Chapter 8 · The level of overall economic activity
The business cycle
Read the phases of the business cycle: expansion, peak, contraction and trough. Compare changes in real GDP with long-term trend growth.
The economic idea
National output is the total value of goods and services produced by an economy during a period. Gross domestic product measures final production within a country, while real GDP adjusts that value for changes in the general price level so that changes in the volume of output can be compared over time.
The business cycle is the recurring fluctuation of actual real GDP around its long-term trend or potential output. The standard phases are expansion, peak, contraction and trough. These phases describe the direction and turning points of actual activity; they do not imply that every cycle has the same duration or severity.
Actual economic growth is an increase in real GDP. It may occur because idle resources are brought back into use during a recovery. Potential economic growth is an increase in the economy’s productive capacity, caused by changes such as capital formation, improved human capital, technological progress or a larger and more productive labour force.
Potential output is the level of real output that can be sustained when resources are employed at normal capacity. An output gap is the difference between actual real GDP and potential output. Actual output below potential creates a negative output gap; actual output above sustainable potential creates a positive output gap.
During a contraction, falling production tends to reduce firms’ demand for labour and raise cyclical unemployment. Near or above potential output, unemployment is usually lower but demand pressure may contribute to inflation. These are likely relationships rather than outcomes mechanically guaranteed by the curve alone.
Reading the cycle from Peak to Trough and into recovery
“Time” is on the horizontal axis. Moving from left to right follows the economy through successive periods rather than showing different quantities demanded or supplied at one moment.
“Real GDP” is on the vertical axis and represents inflation-adjusted national output. A higher position means a larger volume of goods and services is being produced.
“Long-term growth trend” represents the underlying path of potential output. “Actual real GDP” tracks observed national output, which may move above or below that path.
“Peak” and “Trough” are turning points on “Actual real GDP”. Their guide lines locate the corresponding time and output level without changing the economic sequence.
The long-run path: Long-term growth trend
“Long-term growth trend” slopes upward, representing growth in the economy’s productive potential over time.
Expansion and the turning point at Peak
Before “Peak”, “Actual real GDP” is rising. This is an expansion: actual real GDP increases as firms produce more, employment normally rises and cyclical unemployment normally falls. When recovery closes a negative output gap, this is actual growth through better use of existing capacity, not necessarily potential growth.
At “Peak”, “Actual real GDP” is above “Long-term growth trend”. The economy has a positive output gap in this stylized model: actual output is above its sustainable trend, so scarce resources are likely to be under greater pressure.
Contraction and the turning point at Trough
Between “Peak” and “Trough”, “Actual real GDP” falls. This is a contraction: actual real GDP decreases, firms generally reduce production and cyclical unemployment tends to rise. A prolonged or sufficiently broad decline in economic activity may be described as a recession.
At “Trough”, “Actual real GDP” is below “Long-term growth trend”. The economy has a negative output gap in this stylized model: output and employment are below their sustainable potential.
Recovery after Trough
After “Trough”, “Actual real GDP” turns upward. Firms respond to recovering expenditure by increasing output and rehiring resources. Actual output first moves back toward “Long-term growth trend”; only a rise in the trend itself represents an increase in productive capacity.
Is recovery the same as a return to full employment?
Not necessarily. Real GDP can be rising while it remains below potential output. Firms may be taking on more workers, but some cyclical unemployment can remain until the negative output gap closes.
To explain a phase, describe whether actual output is rising or falling. To explain an output gap, compare actual output with the trend at the same point in time. These are two different comparisons.
How to explain one complete cycle
Begin with “Actual real GDP”, not the labels alone: its upward movement toward “Peak” is expansion and actual economic growth.
Follow the downward movement of “Actual real GDP” from “Peak” to “Trough”. Falling real GDP is contraction and is likely to raise cyclical unemployment.
Finish with the rise after “Trough”. This is recovery in actual output; compare it with “Long-term growth trend” before claiming that productive capacity has increased.
Common mistakes to avoid
- A recession and a negative output gap are not synonyms. A recession concerns falling actual activity; a negative output gap concerns the level of “Actual real GDP” relative to “Long-term growth trend”.
- A recovery toward “Long-term growth trend” is actual growth through greater resource use. It does not by itself shift “Long-term growth trend” or prove potential growth.
- “Peak” is a turning point from expansion to contraction, not automatically the economy’s maximum possible output.
- The familiar rule of two consecutive quarters of falling real GDP is a convenient convention, not a complete definition used by every institution.
- The diagram describes output over time; it does not show the average price level, so inflation must not be read directly from the vertical distance between the curves.
How to draw this diagram
- Title the diagram “The business cycle”. Label the horizontal axis “Time” and the vertical axis “Real GDP”.
- Draw Long-term growth trend first and label it clearly.
- Draw Actual real GDP next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The curve is stylized: real business cycles differ in duration, depth and causes, and are not regular waves.
- The trend is an estimate of potential output, which cannot be observed directly and may be revised as new data become available.
- GDP measures production, not welfare. It omits or imperfectly captures distribution, unpaid work, environmental damage, leisure and many quality changes.
- The diagram does not identify the source of a fluctuation. Demand shocks, supply shocks, financial conditions, expectations and policy can produce different combinations of output, employment and inflation.
- A positive output gap can be sustained only temporarily; the model does not show the inflation process or the policy response needed to return output to a sustainable level.