2.7 Business Cycles

Phases of the business cycle

The business cycle shows fluctuations in real GDP over time through four phases: expansion (rising output/employment), peak (highest point before decline), contraction/recession (falling real GDP, rising unemployment), and trough (lowest point before recovery begins). A recession is often defined as two consecutive quarters of declining real GDP.

Full employment and potential GDP

Potential GDP (or full-employment GDP) represents the economy's long-run productive capacity when resources are used at sustainable rates, including a natural rate of unemployment. Actual real GDP fluctuates around potential GDP: during expansions it may exceed potential (inflationary pressure), and during recessions it falls below potential (an output gap).

Leading, lagging, and coincident indicators

Economists track indicators to identify where the economy is in the cycle. Leading indicators (stock prices, building permits) change before the economy shifts. Lagging indicators (unemployment rate, inflation) change after. Coincident indicators (real GDP, personal income) move with the economy in real time.

Key terms

Business cycle

Fluctuations in real GDP over time, moving through expansion, peak, contraction, and trough.

Peak

The highest point of economic activity before a contraction begins.

Trough

The lowest point of economic activity before recovery/expansion begins.

Potential GDP

The sustainable level of output the economy can produce at full employment, using resources without excess strain.

Leading vs. lagging indicators

Leading indicators (e.g., stock prices, building permits) change before the economy shifts; lagging indicators (e.g., unemployment rate) change after.

Try an AP-style question

During a recession, which typically rises?

1. Business investment
2. Tax revenue
3. Real GDP
4. Cyclical unemployment