Business Cycles — AP® Macroeconomics Notes

Ups and downs around a rising trend

Real GDP does not grow smoothly. For a few years it rises quickly, firms hire and unemployment falls; then spending slows, firms cut back and unemployment rises. These repeated swings are the business cycle. Underneath them is a steadier line: the economy's potential output, the real GDP it produces when unemployment is at its natural rate (full employment). Potential output grows over time as the economy gains workers, capital and better technology, and actual real GDP moves above and below it.

Graph of real GDP against time. Potential output is a rising dashed line. Actual real GDP waves around it: an expansion up to a peak, a contraction down to a trough, then another expansion. Output above potential is a positive, or inflationary, output gap; output below potential is a negative, or recessionary, output gap. — **Figure 1.** Real GDP rises and falls around potential output; the shaded areas are the output gaps. LevlPrep original diagram.

Two phases and two turning points

Expansion: real GDP rises. Firms hire, unemployment falls, and near the end inflation tends to pick up.
Contraction: real GDP falls. Firms cut production and lay off workers, so cyclical unemployment rises, and inflation tends to slow.

The peak is the turning point where an expansion ends; the trough is where a contraction ends and the next expansion begins. Peak and trough are points in time, not phases. A recession is a severe, lasting contraction. In the United States a committee of economists dates recessions as a significant, widespread fall in activity lasting more than a few months; a common rule of thumb is two quarters in a row of falling real GDP.

The output gap

The output gap compares where the economy is with where it could sustainably be:

$\text{output gap}$ $= \text{real GDP} - \text{potential output}$

	Negative (recessionary) gap	No gap	Positive (inflationary) gap
Real GDP	Below potential	Equal to potential	Above potential
Unemployment	Above the natural rate: cyclical unemployment	At the natural rate: full employment	Below the natural rate
Inflation	Tends to slow	Steady	Tends to rise
On a PPC	A point inside the curve	A point on the curve	Output stretched beyond its sustainable level for a while

How can output exceed potential? Potential is the sustainable level, not the physical maximum. In a boom firms run extra shifts and pay overtime, and some people put off retiring, so output can rise above potential for a while. Workers and capacity are stretched, firms bid up wages and raise prices, and inflation rises.

Worked example: reading a cycle (invented data, billions of dollars).

Quarter	1	2	3	4	5	6	7	8	9	10
Real GDP	100	103	106	108	107	104	101	102	105	108
Potential	100	101	102	103	104	105	106	107	108	109

Phases. Expansion from Quarter 1 to 4; peak in Quarter 4; contraction from Quarter 4 to 7; trough in Quarter 7; expansion again from Quarter 7.

Gaps. Quarter 4: $108 - 103 = +5$ , a positive (inflationary) gap. Quarter 7: $101 - 106 = -5$ , a negative (recessionary) gap.

The slip: writing the gap with the wrong sign. Subtract potential from actual, and say whether output is above or below potential.

Linking the cycle to unemployment

Cyclical unemployment and the output gap are two views of the same thing. If Halvet's unemployment rate rises to 7.0% while its natural rate is 4.5%, cyclical unemployment is $7.0 - 4.5 = 2.5\%$ , and real GDP must be below potential output: a recessionary gap. If Berovia's unemployment is 3.0% with a natural rate of 5.0%, output is above potential: an inflationary gap.

The chain to explain a downturn: total spending falls, so firms sell less and produce less; real GDP falls below potential (a negative output gap); firms need fewer workers, so cyclical unemployment rises. Later units of the AP® Macroeconomics course model these swings with graphs and show how the economy can return to potential output.