Economic Growth, Unemployment and Inflation: Question 2

Worked solution

Part (a): Defining economic growth and identifying the recession

Economic growth is an increase in the real value of the goods and services produced in an economy over a period of time. It is measured as the percentage change in real GDP.

Real GDP fell from Year 2 to Year 3: $\text{Percentage change} = \frac{\text{new value} - \text{old value}}{\text{old value}} \times 100$

$\frac{246 - 252}{252} \times 100 = \frac{-6}{252} \times 100 \approx -2.4\%$

Because this percentage change is negative (real GDP fell rather than rose), the data show that Boravia’s economy experienced a recession in Year 3, rather than growth.

Part (b): Other causes of a fall in real GDP

The question asks for causes other than a fall in total demand. Real GDP can also fall because of changes on the supply side of the economy:

• A decrease in the quantity of resources: for example, workers leaving the labour force (through emigration or retirement) or the capital stock shrinking as old machinery is not replaced. With fewer resources available, the economy is able to produce less.
• A decrease in the quality of resources: for example, a fall in the average skill level of the workforce, or firms being forced to rely on older, less efficient equipment and technology. Even with the same quantity of resources, lower-quality resources produce less output.

Either of these reduces what the economy is capable of producing, causing real GDP to fall even if total demand had stayed the same.

Part (c): Consequences of the recession for firms

During a recession, consumers and other firms typically cut back their spending. For firms in Boravia, this is likely to mean:

• Falling sales revenue: with total spending in the economy lower, firms sell fewer goods and services, so their revenue falls.
• Falling profits, leading to cost-cutting: as revenue falls while some costs (such as rent) stay fixed, profit margins are squeezed. Firms often respond by cutting costs (for example, postponing investment in new equipment or making workers redundant) and in more severe cases, some firms may be unable to continue trading and may close down.

Final answers

• (a) Economic growth = percentage change in real GDP; real GDP fell by about 2.4% from Year 2 to Year 3, so Boravia was in recession.
• (b) A fall in the quantity of resources (e.g. fewer workers/less capital) or a fall in the quality of resources (e.g. less-skilled workers/older technology).
• (c) Falling sales revenue and falling profits leading to cost-cutting (including possible redundancies) for firms.