The business cycle (or trade cycle) is the pattern of real GDP rising faster, then slower, then falling, then recovering, around its long-run trend. The trend is the economy's potential output: what it can produce with its resources fully used. It rises at the trend growth rate as the quantity and quality of resources grow.
How to read it.
- The top graph is real GDP each quarter over twelve years. The dashed line is the trend (potential output); the solid line is actual output. The gap between them is the output gap: above trend is a positive gap (an inflationary gap), below it a negative gap (spare capacity).
- The coloured strip names each quarter's phase:
- Boom: real GDP is rising and above trend; the peak is its highest point, just before it starts to fall.
- Downturn or recession: real GDP is falling. Two or more consecutive quarters of negative growth is a recession (shaded on both graphs).
- Slump (the trough): the lowest point, just before output starts to rise again.
- Recovery: real GDP is rising again but still below trend.
If the trend growth rate is high and the cycle mild, real GDP may never fall: growth just slows. Then the peak and trough are measured against trend, and the slowdown is a downturn but not a recession.
- The bottom graph is the growth rate of real GDP: on the previous quarter, or (choose Annual in the title bar) each year's real GDP on the year before. The dashed line is the trend growth rate.
- Drag the cursor (or use the Time slider) to see, at that point, the phase, the output gap and what typically happens to unemployment, inflation pressure, tax revenue and welfare spending.
GDP can be high while its growth rate falls. Near the peak, real GDP is at its highest, but its growth rate has already been falling for some time. A falling growth rate is a slowdown, not a fall in output: only a negative growth rate means real GDP is falling.
The sliders. Trend growth sets how fast potential output rises each year. Size of the cycle is how far above and below trend actual output swings, as a percentage of trend. Length of the cycle is the years from one peak to the next. Choose Real and nominal to add nominal GDP, which also rises with inflation: nominal GDP can grow while real GDP falls.
Key formulae. Growth rate = (GDPt − GDPt−1) ÷ GDPt−1 × 100. Output gap = actual real GDP − trend (potential) real GDP. Real GDP = nominal GDP adjusted for inflation (nominal GDP ÷ price index × 100).
Common exam mistakes.
- Saying a recession is when growth slows. A recession is negative growth (falling real GDP) for two consecutive quarters; slower positive growth is a slowdown.
- Reading a fall in the growth rate as a fall in GDP. If growth falls from 4% to 1%, GDP is still rising.
- Using nominal GDP to measure growth: rising prices make nominal GDP grow even when output doesn't.
- Expecting unemployment to fall the moment the economy recovers: it lags behind output, so it is often still high early in the recovery.
Objective: Cambridge IGCSE Economics (0455): economic growth, the stages of the business cycle and the causes and consequences of recession; Cambridge International AS Level Economics (9708): the macroeconomy, economic growth, the output gap and the business cycle, and real against nominal GDP.
Where this fits
- AP: AP Macroeconomics
- AQA: AQA A Level Economics (7136)
- Cambridge: Cambridge IGCSE Economics (0455); Cambridge A Level Economics (9708); Cambridge AS Level Economics (9708) Goes beyond Cambridge IGCSE Economics (0455): 0455 has growth and recession but not the cycle's phases or the output gap.
Goes beyond Cambridge AS Level Economics (9708): The business cycle's phases and the output gap are A Level (9.2), not AS.
- IB: IB Economics HL; IB Economics SL
- NCEA Level 2 Economics: 91222 Analyse inflation using economic concepts and models; 91224 Analyse economic growth using economic concepts and models
- NCEA Level 3 Economics: 91403 Demonstrate understanding of macro-economic influences on the New Zealand economy
- Pearson Edexcel International: Edexcel International GCSE Economics (4EC1); Edexcel International A Level Economics
- USDP: USDP Economics
