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Lesson summary: Business cycles

AP.MACRO:
MEA‑2 (EU)
,
MEA‑2.A (LO)
,
MEA‑2.A.1 (EK)
,
MEA‑2.A.2 (EK)
,
MEA‑2.A.3 (EK)
,
MEA‑2.A.4 (EK)
,
MEA‑2.A.5 (EK)
In this lesson summary review and remind yourself of the key terms, concepts, and graphs related to the business cycle. Topics include the four phases of the business cycle and the relationship between key macroeconomic indicators at different phases of the business cycle.

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 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.
  • 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.

Discussion questions

1) Why does unemployment rise during the recession phase of the business cycle?
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?

Want to join the conversation?

  • blobby green style avatar for user 22sabharwalv
    1. Unemployment rises during the recession phase of the recession phase of the business cycle because the aggregate supply is typically more than the aggregate demand so there is less of a need for employees, less goods and services are being produced. Cyclical unemployment increases because business began laying ooff workers in the need to save money because of low demand for their products.
    2. The difference between a recession and a depression is that a recession is when an economy is on a more gradual decline while a depression is when an economy is on a steep downturn, more than a recession.
    3. If a country is producing beyond its production possibilities curve it is likely experiencing an expansion, where unemployment is significantly decreasing and inflation is increasing. This is typically an unsustainable period that leads t the peak where the economy starts slowly receding.
    (7 votes)
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  • aqualine seed style avatar for user skandasami
    Can a production possibility curve (PPC) be upward-sloping? Why or why not?
    (2 votes)
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  • blobby green style avatar for user san
    Would a government use the same polices to tackle inflation and recession? Kindly explain
    (1 vote)
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  • blobby purple style avatar for user John Smith
    How can a country produce outside their PPC? I thought that is the limit. What's the point of "potential output" if you can output much more than it?
    (1 vote)
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  • scuttlebug green style avatar for user 254564
    Can someone explain why, in the short-run, a business cycle graph shows fluctuations in GDP? I would think that fluctuations in GDP would be in the long-run considering that an entire buisness cycle graph represents fluctuations in GDP from its sinusoidal graph.
    (1 vote)
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  • piceratops seed style avatar for user Iroda Makhamatjonova
    As we move across a business cycle, we are likely to find all of the following EXCEPT:

    a. the same rate of growth for a typical economy, year after year



    b. inflationary gaps



    c. recessionary gaps



    d. real GDP growth that is equal to potential real GDP growth
    please help me with this question
    (1 vote)
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  • blobby green style avatar for user Diamond  Johnson
    What would you expect to happen to the business cycle if a country had a high Gross Domestic Product and a low unemployment rate?
    (0 votes)
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  • piceratops seed style avatar for user vincentlungu001
    I'm happy o see this online of which it can change my future in economics. please pass me more question so that I may get improvement it .?
    (0 votes)
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  • leaf green style avatar for user zd839573
    how does aggregate output change over a business cycle
    (0 votes)
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