Short on time? This page is the recap. For explanations and worked examples, use the full study guide.
Recap
- A business cycle is the short-run rise and fall of real output and employment, caused by changes in aggregate demand and/or aggregate supply.
- Expansion: real GDP rises. Recession: real GDP falls.
- Peak: the turning point where expansion ends. Trough: the turning point where recession ends.
- Potential output = full-employment output: unemployment equals the natural rate (frictional + structural).
- Output gap = actual − potential. Negative = recessionary; positive = inflationary.
- “Two quarters of falling real GDP” is only a rule of thumb; official dating bodies look at many indicators.
Key relationships
| Relationship | Formula or rule | Use it to |
|---|---|---|
| Output gap | actual real GDP − potential real GDP | size the gap in money |
| Output gap (%) | (actual − potential) ÷ potential × 100 | compare gaps across years |
| Cyclical unemployment | actual unemployment rate − natural rate | link the gap to jobs |
| Phase | sign of the change in real GDP | recession (−) or expansion (+) |
| Peak-to-trough change | (trough − peak) ÷ peak × 100 | size a recession |
Reading a business cycle graph
- Straight upward line = potential output (trend).
- High points of the actual curve = peaks; low points = troughs.
- Curve falling = recession; rising = expansion.
- Curve above the line = positive gap, unemployment below the natural rate; below the line = negative gap, unemployment above it.
Assumptions behind the numbers
- Real GDP (not nominal) measures output (Topic 2.6).
- Potential output and the natural rate are estimates and can change over time.
- Explaining why AD or AS changes is Unit 3; here you describe and measure the cycle.
Mistakes to avoid
- Calling slower growth a recession. Real GDP must fall.
- Assuming expansion means a positive gap. Early expansions often have negative gaps.
- Calling peaks and troughs phases.
- Reversing the gap sign: actual − potential.
- Thinking full employment means 0% unemployment.
- Dividing the gap by actual output instead of potential.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- Actual real GDP is VD 570 billion and potential is VD 600 billion. What is the output gap? (−VD 30 billion, −5% of potential; recessionary)
- Unemployment is 6.5% and the natural rate is 4.5%. What is cyclical unemployment? (2 percentage points)
- Real GDP fell for two quarters and has just risen by 0.5%. Which phase is the economy in? (Expansion; the trough has passed.)
Next: practice questions.