Business Cycle

AP – PPT
 Significance?
Every nation’s economy fluctuates between periods of expansion and contraction. These changes
are caused by levels of employment, productivity, and the total demand for and supply of the
nation’s goods and services. In the short-run, these changes lead to periods of expansion and
recession. But in the long-run, economic growth can occur, allowing a nation to increase its
potential level of output over time.
 Key Terms
 Business Cycle Model
 A model showing the increases and decreases in a nation’s real GDP over time; this model typically
demonstrates an increase in real GDP over the long run, combined with short-run fluctuations in
output.
 Aggregate Demand
 The total demand for a nation’s output, including household consumption, government spending,
business investment, and net exports.
 Aggregate Supply
 The total supply of goods and services produced by a nation’s businesses.
 Expansion
 The phase of the business cycle during which output is falling.
 Key Terms
 Recession
 The phase of the business cycle during which output is falling.
 Depression
 A deep and prolonged recession.
 Peak
 The turning point in the business cycle between an expansion and a contraction; during a peak in the
business cycle, output has stopped increasing and begins to decrease.
 Trough
 The turning point in the business cycle between a recession and an expansion; during a trough in the
business cycle, output that had been falling during the recession stage of the business cycle bottoms
out and begins to increase again.
 Key Terms
 Recovery
 When GDP begins to increase following a contraction and a trough in the business cycle; an economy
is considered in recovery until real GDP returns to its long-run potential level.
 Potential output
 The level of output an economy can achieve when it is producing at full employment; when an
economy is producing at its potential output, it experiences only its natural rate of unemployment, no
more and no less.
 Growth trend
 The straight line in the business cycle model, which is usually upward sloping and shows the long-run
pattern of change in real GDP over time.
 Key Terms
 Positive Output Gap
 The difference between actual output and potential output when an economy is producing more than
full employment output; when there is a positive output gap, the rate of unemployment is less than the
natural rate of unemployment and an economy is operating outside of its PPC.
 Negative Output Gap
 The difference between actual output and potential output when an economy is producing less than
full employment and output; when there is a negative output gap, the rate of unemployment is greater
than the natural rate of unemployment and an economy is operating inside its PPC.
 The Business Cycle
 The business cycle model shows how a nation’s real GDP fluctuates over time, going through
phases as aggregate output increases and decreases. Over the long-run, the business cycle shows
a steady increase in potential output in a growing economy.
 Phases and turning points of the business cycle:
 Expansion
 Peak
 Recession
 Trough
 Output Gaps in the Business Cycle
 The output gap is the difference between actual output and potential output in the business
cycle. Potential output is what a nation could be producing if all of its resources were being
used efficiently. In the business cycle model, a nation’s potential output at any given time is
represented as the long-run growth trend.
 Output gaps exist whenever the current amount that a nation is producing is more or less than
potential output. In the business cycle model, whenever the business cycle curve is above the
growth trend that means an economy is experiencing a positive output gap. Whenever the
business cycle curve is below the growth trend that means the economy is experiencing a
negative output gap.
 Output Gaps in the Business Cycle
 When actual output is above the potential output, aggregate demand has grown faster than
aggregate supply, causing the economy to overheat. Overheating in this instance means output
is occurring at a unsustainably high level, at which the unemployment rate is lower than the
natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a
recession.
 When actual output is below the potential output, aggregate demand or aggregate supply have
fallen, causing a fall in employment and output. When a negative output gap exists, the
unemployment rate will be higher than the natural rate of unemployment. Eventually, the
business cycle will reach a trough and enter a recovery and expansion.
 Potential Output in the Business Cycle
 Potential output is also called full-employment output. Potential output is the level of real GDP
that would be produced if all resources are used efficiently.
 For example, if labor is used efficiently, the actual rate of unemployment will be equal to the
natural rate of unemployment.
 When there is a positive output gap, an economy is producing beyond its long-run potential and
the unemployment rate will be lower than the NRU.
 During a recession, real GDP falls below its potential and the unemployment rate is higher than
the NRU.
 The actual unemployment rate is different than the natural rate of unemployment, at different
points along the business cycle, because cyclical unemployment changes along the business
cycle. Cyclical unemployment increases due to reduced output during recessions, and cyclical
unemployment decreases due to increased output during expansions.
 Key Model – The Business Cycle
 Output gaps are represented by the difference between actual output. During an expansion, the
business cycle line is above the growth trend. During a recession, the business cycle is below
the growth trend.
 Key Model – The PPC
 Fluctuations experienced in the business cycle can also be illustrated using the PPC.
 Positive output gap: Point Z
 Negative output gap: Point X
 Common Misconceptions
 An expansion is not necessarily economic growth. When an economy is recovering from
recession, it is in the expansion phase of the business cycle, but it is not experiencing economic
growth. Economic growth occurs when the potential and actual output of a nation increases
over time. That growth is either shown by the dashed, upward-sloping trend line (the growth
trend) in the business cycle model, or by an outward shift of the PPC.
 An economy can produce beyond its full employment level of output. Resources can be over
utilized, such as workers working very, very long hours. However, as any student who has ever
pulled an all-nigh study session for an exam knows, you can’t sustain that kind of effort for
long.