2.7 Business Cycles

The business cycle is the pattern of real GDP rising and falling over time around potential output. Its two phases are expansion and recession, and its two turning points are peak and trough.

Business Cycles Summary

Business cycles are short-run fluctuations in real GDP and employment caused by changes in aggregate demand and/or aggregate supply. The economy moves through two phases: expansion, when real GDP rises, and recession, when real GDP falls. The turning points are the peak before output falls and the trough before output rises again.

AP Macroeconomics Topic 2.7 also expects you to connect the cycle to potential output. Potential output is the full-employment level of GDP, where unemployment equals the natural rate. The output gap is the difference between actual output and potential output, so an economy can be above, below, or at full-employment output during different parts of the cycle.

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Why This Matters for the AP Macroeconomics Exam

Business cycles connect everything you measured earlier in Unit 2 (GDP, unemployment, and inflation) into one picture of economic health. On the AP Macroeconomics exam, you may need to read a business cycle graph or real GDP data, label phases and turning points, and explain what is happening to output and unemployment at each stage. This topic also sets up later units, where you use the AD-AS model to show how shifts in aggregate demand or aggregate supply pull the economy above or below potential output.

Key Takeaways

• A business cycle is the fluctuation of real GDP (and employment) over time, driven by changes in aggregate demand and/or aggregate supply.
• The two phases are expansion (real GDP rising) and recession (real GDP falling).
• The two turning points are the peak (highest point before output falls) and the trough (lowest point before output rises).
• Potential output, also called full-employment output, is the level of real GDP where unemployment equals the natural rate of unemployment.
• The output gap is the difference between actual output and potential output: positive when actual output is above potential, negative when it is below.
• During expansions, unemployment tends to fall; during recessions, unemployment tends to rise.

Measuring Change in the Economy

Earlier in Unit 2, you learned three major measures of economic activity: gross domestic product (GDP), unemployment, and inflation. The business cycle is how you put those measures together over time to judge where the economy is and how healthy it is.

The economy is cyclical, which means real GDP and employment go through repeated ups and downs instead of growing in a perfectly straight line. That repeating pattern of expansion and contraction is the business cycle.

Business cycles are fluctuations in aggregate output and employment caused by changes in aggregate demand and/or aggregate supply. In AP Macroeconomics, these short-run fluctuations are shown as real GDP and employment rising or falling around potential output. When aggregate demand or aggregate supply increases, real GDP and employment tend to rise; when either decreases, real GDP and employment tend to fall.

The Parts of the Business Cycle

The business cycle is usually drawn by graphing real GDP (total output) over time, with a long-run growth trend line running through the middle.

On that graph:

• Expansion is the upward movement of real GDP from a trough toward a peak.
• Recession is the downward movement of real GDP from a peak toward a trough.
• The peak is the highest point before real GDP begins to fall.
• The trough is the lowest point before real GDP begins to rise.
• The growth trend line represents potential output (full-employment output), the economy's long-run path.

When the actual real GDP curve is above the trend line, there is a positive output gap. When it is below the trend line, there is a negative output gap.

Expansion and Peak

Expansion is the phase where real GDP increases in the short run. During an expansion, unemployment is typically low and falling. The economy keeps growing until it reaches a peak, the turning point where expansion ends and output begins to decline.

Potential output, also called full-employment output, is the level of real GDP that occurs when unemployment equals the natural rate of unemployment. When actual output rises above potential output, the economy has a positive output gap.

Recession and Trough

After a peak, the economy enters a recession, the phase where real GDP declines and unemployment tends to rise. When actual output falls below potential output, the economy has a negative output gap. The recession continues until the economy reaches a trough, the turning point where contraction ends and a new expansion begins.

You may have heard recession defined as two consecutive quarters of negative real GDP growth. For AP Macroeconomics, focus on recession as a phase of the business cycle (a period of declining output), not on that specific rule.

The Business Cycle in Real Life

The business cycle is not just a theory; you can see it in real data. In a graph of U.S. real GDP growth over time, recessions show up as periods when output growth weakens or falls, while expansions are periods when output rises steadily. The gaps between recessions vary in length, so the cycle is real but not perfectly regular.

A graph of the unemployment rate over time tells the same story from the labor market side. Unemployment generally rises during recessions and falls during expansions. Comparing the output picture and the unemployment picture shows why these two indicators move in opposite directions across the cycle.

How to Use This on the AP Macroeconomics Exam

MCQ

• Match descriptions to phases and turning points: rising real GDP is expansion, falling real GDP is recession, the high point is the peak, the low point is the trough.
• Connect the cycle to unemployment: expect lower unemployment in expansions and higher unemployment in recessions.
• Identify the output gap from a graph or description. Above potential output is a positive gap; below potential output is a negative gap.

Free Response

• If asked to draw or label a business cycle graph, plot real GDP over time with a trend line, then mark expansion, recession, peak, and trough clearly.
• Explain cause and effect. Tie movements in real GDP and employment back to changes in aggregate demand and/or aggregate supply.
• Use precise terms. Say "positive output gap" or "negative output gap" instead of vague phrases like "the economy is doing well."

Common Trap

• Do not confuse a turning point (peak or trough) with a phase (expansion or recession). A peak ends an expansion; a trough ends a recession.

Common Misconceptions

• Expansion and recession are phases, while peak and trough are turning points. Mixing these up is a common error.
• A recession is a period of falling real GDP, not just slow growth. For this course, treat it as a phase of the cycle rather than only the "two quarters" rule.
• Potential output is not the maximum possible output. It is the full-employment level where unemployment equals the natural rate, so the economy can temporarily produce above it (positive output gap).
• A positive output gap is not automatically "good" and a negative output gap is not the only problem. A positive gap is linked to rising inflationary pressure, while a negative gap is linked to higher cyclical unemployment.
• The business cycle is not perfectly regular. Real expansions and recessions vary in length and strength, so the timing between recessions is not fixed.

Related AP Macroeconomics Guides

• 2.1 Circular Flow and GDP
• 2.4 Price Indices and Inflation
• 2.2 Limitations of GDP
• 2.3 Unemployment
• Unit 2 Overview: Economic Indicators and the Business Cycle
• 2.6 Real vs Nominal GDP