Topic 2.7 Notes – Business Cycles

1. What the Business Cycle Is

The business cycle is the recurring pattern of fluctuations in aggregate output (real GDP) and employment.

At its core:

• Real GDP measures total production.
• Unemployment rate measures unused labor.
• Inflation often moves with the cycle.

These fluctuations happen because of changes in aggregate demand (AD) and/or aggregate supply (AS). A financial crisis, a boom in consumer confidence, a supply shock, new technology, government policy shifts. All of these can move AD or AS and push the economy into expansion or recession.

Over time, real GDP trends upward because of:

• Growth in the labor force
• Capital accumulation
• Technological progress

But in the short run, the economy moves above and below that long-run path. Think of it as wiggles around an upward-sloping trend line.

2. Phases and Turning Points of the Business Cycle

Here’s the full picture of one cycle. Notice how real GDP moves above and below its long-run average trend over time.

The business cycle around a rising long-run trend

There are two phases and two turning points.

Expansion (Phase 1)

During an expansion:

• Real GDP is rising
• Employment is increasing
• Unemployment is falling
• Inflation often starts to rise

If output rises above potential output, the economy enters an inflationary gap. That often happens late in an expansion when demand is strong.

Example:

• The long expansion of the 1990s tech boom
• The post-World War II economic boom

Peak (Turning Point #1)

The peak is the highest point of the cycle.

• GDP stops increasing
• The economy is often overheating
• Marks the shift from expansion to contraction

On exams, a peak is identified where the curve changes from rising to falling.

Contraction (Recession) (Phase 2)

A contraction means:

• Real GDP is decreasing
• Unemployment is rising
• Spending falls
• Inflation typically slows

A recession is defined as two consecutive quarters of negative real GDP growth.

A very severe and prolonged recession is called a depression.

Example:

• Great Depression (1930s)
  • Unemployment reached about 25%
• 2008 Financial Crisis
  • Collapse of housing market
  • Sharp drop in AD
  • Unemployment rose above 10%

Trough (Turning Point #2)

The trough is the lowest point.

• GDP stops falling
• Marks contraction to expansion

This is where recovery begins.

3. Potential Output and the Output Gap

To understand where the economy is in the cycle, you compare actual GDP to potential GDP.

Potential Output

Also called full-employment output.

It is the level of GDP where:

• Unemployment = natural rate of unemployment
• The economy is operating on the LRAS curve

Important:

• Full employment does not mean zero unemployment.
• It includes frictional and structural unemployment.

Output Gap

$$\text{Output Gap} = \text{Actual GDP} - \text{Potential GDP}$$

There are two possibilities:

On an AD-AS graph:

• Inflationary gap → equilibrium output is right of LRAS
• Recessionary gap → equilibrium output is left of LRAS

This shows up constantly in FRQs where you must identify whether the economy is above or below full employment.

4. How AD and AS Drive the Cycle

Business cycles are caused by shifts in AD and/or AS.

Expansion Example

Suppose consumer confidence rises.

• Consumption increases
• AD shifts right
• GDP rises
• Unemployment falls

If the increase is large, the economy may move into an inflationary gap.

Contraction Example

During the 2008 Financial Crisis:

• Housing prices collapsed
• Wealth fell
• Investment spending dropped
• AD shifted left
• GDP fell sharply
• Unemployment spiked

That leftward AD shift created a recessionary gap.

The Long-Run Perspective

Even though we cycle through expansions and recessions, the LRAS curve shifts right over time because of:

• Technology improvements
• Growth in capital
• Labor force growth

That’s why the long-run trend of real GDP is upward, even though the short run fluctuates.

On AP questions, be clear about whether they are asking about:

• A short-run fluctuation (business cycle)
• Or long-run economic growth (shifts in LRAS)

They are related but not the same thing.