Lesson Overview

Heraclitus once said, “Change is the only thing that is constant.”. This certainly applies to national economies.
Every nation’s economy fluctuates between periods of expansion and contraction. These changes are caused by levels of employment, productivity, and the total demand for and supply of the nation’s goods and services. In the short-run, these changes lead to periods of expansion and recession. But in the long-run, economic growth can occur, allowing a nation to increase its potential level of output over time.

Key terms

Key termDefinition
business cycle modela model showing the increases and decreases in a nation’s real GDP over time; this model typically demonstrates an increase in real GDP over the long run, combined with short-run fluctuations in output.
aggregate demandthe total demand for a nation’s output, including household consumption, government spending, business investment, and net exports
aggregate supplythe total supply of goods and services produced by a nation’s businesses
expansionthe phase of the business cycle during which output is increasing
recessionthe phase of the business cycle during which output is falling
depressiona deep and prolonged recession
peakthe turning point in the business cycle between an expansion and a contraction; during a peak in the business cycle, output has stopped increasing and begins to decrease.
troughthe turning point in the business cycle between a recession and an expansion; during a trough in the business cycle, output that had been falling during the recession stage of the business cycle bottoms out and begins to increase again.
recoverywhen GDP begins to increase following a contraction and a trough in the business cycle; an economy is considered in recovery until real GDP returns to its long-run potential level.
potential outputthe level of output an economy can achieve when it is producing at full employment; when an economy is producing at its potential output, it experiences only its natural rate of unemployment, no more and no less.
growth trendthe straight line in the business cycle model, which is usually upward sloping and shows the long-run pattern of change in real GDP over time
positive output gapthe difference between actual output and potential output when an economy is producing more than full employment output; when there is a positive output gap, the rate of unemployment is less than the natural rate of unemployment and an economy is operating outside of its PPC.
negative output gapthe difference between actual output and potential output when an economy is producing less than full employment output; when there is a negative output gap, the rate of unemployment is greater than the natural rate of unemployment and an economy is operating inside its PPC.

Key Takeaways

The business cycle

The business cycle model shows how a nation’s real GDP fluctuates over time, going through phases as aggregate output increases and decreases. Over the long-run, the business cycle shows a steady increase in potential output in a growing economy.

Phases and turning points of the business cycle

The typical business cycle has four phases, which progress as follows:
Phase of cycleDescription
ExpansionWhen real GDP is increasing and unemployment is decreasing
PeakThe turning point in the business cycle at which output stops increasing and starts decreasing
RecessionWhen output is decreasing and unemployment is increasing
TroughThe turning point at which a recession ends and output starts increasing again

Output gaps in the business cycle

The output gap is the difference between actual output and potential output in the business cycle. Potential output is what a nation could be producing if all of its resources were being used efficiently. In the business cycle model, a nation’s potential output at any given time is represented as the long-run growth trend.
Output gaps exist whenever the current amount that a nation is producing is more or less than potential output. In the business cycle model, whenever the business cycle curve is above the growth trend that means an economy is experiencing a positive output gap. Whenever the business cycle curve is below the growth trend that means the economy is experiencing a negative output gap.
When actual output is above the potential output, aggregate demand has grown faster than aggregate supply, causing the economy to overheat. Overheating in this instance means output is occurring at an unsustainably high level, at which the unemployment rate is lower than the natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a recession.
When actual output is below the potential output, aggregate demand or aggregate supply have fallen, causing a fall in employment and output. When a negative output gap exists, the unemployment rate will be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and enter a recovery and expansion.

Potential output in the business cycle

Potential output is also called full-employment output. Potential output is the level of real GDP that would be produced if all resources are used efficiently. For example, if labor is used efficiently, the actual rate of unemployment will be equal to the natural rate of unemployment. When there is a positive output gap, an economy is producing beyond its long-run potential and the unemployment rate will be lower than the NRU. During a recession, real GDP falls below its potential and the unemployment rate is higher than the NRU.
The actual unemployment rate is different than the natural rate of unemployment, at different points along the business cycle, because cyclical unemployment changes along the business cycle. Cyclical unemployment increases due to reduced output during recessions, and cyclical unemployment decreases due to increased output during expansions.

