The meaning and causes of business cycles

Business cycles describe the short-term fluctuations in an economy's overall economic activity. These cycles show how economies experience periods of growth and decline over time, even as long-term economic growth is possible.

Business cycles are fluctuations in aggregate output and employment. Aggregate output refers to the total production of goods and services in an economy, often measured by gross domestic product (GDP). These fluctuations happen because of changes in aggregate supply (the total supply of goods and services that firms are willing to produce) or aggregate demand (the total demand for goods and services in an economy).

As a result, economies do not grow at a steady rate. Instead, they go through ups and downs, affecting jobs, production, and overall economic health.

The phases of a business cycle

A business cycle consists of two main phases that alternate, reflecting changes in economic activity. These phases can be shown on graphs plotting real GDP over time, where the trend line represents long-term potential growth.

Expansion

Expansion is a phase where the economy grows. During expansion, real GDP increases, employment rises, and businesses produce more goods and services. This phase often leads to higher consumer spending and investment, creating a positive cycle of growth.

Recession

Recession is a phase where the economy contracts. In a recession, real GDP decreases for at least two consecutive quarters, unemployment rises, and production falls. This can result from reduced consumer spending or external shocks, leading to a slowdown in economic activity.

These phases connect in a cycle: an expansion builds until it reaches a high point, then shifts into a recession, which continues until the economy begins to recover.

The turning points in a business cycle

Turning points mark the shifts between the phases of a business cycle. They indicate the highest and lowest levels of economic activity and can be identified on graphs of real GDP.

Peak

A peak is the highest point of economic activity in a business cycle. It occurs at the end of an expansion phase, where real GDP is at its maximum before starting to decline. At this point, the economy is often operating above its long-term potential, with low unemployment but possible inflationary pressures.

Trough

A trough is the lowest point of economic activity in a business cycle. It happens at the end of a recession phase, where real GDP is at its minimum before beginning to rise. Here, the economy is typically below its potential, with high unemployment and underused resources.

After a trough, the economy enters a new expansion phase, starting the cycle again. Graphs of business cycles show these turning points as the top and bottom of the wave-like pattern around the long-term growth trend.

Potential output and the output gap

Potential output represents the maximum sustainable level of production an economy can achieve when operating at full capacity. It is also called full-employment output, as it occurs when unemployment equals the natural rate of unemployment (the level of unemployment expected in a healthy economy, including frictional and structural unemployment but not cyclical).

The output gap measures the difference between actual output (the real GDP at a given time) and potential output.

Types of output gaps

• Positive output gap - Occurs when actual output exceeds potential output, often during the late stages of an expansion near a peak. This can lead to inflation as demand outstrips supply.
• Negative output gap - Happens when actual output is below potential output, typically during a recession near a trough. This results in unused resources and higher unemployment.

The output gap helps explain the phases and turning points of business cycles. For example, a widening negative gap signals a deepening recession, while closing a positive gap might indicate an approaching peak.