AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/2/2-7)
Unit 2 · Topic 2.7
2.7 Business Cycles
Business cycles are the short-run ups and downs in real GDP and employment around the economy's long-run growth path. They're caused by shifts in aggregate demand or aggregate supply. You need to know the phases, the turning points and how actual output compares with potential output at each stage.
Key terms
- expansion
- peak
- recession
- trough
- potential (full-employment) output
- output gap
Reading the business cycle graph
Picture a graph with time on the horizontal axis and real GDP on the vertical axis. A straight line slopes gently upward across it: that's potential output (also called full-employment output), the economy's long-run growth trend. A wavy line rises above and dips below the trend line: that's actual real GDP.
The wave has two phases and two turning points. An expansion is when real GDP is rising. It ends at a peak, the highest point. A recession (contraction) is when real GDP is falling. It ends at a trough, the lowest point, and then a new expansion begins.
Potential output and the output gap
Potential output is the level of real GDP the economy produces when unemployment is at its natural rate (2.3). It isn't the most an economy could ever squeeze out; it's what it can sustain.
The output gap = actual real GDP − potential real GDP. A negative (recessionary) gap means actual output is below potential, and unemployment is above the natural rate. A positive (inflationary) gap means actual output is above potential, unemployment is below the natural rate, and prices tend to rise faster.
| Phase or point | Real GDP | Unemployment | Inflation pressure |
|---|---|---|---|
| Expansion | Rising | Falling | Building |
| Peak | At its high, often above potential | Low, often below the natural rate | High |
| Recession | Falling | Rising | Easing |
| Trough | At its low, below potential | High, above the natural rate | Low |
What causes the swings
Business cycles happen because aggregate demand or aggregate supply shifts (Unit 3). A drop in consumer or business spending shifts aggregate demand left and can start a recession. A sharp rise in oil prices shifts short-run aggregate supply left and can, too.
A common rule of thumb calls two quarters in a row of falling real GDP a recession. In the United States, the official dates are set by a committee of economists that looks at a wider range of data, including jobs and income.
Meanwhile the trend line keeps rising over time as the economy gains resources and better technology. That long-run growth is the topic of 5.6.
Output gaps don't last forever. In Unit 3 you'll see how wages and prices adjust over time to pull output back toward potential (3.7), and how government spending, taxes and the central bank can try to speed that up (3.8, 4.6).
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Reading the gap
Potential real GDP is $20 trillion. Actual real GDP is $19 trillion, and it fell over the last two quarters. (a) What phase is the economy in? (b) What is the output gap? (c) Is unemployment above, below or equal to the natural rate?
Show the solutionHide the solution
- Step 1: (a) Real GDP is falling, so the economy is in a recession (contraction).
- Step 2: (b) Output gap = actual − potential = $19 trillion − $20 trillion = −$1 trillion. It's a negative (recessionary) gap, about 5% of potential output.
- Step 3: (c) Output below potential means fewer workers are needed than at full employment, so unemployment is above the natural rate. The extra is cyclical unemployment.
Answer: (a) Recession. (b) A negative gap of $1 trillion. (c) Above the natural rate.
Common mistakes
- Putting time on the vertical axis or the price level on the business cycle graph. It's real GDP (vertical) against time (horizontal).
- Calling the peak and trough phases. They are turning points; the phases are expansion and recession.
- Thinking potential output is fixed. The trend line slopes upward as the economy grows.
- Saying unemployment is zero at the peak. It's usually below the natural rate, but never zero.
On the exam
- You won't have to draw the business cycle graph on the free-response section. Multiple-choice questions give it to you to read: identify the phases, the turning points, and whether output is above or below potential.
- Link each phase to the AD–AS model. A recessionary gap on the cycle graph is the same situation as short-run equilibrium to the left of LRAS in 3.5.
Connected topics
Videos
Check yourself
4 questions on 2.7 Business Cycles. Pick an answer to see if you got it, and why.
If an economy's actual real GDP is below its potential real GDP, which of the following is true?
On a business cycle graph with real GDP on the vertical axis and time on the horizontal axis, an upward-sloping trend line shows potential output. At a point where actual real GDP is above the trend line, the economy has
Business cycles, the short-run fluctuations in real output and employment, are caused mainly by
Potential (full-employment) output is the level of real GDP at which
0 of 4 answered