Key models

The business cycle

Figure 1: A typical business cycle showing fluctuations in aggregate output over time and an overall trend toward increasing output over time (economic growth)
The business cycle model shows the fluctuations in a nation’s aggregate output and employment over time. The model shows the four phases an economy experiences over the long-run: expansion, peak, recession, and trough. The business cycle curve is represented by the solid line in the model shown in Figure 1, and the growth trend is represented by the dashed line in Figure 1.
Output gaps are represented by the difference between actual output. During an expansion, the business cycle line is above the growth trend. During a recession, the business cycle is below the growth trend.
The business cycle for the nation of Jacksonia is shown in Figure 22:
In Figure 22 we see a country experiencing long-run economic growth (represented by the dashed line, which is increasing over this entire period), but also experiences a recession and recovery between 2018 and 2020.
Between 2018 and 2019 GDP falls from $2\$2 trillion to $1.8\$1.8 trillion, leaving the economy with a $0.2\$0.2 trillion negative output gap. Between 2019 and 2020 the economy enters a recovery/expansion and output increases back to $2\$2 trillion. Notice, however, that even after the recovery of 2020 the country is still left with a negative output gap. That occurs because GDP has not recovered to its potential level represented by the growth trend in 2020. Why? Because even though output is down, the economy is likely still creating new capital that expands its potential output in the future, even if its current output has decreased.

The production possibilities curve (PPC)

Fluctuations experienced in the business cycle can also be illustrated using the production possibilities curve (PPC), as in Figure 2.
Figure 2: Phases of the business cycle in a PPC
In the PPC above we can observe the following:
A country producing its full employment level of output is at a point on its PPC, such as point Y. When a country approaches a peak in its business cycle, output temporarily expands beyond the full employment level to a point such as point Z, and there is a positive output gap. This is unsustainable as unemployment is below its natural rate and resource scarcity will ultimately cause output to fall. A fall in output below potential output causes a recession and a movement to a point inside the PPC, such as point X, resulting in a negative output gap. A recovery occurs when an economy that is producing inside its PPC due to a recession sees its output start to increase again, such as from point X to point Y.

Common misperceptions

  • An expansion is not necessarily economic growth. When an economy is recovering from a recession, it is in the expansion phase of the business cycle, but it is not experiencing economic growth. Economic growth occurs when the potential and actual output of a nation increases over time. That growth is either shown by the dashed, upward-sloping trend line (the growth trend) in the business cycle model, or by an outward shift of the PPC.
    Suppose an economy had been producing at its potential, full employment output of $2\$2 trillion at point A on figure 33, but then entered a recession and output fell to $1.9\$1.9 trillion, at point B.
    Once the economy begins to recover and output increases to point C, the country’s GDP increases to $2\$2 trillion. However, the movement from B to C is a short run fluctuation that represents a change in actual output. Growth is a change in potential output. The increase from point A to point D does represent economic growth, because the economy’s potential output has increased over time.
  • An economy can produce beyond its full employment level of output. Resources can be overutilized, such as workers working very, very long hours. However, as any student who has ever pulled an all-night study session for an exam knows, you can’t sustain that kind of effort for long.
    Suppose again an economy is producing their potential output of $2.5\$2.5 trillion as represented by point D in Figure 44.
    Suppose that a nation’s output grows faster than it can produce sustainably over the long run, so the nation’s firms begin hiring t structurally and frictionally unemployed workers to meet increasing demand. By doing so, the nation can temporarily expand its output beyond its potential to point E. But as the unemployment rate approaches zero, further increases in actual output become impossible. The nation’s resources will become increasingly overworked and scarce. Eventually, output will have to return to its potential level (point F on the graph) and unemployment will return to its natural rate.

Discussion questions

1) Why does unemployment rise during the recession phase of the business cycle?
A recession is characterized by falling output. As fewer goods and services are produced, there is less need for the workers who produce them. Cyclical unemployment increases as business lay off workers due to low demand for their products.
2) What is the difference between a recession and a depression?
3) If a country is producing beyond its production possibilities curve, what phase of the business cycle is it most likely experiencing?
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