Business Cycle Phases

Why This Matters

The business cycle isn't just an abstract diagram you'll see on the AP exam—it's the framework economists use to understand why unemployment spikes, when inflation becomes a concern, and how policymakers decide to intervene. You're being tested on your ability to connect these phases to the AD-AS model, identify output gaps, and explain how automatic stabilizers and monetary policy respond to economic fluctuations. Every FRQ about fiscal or monetary policy assumes you understand where the economy sits in the cycle.

Don't just memorize that "expansion means GDP goes up." Know what drives each phase (shifts in aggregate demand or aggregate supply), what indicators signal transitions (leading, coincident, and lagging), and how the output gap changes relative to potential GDP. The College Board wants you to explain turning points, connect phases to cyclical unemployment, and apply concepts like Okun's law to real scenarios. Master the mechanisms, and you'll handle anything they throw at you.

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The Turning Points: Peak and Trough

Turning points mark the transitions between growth and decline. These aren't phases with duration—they're moments when the economy's direction changes. The NBER business cycle dating committee officially identifies these points, often months after they occur.

Peak

• Maximum real GDP—the economy has reached its highest output level before a downturn begins
• Inflationary pressure often peaks here as demand outpaces supply, creating an expansionary gap where actual GDP exceeds potential GDP
• Capacity utilization hits maximum levels, signaling that further growth is unsustainable without triggering accelerating inflation

Trough

• Minimum real GDP—economic activity bottoms out, marking the end of contraction and the start of recovery
• Cyclical unemployment reaches its highest point as the contractionary gap (actual GDP below potential) is at its widest
• Leading indicators like stock prices and new orders begin turning positive, signaling the economy is poised to recover

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The Growth Phase: Expansion

Expansion represents the upward movement from trough toward peak. This is when aggregate demand typically shifts rightward faster than long-run capacity grows, pulling the economy toward or beyond potential output.

Expansion

• Rising real GDP—output increases as businesses respond to growing consumer and investment demand
• Declining unemployment as firms hire workers, reducing cyclical unemployment toward the natural rate of unemployment
• Increasing consumer confidence drives the spending multiplier effect, reinforcing AD shifts and sustaining growth

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The Decline Phase: Contraction (Recession)

Contraction occurs when the economy moves from peak toward trough. This phase results from negative aggregate demand shocks (falling consumption, investment, or net exports) or negative aggregate supply shocks (rising input costs, supply disruptions).

Contraction (Recession)

• Falling real GDP—officially, two consecutive quarters of negative growth, though the NBER uses broader criteria
• Rising cyclical unemployment as businesses reduce production and lay off workers, widening the contractionary gap
• Automatic stabilizers activate—progressive taxes collect less revenue while unemployment insurance and transfer payments increase, partially offsetting the decline in aggregate demand

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The Transition Phase: Recovery

Recovery bridges the trough and full expansion. It's characterized by GDP growth that hasn't yet returned the economy to potential output—the contractionary gap is shrinking but still exists.

Recovery

• GDP growth resumes—real output increases from the trough, though actual GDP remains below potential output
• Unemployment falls gradually as hiring lags behind output growth due to labor market frictions and employer caution
• Monetary and fiscal stimulus from the recession period continues supporting AD, while low inflation gives policymakers room to maintain expansionary policy

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Policy Responses Across the Cycle

Understanding when and why policymakers intervene connects business cycle phases to Units 4 and 5 content. The goal is always to close the output gap—either contractionary or expansionary.

Expansionary Policy (During Contraction/Recovery)

• Countercyclical fiscal policy—discretionary tax cuts or spending increases shift AD rightward to close a contractionary gap
• Monetary policy response—the central bank cuts interest rates to stimulate investment and consumption
• Automatic stabilizers work without legislation—unemployment insurance maintains consumer spending while progressive taxation reduces the tax burden as incomes fall

Contractionary Policy (Near Peak/Overheating)

• Fiscal restraint—reducing government spending or raising taxes to cool an overheating economy
• Interest rate increases—the central bank raises rates to reduce borrowing, slowing AD growth and preventing runaway inflation
• Policy timing challenges—recognition, implementation, and impact lags mean policy often takes effect after the economy has already turned

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Quick Reference Table

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Self-Check Questions

1. Which two phases are characterized by a contractionary gap, and how does cyclical unemployment differ between them?

2. Compare and contrast a recession caused by a negative AD shock versus one caused by a negative AS shock. How would inflation behave differently in each scenario?

3. At which phase of the business cycle would you expect automatic stabilizers to be injecting the most spending into the economy, and why?

4. If the NBER announces a trough occurred six months ago, what phase is the economy currently in, and what should be happening to the output gap?

5. An FRQ asks you to explain why expansionary monetary policy is appropriate during a contraction but potentially harmful at the peak. Using the concepts of output gap and inflation, construct your response.