business cycle

Business cycle, also known as the economic cycle, refers to the ups and downs in the economy.

Learning Objectives

In this lesson, we will learn about

1. A basic definition of the business cycle.
2. Four distinct phases of business cycle – expansion, peak, contraction, and trough.
3. Fluctuations in the business cycle.
4. Potential output and output gaps in the business cycle.
5. Nature of business cycle - recurrence, persistence, and co-movement.

What is the business cycle?

The business cycle is the upward and downward movement of GDP levels. It involves the shifts over time between periods of the relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession).

Phases of the business cycle

1. Real GDP
2. Peak 
3. Peak 
4. Contraction
5. Expansion
6. Trough
7. Time

The business cycle has four distinct phases:

1. Expansion – When real GDP is increasing, there is economic growth and unemployment is decreasing.
2. Peak – This is the highest point of the business cycle, when the economy is producing at the maximum allowable output, employment is at or above full employment and inflationary pressures on prices.
3. Contraction – This follows a peak when the economy typically enters into a correction which is characterized by a slow down in growth, a decrease in output, and a rise in unemployment. A particularly long contraction is termed as ‘recession’. During a recession, businesses are slumping, companies are laying off workers, and consumers are generally upset.  If a recession lasts a particularly long time and gets progressively worse, it is called ‘depression’. For example, the Great Depression lasted more than a decade and resulted in thousands of people losing their jobs and their life savings.
4. Trough – The slowing ceases at this phase and at this point the economy has hit a bottom from which the next phase of expansion and contraction will emerge. At this point, contraction ends and the output starts increasing again.

Business cycle fluctuations

The fluctuations in the business cycle are measured in terms of the growth rate of real GDP and occur around a long-term growth trend.

• The period from a trough to a peak is called expansion.
• The period from a peak to a trough is called a recession.

The economy is said to be in a state of depression if it does not begin to expand again after a period of recession.

Potential output

It is the level of real GDP that would be produced if all resources are used efficiently.

For example, if labor is used efficiently, the actual rate of unemployment will be equal to the natural rate of unemployment. When there is a positive output gap, an economy is producing beyond its long-run potential and the unemployment rate is lower than the natural rate of unemployment. During a recession, real GDP falls below its potential and the unemployment rate is higher than the natural rate of unemployment.

The actual unemployment rate is different than the natural rate of unemployment, at different points along the business cycle, because of cyclical unemployment changes along the business cycle. Cyclical unemployment increases due to reduced output during recessions, and cyclical unemployment decreases due to increased output during expansions.

Output gaps in the business cycle

The difference between actual output and potential output in the business cycle is called the output gap.

• Potential output is what a nation could be produced if all of its resources were being used efficiently. It is represented as the long-run growth trend.
• Actual output is what a nation is actually producing.

Whenever the current amount that a nation is producing is more or less than potential output, the output gap exists.

A positive output gap exists whenever the business cycle curve is above the growth trend.

When the actual output is above the potential output, it means aggregate demand has grown faster than aggregate supply. This causes the economy to overheat i.e. output is occurring at an unsustainable high level, at which the unemployment rate is lower than the natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a recession.

A negative output gap exists whenever the business cycle curve is below the growth trend. 

When the actual output is below the potential output, it means aggregate demand or aggregate supply have fallen, causing a fall in employment and output. The unemployment rate will be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and enter recovery and expansion.

Recurrence, persistence, and co-movement in the business cycle

The business cycle is recurrent, as there are repeated episodes of contractions and expansions over time.

The business cycle also displays persistence, as declines in an economic activity tend to be followed by further declines for some time, while growth in economic activity tends to be followed by further growth for some time.

Co-movement means that many economic variables move together in a predictable way over the business cycle. 

A variable that moves in the same direction as aggregate economic activity is said to be 'procyclical', while a variable that moves in the opposite direction is 'countercyclical'. For example, production, investment, average labor productivity, and the real wage are 'procyclical' variables; and the unemployment rate is 'countercyclical'.

If the peaks and troughs of a variable occur before the peaks and troughs in aggregate economic activity, it is said to be a leading variable.

If a variable’s peaks and troughs occur at the same time as the peaks and troughs in aggregate economic activity, it is said to be a coincident variable.

If a variable’s peaks and troughs come after the peaks and troughs of aggregate economic activity, it is said to be a lagging variable.