Question

Please provide a guided answer or a brief explanation, your help is very appreciated.

The figure below illustrates nominal (in current prices) and real (in prices of previous year) GDP of Estonia in 2000- 2015, in billion euro. Estonia 30 25 20 15 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 BGDP (constant 2010 USS) GDP (current USS) a) b) c) Using the figure above, highlight 4 stages of business cycle and describe each stage. What problem is observed in 2008-2009? What should the government and the Central bank do in this situation?

Answer 1

Answer:

a) The real GDP is taken into consideration for the year-to-year analysis to study the 4-stages of business cycle. It is becuase real GDP is a parameter without inflation, while nominal GDP has inflation included in it.

The given phase is 2000-2015. As it is known that there was recession during early 2000s. Thus from the diagram it can be concluded that the economy was at its Trough (lowest point of the cycle) graph starts at the stage of business cycle which is known as Recovery stage. The economy has revived till 2003-2004 (as per the graph). Since the GDP was growing; and the real GDP was significantly more than the nominal GDP. Then it can be observed that the difference between the real GDP and nominal GDP was decreasing. This implies inflation growth. Hence, it reached the stage of Prosperity. From the graph we see in 2007 the economy reached it Peak (highest point of the cycle). Then we see a downfall in the economy where GDP is falling and real GDP is less than nominal GDP, thus indicating high inflation. Thus the economy entered into the Recession stage. This is at 2008-2009. When the GDP is lower than this then there will be the stage of Depression. This is a stage that is not clearly depicted in the graph. It could have occured before 2000. When the situation of recession aggrevates more, then depression occurs. But after 2007 recession recession was pretty much at around a constant. But the graph is clearly showing inflation and even hyperinflation.

b) In 2008-2009, it is observed that real GDP is less than nominal GDP. And hence the problem is inflation. Due to this inflation nominal GDP has grown at a faster than real GDP.

c) In this situation, the government should adapt contractionary policy, i.e., reducing money supply within the economy by decreasion bond prices and increasing interest rates and government spending should also be reduced. The central bank should raise the policy rates, i.e., CRR, SLR, repo rate, bank rates, hence increasing the lending rates.