports (X − M) – fall if the domestic currency appreciates or if foreign demand weakens.

Result: AD shifts left; SRAS unchanged → lower output and lower price level (recessionary gap).

9.2 Decrease in the quantity of resources (factors of production)

• Labour supply falls – e.g., ageing population, emigration, health crises.
• Capital stock falls – e.g., natural disaster destroys factories, depreciation > replacement.
• Land/natural‑resource loss – droughts, depletion of mineral reserves.

Effect: LRAS (potential output) shifts left. Because LRAS is vertical, the price level may stay roughly unchanged while real GDP falls – a supply‑side recession.

9.3 Decrease in the quality of resources

• Labour quality falls – loss of skilled workers, poor health, low education standards.
• Capital quality falls – outdated machinery, low R&D, poor maintenance.
• Entrepreneurial quality falls – restrictive regulations, weak innovation culture.

Effect: SRAS shifts left; AD unchanged → lower output and higher price level (stagflation‑type recession).

10. Policy responses to each cause of recession

11. Summary table – Causes, Mechanisms, Diagram Shifts, and Typical Policies

12. Key points to remember

• A recession can arise from a demand‑side shock, a quantity‑supply shock, or a quality‑supply shock.
• Demand‑side shocks move the AD curve; quantity‑supply shocks move the LRAS curve; quality‑supply shocks move the SRAS curve.
• Short‑run effects (output, price level) differ from long‑run effects (potential output).
• Correct policy choice depends on diagnosing the underlying cause.
• Macro‑economic aims often conflict – e.g., stimulus to cut unemployment may increase inflation.
• Sustainable “green” growth seeks to raise output while protecting the environment and natural resource base.