Output does not grow smoothly
Over many years, most economies produce more and more. In the short run, though, real GDP does not rise in a straight line. Some years it grows quickly, some years slowly, and sometimes it falls. Employment moves with it: when output falls, firms need fewer workers and unemployment rises.
A business cycle is this pattern of short-run ups and downs in aggregate output (real GDP) and employment. The cycles happen because of changes in aggregate demand (total spending in the economy) and/or aggregate supply (total production at each price level). For example, a fall in household and business spending, or a sudden rise in the cost of energy, can push output down. You will model these causes with the AD–AS model in Unit 3; for now, focus on describing and measuring the cycle.
Always track the cycle with real GDP. As Topic 2.6 showed, nominal GDP can rise while output falls, simply because prices rise.
Phases and turning points
The cycle has two phases and two turning points.
| Part | Type | What happens |
|---|---|---|
| Expansion | phase | Real GDP rises; employment usually rises and unemployment falls. |
| Peak | turning point | The highest point of real GDP before it starts to fall. The expansion ends here. |
| Recession | phase | Real GDP falls; employment usually falls and unemployment rises. |
| Trough | turning point | The lowest point of real GDP before it starts to rise. The recession ends here. |
The order is always: expansion → peak → recession → trough → expansion, and so on. Peaks and troughs are points in time, not periods. Some textbooks call the recession phase a “contraction”; the idea is the same.
How long is a recession? A popular rule of thumb calls two consecutive quarters of falling real GDP a recession. It is only a rule of thumb. In the United States, for example, recession dates are set by a committee of the National Bureau of Economic Research (NBER), which looks at a wide range of indicators such as employment, real income and industrial production, not real GDP alone. For your work, use real GDP data: falling real GDP means recession; rising real GDP means expansion.
Potential output and the output gap
Potential output is the level of real GDP the economy produces when it is at full employment. It is also called full-employment output. At potential output, the unemployment rate equals the natural rate of unemployment: there is frictional and structural unemployment, but no cyclical unemployment (Topic 2.3).
Potential output is not the maximum the economy could ever produce. For a short time, firms can run extra shifts and pay overtime, so actual output can rise above potential. Potential output also grows over time as the economy gains resources and better technology; that long-run growth is the topic of Topic 5.6, Economic Growth.
The output gap measures how far actual output is from potential output:
Output gap = actual real GDP − potential real GDP
It is often shown as a percentage of potential: (actual − potential) ÷ potential × 100.
| Output gap | Actual vs potential | Unemployment | Cyclical unemployment | Name |
|---|---|---|---|---|
| Negative | actual < potential | above the natural rate | positive | recessionary gap |
| Zero | actual = potential | equal to the natural rate | zero | full employment |
| Positive | actual > potential | below the natural rate | negative | inflationary gap |
The names hint at what comes later in the course: a negative gap goes with slack resources and high unemployment; a positive gap tends to put upward pressure on prices.
Worked example 1: reading the cycle from data
Valdoria (fictional country, currency the valda, VD) publishes quarterly real GDP and an estimate of potential output. Figures are in VD billion at 2023 prices. All data are fictional.
| Quarter | Actual real GDP | Potential real GDP |
|---|---|---|
| 2024 Q1 | 101 | 100 |
| 2024 Q2 | 103 | 101 |
| 2024 Q3 | 104 | 102 |
| 2024 Q4 | 103 | 103 |
| 2025 Q1 | 101 | 104 |
| 2025 Q2 | 100 | 105 |
| 2025 Q3 | 102 | 106 |
| 2025 Q4 | 105 | 107 |
| 2026 Q1 | 108 | 108 |
| 2026 Q2 | 110 | 109 |
Question. (a) Identify the peak and the trough. (b) Identify the quarters of recession and of expansion. (c) Calculate the percentage fall in real GDP from peak to trough. (d) Calculate the output gap at the peak and at the trough, in VD billion and as a percentage of potential.
(a) Real GDP rises to 104 in 2024 Q3 and then falls, so 2024 Q3 is the peak. It falls to 100 in 2025 Q2 and then rises, so 2025 Q2 is the trough.
(b) Recession: real GDP falls in 2024 Q4, 2025 Q1 and 2025 Q2 (three quarters in a row). Expansion: real GDP rises up to the peak (2024 Q1 to Q3) and again from 2025 Q3 to 2026 Q2.
