Lesson preview · Business Cycle
The Business Cycle
~10 min · Free to read
Since World War II the US economy has grown by about 2% a year on average. But it has never grown by 2% in a straight line. Some years it races ahead at 5%; in 2009 it shrank by nearly 3%, and in 2020 it fell off a cliff and then bounced back within months. Growth comes in waves.
Those waves are regular enough to have a name and a shape. Economists call the up-and-down pattern the business cycle, and every cycle moves through the same four phases.
Key Term
The four phases
Expansion — output is rising, firms hire, unemployment falls.
Peak — the top of the cycle, where output stops rising.
Recession (contraction) — output falls, firms lay workers off, unemployment climbs.
Trough — the bottom, where output stops falling and the next expansion begins.
The cycle then repeats: trough → expansion → peak → recession → trough.
Key Term
Potential output — the trend the cycle rides on
Potential output is what the economy can produce when it’s at full employment — all its workers, factories, and know-how in normal use. It isn’t a ceiling the economy can never cross; it’s the sustainable trend. Because the labour force, the capital stock, and technology all grow over time, potential output trends steadily upward. Actual GDP wobbles above and below this rising trend — that wobble is the business cycle.
Key Term
The output gap
The output gap is the distance between actual GDP and potential output.
- A recessionary gap (actual below potential) means idle factories and workers — this is where cyclical unemployment shows up.
- An inflationary gap (actual above potential) means the economy is running hot — straining its capacity, which pushes prices up.
The sign of the gap is what unemployment and inflation track.
That’s the big picture: the economy doesn’t grow smoothly, it cycles around a rising trend — and the sign of the output gap is the link to everything else. A recessionary gap means high cyclical unemployment; an inflationary gap means rising inflation. The next two lessons build the engine — aggregate demand and aggregate supply — that actually drives output above or below potential.
Negative means a recessionary gap (slack); positive means an inflationary gap (overheating); zero means the economy is at potential.
Trap · Common Misconception
"A recession is two quarters of falling GDP"
That’s a handy rule of thumb, not the official definition. In the US the call is made by the National Bureau of Economic Research (NBER), which looks at a broad set of indicators — employment, incomes, spending, production — and asks whether activity is in a significant, economy-wide decline. In 2022, US real GDP fell for two straight quarters, yet the NBER did not declare a recession, because jobs and incomes kept growing strongly. The two-quarter rule said “recession”; the broader evidence said otherwise.
Check yourself · no marks
In the first half of 2022, US real GDP fell for two consecutive quarters — the popular definition of a recession. Yet the NBER did not call one. How can both be true?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
An economy’s potential output is 1,000 billion dollars. (a) In a downturn its actual real GDP is 940 billion dollars. Find the output gap, name it, and say which kind of unemployment is elevated. (b) Two years later actual GDP is 1,030 billion dollars. Find the new gap, name it, and say what to expect for inflation.
Practice · 1 / 4
Which phase of the business cycle comes immediately after the peak?
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