(c) (100 − 104) ÷ 104 × 100 = −3.85%.
(d) Peak: 104 − 102 = +VD 2 billion, or 2 ÷ 102 × 100 = +1.96% (a positive, inflationary gap). Trough: 100 − 105 = −VD 5 billion, or −5 ÷ 105 × 100 = −4.76% (a negative, recessionary gap).
Interpretation. Look at 2025 Q3 and Q4. The economy is in an expansion (real GDP is rising), yet the output gap is still negative (−4 and −2). Recovery takes time: output must grow faster than potential to close the gap. The gap closes in 2026 Q1, when actual and potential are both VD 108 billion.
Check. In 2024 Q4 the gap is zero even though the economy is already in recession. The phase depends on the direction of real GDP; the gap depends on its level compared with potential. They answer different questions.
Worked example 2: the cycle and unemployment
Valdoria’s natural rate of unemployment is 5.0%. Its unemployment rate was 4.2% at the peak (2024 Q3), 7.5% at the trough (2025 Q2) and 5.0% in 2026 Q1.
Question. (a) Calculate cyclical unemployment in each of these quarters. (b) Explain how each figure fits the output gap in Worked example 1.
(a) Cyclical unemployment = actual unemployment rate − natural rate.
- Peak: 4.2% − 5.0% = −0.8 percentage points
- Trough: 7.5% − 5.0% = +2.5 percentage points
- 2026 Q1: 5.0% − 5.0% = 0
(b) At the peak, output is above potential (positive gap). Firms are producing more than the full-employment level, so they hire extra workers, and unemployment falls below the natural rate. Negative cyclical unemployment simply means unemployment is lower than its natural level.
At the trough, output is below potential (negative gap of VD 5 billion). Firms need fewer workers, so unemployment rises above the natural rate. The extra 2.5 percentage points of unemployment are cyclical: people out of work because of the recession, not because of normal job search or changes in the structure of the economy.
In 2026 Q1 the gap is zero: output equals potential and unemployment equals the natural rate. This matches the definition of potential output as full-employment output.
Reading a business cycle graph
In multiple-choice questions you may be given a business cycle graph like Figure 1, with time on the horizontal axis and real GDP on the vertical axis. Use this routine:
- Find the potential output line. It is usually a straight, upward-sloping line (the long-run trend).
- Find the turning points on the actual GDP curve: high points are peaks, low points are troughs.
- Read the phase from the slope of the actual curve: falling = recession, rising = expansion.
- Read the gap from the vertical distance: curve above the line = positive gap and unemployment below the natural rate; curve below the line = negative gap and unemployment above the natural rate.
Common misconceptions
- “Slower growth is a recession.” If real GDP still rises, it is an expansion. Recession needs real GDP to fall. (This is like disinflation versus deflation in Topic 2.4.)
- “Expansion means the economy is above potential.” Not necessarily. Early in an expansion, output is often still below potential (2025 Q3 and Q4 in Worked example 1).
- “Peaks and troughs are phases.” They are turning points; the two phases are recession and expansion.
- “Potential output is the most the economy can ever produce.” Actual output can exceed potential for a while, with unemployment below the natural rate.
- Getting the sign of the gap backwards. Gap = actual − potential. Actual below potential gives a negative (recessionary) gap.
- “Zero unemployment at full employment.” At potential output, unemployment equals the natural rate (frictional + structural), not zero.
- Using nominal GDP to spot a recession. Rising prices can hide falling output. Use real GDP.
- Dividing the gap by actual output. The percentage gap is measured relative to potential output.
Where this leads
Unit 3 explains why the cycle happens, using aggregate demand and aggregate supply. You start with Aggregate Demand (AD). First, try the practice questions, then use the revision notes and the checklist to consolidate. If real GDP still feels shaky, go back to Real v. Nominal GDP.
Quick questions
Is a fall in the growth rate a recession?
No. If real GDP grows more slowly but is still rising, the economy is still in an expansion. A recession means real GDP itself is falling.
Will I have to draw a business cycle graph?
The course expects you to read and interpret a provided business cycle graph rather than draw one in a free-response answer. You should still be able to identify every part of it.